Portfolio Manager 40/60:
Born 1990 / Died 2022
Investors should include a deflationary hedge in the form of a short-term bond allocation
By Mark A. Stairs
May 10, 2023
The now widely adopted 40%-10yr US treasury bond and 60%-S&P500 portfolio just capped off its third worst year ever, plunging a rather painful 18% in 2022. You have to go back to the depression era of the early 20th century to find worse results: 1931 (-27.2%) and 1937 (-20.6%). So what happened?… It was all about bonds.
The 40%-10yr US treasury bond and 60%-S&P500 portfolio just capped off its third worst year ever, plunging a rather painful 18% in 2022.
No doubt it was a rough year for US equity investors with the S&P500 down 19.4%. However, from a historical perspective, this decline was not particularly notable, in fact, it’s been down more than nine times over the past century.
The standout was the concurrent negative returns on the bond component of this standard model. Ten-year treasury bonds fell a horrific 17.8%! Indeed, the bond damage was global in nature, with the Bloomberg Global Fixed Income Aggregate Index off 16.2% (in USD).
Intergenerational Recency Bias & Dogma
The 40/60 bond/stock portfolio wasn’t always the gold standard, this evolution really only began in the late 80s. During the 40-year period following WW2 portfolio construction was quite different, for example, conventional wisdom in the 1970s and 80s was that all investors should have a 5-10% allocation to precious metals.
‘The bond damage was global in nature, with the Bloomberg Global Fixed Income Aggregate Index off 16.2% (in USD).’
So, what happened in 2022? Why did so many professional money managers get hammered so badly? I think there are several important factors which led to this result; most importantly a very long declining trend in both rates and bond market volatility from their peak in 1982, complacency resulting from recency bias and the rise of passive investing starting in the early 2000s.
Prior to 1980 the volatility in bonds was higher and the variability of their correlation with stocks was also greater, sometimes positively correlated and sometimes negatively so, with few persistent long-term trends. This required managers to be more vigilant, on their guard and to shift their portfolio structure more frequently.
But the 40-year decline in rates accompanied by lower volatility and a persistently trending negative correlation with stocks had most managers convinced these trends would be with us forever. It did last a very long time, so recency bias eventually became dogma. The only portfolio investors needed was a US-centric 40/60 bond/stock portfolio. No requirement for precious metals anymore, no use for international diversification, this was the portfolio.
‘Prior to 1980 the volatility in bonds was higher and the variability of their correlation with stocks was also greater, with few persistent long-term trends.’
After all, due to its persistent negative correlation with stocks during market selloffs, managers came to believe they had found the Holy Grail of portfolio hedging, an asset with zero hedging costs that went up in value during periods when the riskier stock side of their portfolio was declining.
But because stocks are generally more volatile than bonds when stocks fell 15%, the less volatile, smaller bond allocation might only go up 5%. So smart guys like Ray Dalio, founder of Bridgewater & Associates, realized as early as the 1990s that they could lever up the bond side of the portfolio 3-5x in a volatility-size-matching exercise and structure their portfolio in such a way that when stocks fell 15%, their bonds would go up on a proportionate dollar-for-dollar basis, offsetting all their equity losses.
Furthermore, because they could borrow short at rock-bottom rates and invest in longer-dated bonds, they could earn a positive carry on this portfolio structure. Levered institutional portfolios, what could possibly go wrong!?
‘When stocks fell 15%, their bonds would go up on a proportionate dollar-for-dollar basis, offsetting all their equity losses.’
Throw in a constant bid from the growing trillions of price indiscriminate passive money flows driving prices higher, coupled with a dearth of money managers who have nary a recollection of elevated bond volatility and positive bond-stock correlations and you get a complacent, multi-generational group of money managers that were destined to take the shellacking they did in 2022.
A Bullet-Proof Portfolio for a New Era
Ironically enough, this group of money managers still seems ill-positioned, despite the wake-up call that was 2022. So ingrained is the recency bias, that most are still positioned as they have been for the past two decades, overweight long-duration assets such as non-dividend paying tech stocks and long-dated US treasury bonds, expecting the halcyon days to return soon: the days of central bank QE, zero interest rates, 2% inflation, low volatility, and the limitless expansion of tech stock valuations.
‘…investors should include a deflationary hedge in the form of a short-term bond allocation.’
Indeed, Cathy Wood’s Ark Innovation Fund, the poster child for this cycle’s excesses, saw positive inflows in 2022! This is despite the fact that her collection of grossly overvalued, unprofitable, non-dividend-paying stocks is down 70% from its peak. The bear market won’t be over until these investors have thrown in the towel.
While I believe a paradigm shift to a more volatile, higher inflation decade is underway, I am willing to acknowledge that I could be wrong about this and thus investors should include a deflationary hedge in the form of a short-term bond allocation.
In my opinion, the new bullet-proof portfolio for the coming decade looks more like 30% 1-5yr gov. guaranteed fixed income products, 25% commodity inflation hedges (copper, uranium, oil, nickel, gas, fertilizers, lithium, chemicals), 10% precious metal (disaster insurance), 35% defensive dividend payers (telcos, cable, pharma, tobacco, pipelines, power producers, grocery).
Prepare yourself psychologically now, for the rodeo that lies ahead. In investing, mental toughness counts. Sincerely, Mark.
Mark A. Stairs, B.Eng., CFA. Following the completion of a mechanical engineering degree Mark entered the financial services industry in 1993, finally joining Nesbitt Burns in 1997. Mark is also an avid tennis player and enjoys working on his farm where he grows pine trees.