Looking beyond the 60/40 portfolio

Key takeaways

• Having posted an average annual return of 10% since 1980, we expect a 60/40 portfolio to return 4.3% in the coming 10 years. This prospective drop in returns is leading to increased interest in the endowment asset allocation approach, which promises better returns—over 6% on average.
• The endowment approach is characterised by a heavy allocation to equities and alternative assets and involves significant active management to add alpha.
• The alternative investments are used in this approach in order to diversify equity market risk and to hedge against inflation.
• Thanks to their long-term investment horizon, endowment funds are able to bear short-term volatility in order to pursue superior long-term returns.
  

Looking beyond the 60/40 portfolio

Although many optimisation-based asset allocation approaches for a well-diversified portfolio have been developed since the 1950s (for example the mean-variance optimisation (MVO) framework, the Black-Litterman model or the risk-parity approach), some investors, however, ignore these optimisation techniques and prefer to adopt the classic portfolio approach, consisting of 60% equities and 40% fixed income. A 60/40 portfolio is considered to represent a balanced asset allocation and is referred to frequently in Horizon. Equities play the role of supplying capital growth, while bonds are included to provide income returns and risk-reduction benefits.

A US 60/40 portfolio (60% US equites, 40% US 10-year Treasuries) has delivered an average annual return of 8.1% across rolling 10-year periods since 1900. Since 1980, such a portfolio’s 10-year average annualised return has been around 10%, and even higher from the late-1980s to the late-1990s. In that period, equities performed well and, thanks to the drop in long-term yields, so did bonds. The global financial crisis of 2008-2009 took its toll on 60/40 portfolios, but returns rebounded thereafter (see chart 1).

However, in recent years, our return expectations for 60/40 portfolios have declined substantially. We now expect a US 60/40 portfolio to return 4.3% (in US dollars) on average over the next 10 years. To hope for better returns, we believe investors will need to consider private assets.  But such assets are illiquid and their reported returns do not accurately reflect the true risk and correlations with traditional assets. This makes it difficult to apply the optimisation techniques mentioned above.

One approach of particular interest that integrates private assets without recourse to optimisation techniques is the endowment style of investing.

“Many institutional investors have adopted the endowment style of investing.”

The endowment investing approach, pioneered by David Swensen[1], continues to arouse growing interest from institutional investors and wealthy individual investors alike.

The endowment approach is characterised by a heavy allocation to equities and alternative assets and involves significant active management to add alpha. The philosophy underlying the endowment approach is that long-term investors have the ability to bear short-term volatility and therefore can forgo some liquidity to pursue superior returns.

Many institutional investors have adopted the endowment style of investing, including  universities, foundations, pension funds, sovereign funds and even wealth managers. The primary investment objective of endowment funds is to preserve the real value of assets in perpetuity while providing substantial support to their institutions’ operating budget. Endowments rely on a range of alternative investments to diversify equity market risk and to hedge against inflation.

Our return expectations for a standard US 60/40 portfolio over the next 10 years stand at an annual average of 4.3%. But according to our analysis, US endowment funds could provide an average annual return of 5.6% over the same period, with the largest endowments returning 6.4%.

The asset allocation approaches discussed previously assume investors to be rational and ignores their behavioral biases. A goals-based asset allocation is an alternative approach that incorporates behavioural finance into portfolio construction. In this approach, investors’ portfolios are split into a number of sub-portfolios. Each sub-portfolio is designed to be aligned with an individual’s goals in terms of time horizon and risk tolerance, a topic discussed in a separate article.