The Wall Street Journal had an article about the standard 60/40 portfolio, that is 60% allocated to stocks and 40% allocated to fixed income. Last year, 60/40 "tanked" but this year it is doing better.
I've been bagging on straight 60/40 for a long time. It is valid, no doubt about it, it is a valid strategy, but it has been a long time since 40% to fixed income was optimal. The way I've been approaching this has been to build the 40% differently, to not pile the 40% or 35% or 45% depending on the client, all into fixed income. The presence of lower yields, that yes kept going lower, turned bonds, as opposed to bills and some notes, into equity beta. Some called the lowest yields "return free risk."
My experience is that the typical retired person/couple expects growth in exchange for some volatility from the equity portion of their portfolio, they don't want it from their fixed income sleeve. Fixed income holdings with equity beta stand to be far less effective at helping manage equity volatility with 2022 being a text book example that we'll study for the rest of our careers.
The framing of this has always been simple. When bond yields were at all time lows that means prices were at all time highs. Buying a ten year Treasury note or ETF that tracks the ten year when the yield on the note was under 1.00% was taking equity risk. That's the very simple reality. Really under 2.00% it was taking equity risk. But when you buy an equity or equity proxy, there is no zero bound to prevent that equity from going up further. Yeah, you might pick the wrong stock or the wrong time for that stock but there's no "law of physics" to prevent higher prices. If the ten year had gone negative that would have been even a worse trade. The above is why I've taken to referring to bonds as sources of unreliable volatility.
It made no sense to buy down at that low yield to manage equity volatility and 2022 showed it increased portfolio volatility.
Yields were kind of low in the mid 2000's before the financial crisis which was part of the story for why I started to use liquid alternatives (that term didn't exist yet), bond substitutes and bond proxies. This evolved for me into leveraging down and using more reliably negatively correlated holdings. Here's an interesting chart.
One of those lines is a 100% allocation to Vanguard Balanced Index Fund (VBAIX) which is a proxy for a 60/40 portfolio. The other line is 80% to a broad based equity index ETF and 20% to ProShares Short S&P 500 (SH). Over ten years studied, the CAGRs nine basis points apart and the standard deviations are more meaningful 0.54% apart.
They're essentially the same portfolio but the one with SH took no interest rate risk last year and outperformed VBAIX by 491 basis points. I don't have that portfolio for anyone and never would but it is instructive to create understanding for how substitutes can be used to capture certain effects while avoiding the one year/event that was a catastrophe.
If the math is not clear on the 80/20 looking like 60% equities, the allocation is 80% plain vanilla equity and then subtract the 20% in the inverse fund which gets to a 60% net equity exposure.
Here's something else that is interesting.
Each portfolio is just one fund. Both funds are 100% equities. The blue line is the same broad equity index fund as above and was down 19.47% in 2022 while the red line was up 0.71%. Not much yield from the red line but in terms of volatility, I think this is what many people hope for from their bonds. If you've been reading the blog for a while you might be able to guess that the red line is the Merger Fund (MERFX) which is a client and personal holding.
MERFX, any merger arbitrage fund probably, is 100% equity but it is long short, the type of long short that seeks an absolute type of return. I've described this and few others as horizontal lines that hopefully tilt upward. That's not really an equity attribute. MERFX is 100% equity (for the nitpickers, there is cash) but it is not an equity proxy.
I'm not sure how much fixed income that has equity beta should be in a portfolio but I don't think it's a high number.
I have used SH in client accounts in the past and while there is no near term visibility for using it, I imagine in some future cycle I will.
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