AQR: The 60-40 Portfolio Won’t Protect Investors Anymore

The stable inflation of the last decade is unlikely to repeat itself in the 2020s, which could very well undermine the diversification benefits of the traditional 60/40 portfolio.

Illustration by II

Illustration by II

While a mix of stocks and bonds has provided investors with solid diversification benefits over the last decade, that effect will likely be reduced in the coming years, according to a report by the investment firm AQR.

Citing the unusual performance of the stock market and the bond market — the former with valuations at all-time highs and the latter with yields at all-time lows — AQR suggested that the stable market growth of the past ten years has likely come to an end. The report noted that the yield-based expected real return of a 60/40 portfolio had fluctuated around 5 percent for most of the 20th century, but that it began to drop steadily after 1990, reaching roughly 2 percent in the middle of the last decade. Since last year, when the worlds’ biggest economies rushed to inject liquidity into the markets, that figure has dropped even lower.

“Pandemic-related stimulus has been much larger than stimulus after the Financial Crisis, and the financial system is in a very different state, with more stimulus reaching real economies,” the report said. “Rising inflation would present a headwind for both equities and bonds, and may also reduce the diversification benefits between them.”

The AQR paper then evaluated how different asset classes generally respond to inflation in the United States. It found that gold, commodities, and inflation breakevens (for example, a hypothetical strategy that might be long 10-year U.S. TIPS and short 10-year U.S. Treasuries) can provide investors with the best inflation hedges.

The report added that investors should be especially aware of equity risk, which is typically very high in a return-seeking portfolio. For example, AQR found that even in a fairly conservative portfolio consisting of 55 percent equities and 45 percent other assets, that 55 percent in equities carries 87 percent of the portfolio’s risk. And there’s no guarantee, of course, that in the case of a large market drawdown, the central banks will be able to come to the rescue as they did in March 2020.

“The equity market crash of March 2020 was very short-lived thanks to central bank action, but not all bear markets are limited to a 20 percent drop, and not all are short-lived,” the report said. “There were three drawdowns exceeding 40 percent in the last half century, and worse in the half century before that.”

The authors explained that when faced with low expected returns, investors often turn to one of three strategies: a) they take even more equity risk, which subsequently increases the risk of even greater losses; b) they employ option-based tail-protection strategies, which can protect against sharp crashes but may not help mitigate longer-term losses; or c) they increase their allocation to illiquid private credit and equity assets, which may help smooth short-term fluctuations in portfolio performance but don’t necessarily protect investors against inflation — as they put it, “private equity is still equity, and private credit is still credit.”

As an alternative, AQR suggested that investors add “liquid alternatives” to their portfolios, which are strategies “designed to deliver positive long-term returns without concentrated passive market exposure.” These include risk parity, which seeks to spread portfolio risk over assets with various amounts of risk; long/short equity, which attempts to take advantage of market inefficiencies; trend and macro strategies, which seek to profit from dislocations in global equity, bond, currency, and commodity markets; corporate arbitrage strategies, which look to capture the mispricing of risk premia between two related assets; and multi-asset alternative risk premia, which try to capture the risk premium associated with inefficiencies in the market across several asset classes.

“For investors looking to diversify, private assets have some role to play,” the report concluded. “But an allocation to liquid alternatives is also worthy of consideration, as they provide exposure to complementary and fundamentally different sources of return.”