After the turmoil, balanced portfolios appear to be back on track

The balanced 60/40 portfolio rebounded last year after a traumatic 2022 for investors. Experts see steady returns continuing, with bonds playing a larger role.

A year ago, obituaries for the 60/40 portfolio were piling up after the negative correlation between stocks and bonds collapsed spectacularly. Balanced portfolios saw double-digit losses in 2022 as central banks hiked interest rates in an attempt to slow the highest inflation in decades. Particularly painful was the fact that a conservative asset allocation provided little to no protection.

But after a “reset” of credit and yields — with the Bank of Canada and Federal Reserve each raising their interest rates from near-zero to 5% and higher between early 2022 and mid-2023 — we’re back to a more “normal environment” where asset allocation matters again, said Craig Basinger, chief market strategist with Purpose Investments.

“When the discount rate moves that aggressively in either direction, it just causes all assets to move in the same direction,” he said.

The largest balanced ETF in Canada, the $2.52-billion Vanguard Balanced ETF Portfolio, posted a return of -11.37% in 2022. It bounced back last year, finishing up 12.49%. Over five years, the fund’s annualized return is 6.16%.

Sal D’Angelo, head of product for Vanguard Americas, said the firm forecasts returns in the 6%–7% range for balanced portfolios over the next decade. But while equity returns have driven gains for 60/40 portfolios in recent years, bonds “will do a lot more of the heavy lifting.”

That’s partly because equities are likely to see more modest returns than in the previous decade of low rates, but also because bonds are offering solid yields again. Vanguard’s market outlook for 2024 recommended a higher tilt toward bonds in asset allocations.

Philip Petursson, chief investment strategist with IG Wealth Management, said 60/40 is usually used as an approximation for a balanced portfolio, with managers adjusting based on the market environment. In the low-interest period since the global financial crisis in 2008, that’s meant overweighting equities.

But with aggregate bond funds yielding around 4%, he said, 60/40 is once again the optimal asset allocation.

“Whether you’re looking at government bonds, corporate bonds, investment-grade or high-yield bonds, they’re much more attractive than they’ve been in a long time,” Petursson said.

With a recession looking less likely and corporate balance sheets remaining healthy, “high yield continues to be one of my favourite asset classes within fixed income,” he said.

Basinger said the good news is investors won’t have to lean so heavily on equities now that return expectations for bonds have improved. However, “the bad news is we probably won’t get back to an environment where correlations are as strongly negative as they were for much of the past 12 years,” he said.

Part of the reason is Basinger doesn’t see the so-called “Fed put” — the U.S. central bank intervening with stimulus to prop up markets — being as decisive a factor going forward.

“Since the financial crisis, any time the economy or the market stumbled, the Fed [and other] central banks were pretty quick to apply stimulus in one form or another,” he said.

That backstop may still exist, but to a lesser degree, Basinger said, and with less urgency.

But while stock-bond correlation may not be negative, it will be lower than it was in 2022, D’Angelo said.

“To have diversification, you don’t have to have negative correlation,” he said. “You just need to have non-perfect correlation, which is less than one.”

A year ago, in response to the balanced portfolio’s terrible 2022, some investors were pointing to private assets to diversify portfolios if bonds were no longer providing the ballast. In the year since, several fund managers have introduced new private market products designed for wealthy retail investors.

Basinger said that while alternatives still have a place in portfolios, “I just don’t think the plain vanilla core should be thrown out and overly reduced in lieu of the alternative space.”

He pointed to real assets as a tool to help insulate portfolios from inflation, for example. But he also noted that with yields in the public market more attractive now, not everyone needs private exposure.

Petursson also said there’s a place for alts in portfolios, but that investors should understand the product and who they’re partnering with.

“I think there is a risk in these private equity or private credit funds because there’s been so much money chasing these asset classes over the last couple of years as investment shops have opened up retail products,” he said.

For D’Angelo, the focus for advisors should be keeping clients invested. Last year saw billions of dollars flow into cash products that suddenly offered 5% yield. While D’Angelo said he expects cash to remain a more prominent part of portfolios as interest rates remain higher over the next decade, “that’s not the foundation of an investment portfolio.”

Many investors missed out on last year’s rebound, he added, and advisors should encourage clients to stick to long-term plans and not be thrown by “bumps in the cycle.”