What Happens if the 60/40 Portfolio Underperforms for a Decade?

The success of the simple 60/40 portfolio has been one of the defining features of the investment landscape over the past decade. A combination of persistently declining bond yields and exceptional performance from US equities has meant that it has trounced most alternative allocation approaches. Doing anything but hold a 60/40 portfolio (or a derivation of it) has almost inevitably come at a cost. It is now considered to be the natural, default option by many investors. It is not clear, however, whether this status is because of something innate in the 60/40 structure that makes it the neutral choice, or whether investor opinions would change if it endured a prolonged spell of disappointing returns.   

This piece is not another critique of the 60/40 approach (most of which are attempting to sell another product), nor an assertion that investors must do something else (aside from lower their expectations for future returns). It is about how investors treat evidence. What evidence we choose to use, what we choose to discard and the importance we place on certain elements.

A ‘passive’ allocation to a 60/40-type portfolio is often framed as the obvious, evidence-based investment decision, and there is certainly compelling support for it. The returns have been stellar, particularly since the secular decline in yields began, and it has inevitably been boosted by the low costs typically attached to this approach to investment. Yet in assuming this is now the only approach to adopt in the future, we are inescapably ignoring other pieces of evidence.

Investors in 60/40 portfolios hold significant allocations to the US equity market (which has been a particular boon for non-US investors) and long duration sovereign / quasi-sovereign bonds. Holding a US equity focus in a portfolio now is to choose to ignore the evidence that over the long-run expensive markets tend to produce lower returns than those which are more attractively valued. Furthermore, owning long duration, low yield assets is a recipe for higher volatility and underwhelming returns.

If we suspend our disbelief and imagine that over the next ten years US equities have been trounced by other developed and emerging markets, what would our reaction be? Would the 60/40 still be the in-vogue, evidence-based default, or would something else now be in its place? Given how sensitive our investment perspectives and purported beliefs are to historic performance, it is almost certain that investment industry would be awash with obituaries for a 60/40 approach, probably at the precise time it becomes a more compelling option.

When an investment strategy has been successful, particularly for a sustained period, it is incredibly difficult to envisage this changing. Yet we only have to look at the performance of the value factor over the last ten-years (plus) to understand how this can occur. Having exposure to value is well-supported by the evidence but has failed to deliver meaningfully for a sustained period. Even investment approaches that work will go through arduous period when they don’t. No strategy is immune to this.

In the scenario where a 60/40 portfolio has struggled relative to other options, investors have endured a cost because they have focused on a certain piece of evidence (the long run success of this approach) and ignored other relevant information (the long run poor results of expensive assets). This is perfectly reasonable. All investors are faced with a plethora of evidence, and it is upon us to filter this and focus on that which we believe to be most robust and material.

The danger is to assume that any view we take is neutral. It is not. We are always making judgements and trade-offs. It is easy now to state that a 60/40 approach is simply following the evidence because it has performed so well, for so long. Yet we frame and weigh evidence through the window of recency. If something is working now, then the evidence we have supporting it seems more important and more obvious. It is easy to disregard or underweight evidence to the contrary.

We can see how past performance informs our use of evidence by looking at the typical home equity bias held by investors. From an investment philosophy standpoint there is limited compelling evidence for holding a heavy bias towards our domestic market, but how any given investor perceives the home bias is likely to be dictated by where they are located. In the UK, there is an ongoing clamour to remove this home skew. Not because everyone has suddenly alighted upon the evidence, but because returns from the UK equity market have been wretched (on a relative basis) for years. By contrast, is it unlikely that US investors are desperate to increase their exposure to underperforming international markets.

If anything, in this scenario, it is UK investors that should be more circumspect about the speed of such a shift in allocation given the evidence of strong long-run performance from undervalued markets, but this is far from the case. Recent performance is not only used as the most important piece of evidence, but it also frames how we perceive all other information.  

Our time horizons are also a major defining factor in the evidence we choose to follow and that which we choose to ignore. Investment approaches supported by the most robust evidence only play out over of the long-run (if at all) and patience is required to see it come to fruition. One thing the investment industry has little of is patience. That is why the evidence of what is performing well right now is so compelling. We are not asking people to wait, to believe something different to what they are currently witnessing or bear uncomfortable risks.

Even if we consider something to be the neutral investment option it is imperative to consider the evidence we are using to support that view and also justify why we have chosen to ignore other pieces of evidence. We also need to envisage a future where the default disappoints and understand how we would react in such a scenario. The 60/40 has been a great option for many investors, but we cannot forget that it is an investment view and should treat it as such.  

Only Invest in Active Managers If You Can Withstand Prolonged Periods of Underperformance

The argument against the use of active management is often focused on the difficulty of identifying a fund manager with the requisite skill to outperform the market. This perspective, however, ignores a critical element of employing active fund managers. It is not simply about finding the right ones, it is about being able to stick with them over the long-term. An elegant study recently released by Vanguard put this into sharp contrast. It showed that even successful active funds endured protracted, multi-year spells of underperformance. The message is simple: if we are not able to withstand years of under-par returns, we should not be using active managers at all.

The Vanguard study, which looks at the performance of open-ended actively managed equity funds with US domicile, covers over 2,500 funds across a 25-year period. The entire piece is worth reading but there are some critical observations:

– “Close to 100% of outperforming funds have experienced a drawdown relative to their style and median peer benchmarks over one, three and five year evaluation periods”.

– “Eight out of ten outperforming funds had at least one five year period when they were in the bottom quartile relative to their peers”.

Underperformance is an inevitable and expected part of the return profile of all active managers, even those with skill who manage outperform over the long-term. Hopefully, the study lays to rest the spurious but pervasive notion that years of consistent outperformance is either a reasonable expectation or anything more than random patterns being weaved.

Identifying a skilful active manager is incredibly difficult; but even if we can do it, it will not matter if we are unable to cope with the barren periods. The first question we ask before considering investing in an active manager should not be – do we have the ability to find one? Rather, are we in a position where we could hold them for the uncomfortable and volatile long-term? If the answer is no, we should not even begin the search.

It is easy looking at historic underperformance on a screen before we invest; living through it is an entirely different proposition. The doubts about the quality of an underperforming manager or their suitability for the prevailing market environment are relentless. Fund investors spend most of their time worrying about the managers who are underperforming. It is difficult to overstate how behaviourally taxing it is. The easy option is always to switch from the bothersome laggard and into a flavour of the month leader to make the questions and concerns disappear, at least for a time.  

Persisting with an underperforming active fund as an individual is extremely challenging, but even if we have the personal wherewithal, the problem does not vanish.  It is not just us that has to endure it – it is the other stakeholders too.

The underperforming fund manager and the firm they work for must also retain conviction. It is of little use if we stand firm only to see the manager change their approach or their employer fire them.  The incentive of the fund manager is to keep their job and for the asset management company to preserve assets; keeping faith with an under-scrutiny investment strategy which has delivered years of poor results is not aligned with either of those. Unfortunately, for a fund manager, possessing investment skill might not be enough.

For professional fund investors, the final hurdle is the people we are accountable to. Do we work in an environment that is supportive of adopting a long-term approach and willing to endorse investment decisions that will look wrong, often for sustained periods?  There is no point investing in active funds if we will repeatedly be forced out of them (due to pressure from others) after three years of underperformance. As a pattern of investment behaviour, it is hard to think of a more pernicious strategy.  

There are no easy solutions to the problem of persevering with a struggling but skilful active fund manager. The temptation to sell will often be overwhelming. There are two ways of giving ourselves a fighting chance. The first is setting the correct expectations at the outset – we need to be abundantly clear about the prospects for a fund or manager with all interested parties. Even if we are right, multiple difficult years are inevitable.

The other potential ameliorative is manager blending. Combining active fund managers of different styles should not only smooth returns and provide diversification benefits; if done well it is an effective behavioural tool. When one manager is experiencing a fallow period, another is likely to be enjoying a tailwind and delivering superior results. The whole concept of blending is built on the notion that not everything will work, all the time. Even attempting it helps in setting the correct expectations. Furthermore, the pain of the underperformance from one fund will be offset (somewhat) by its more productive counterpart.

Blending is no panacea. It is far from a precise science and if it is done too well, we will end up owning an expensive version of the market. It will also not stop us and others worrying about the straggler. The pain felt about the underperformer is likely to be more acute. These issues notwithstanding, it is the best option available to investors in active funds.

Unfortunately, even if we can hold active funds through tumultuous periods of performance it is not enough to guarantee positive outcomes. The manager we invest in might actually be underperforming because something has gone wrong, and the right course of action is indeed to sell.

Nobody said it was easy.



Vanguard Study: Patience with Active Performance Cyclicality