So, you want to build a balanced 60/40 portfolio? It makes a big difference what ingredients you use.
In a typical balanced fund, the "60" represents 60% equity and the "40" represents 40% fixed income. The latter portion generally uses an aggregate bond index such as the Vanguard Total Bond Index, the Fidelity U.S. Bond Index or the T. Rowe Price U.S. Bond Index (or an assemblage of bonds that seeks to replicate the aggregate bond index).
The 60% equity piece is usually a large-cap U.S. equity fund or possibly a total U.S. stock market index fund. Thus, most balanced funds end up with exposure to two core asset classes: U.S. fixed-income and U.S. equity (usually large cap).
Ignored in this classic version of a "60/40 balanced" portfolio are the following important asset classes: mid-cap and small-cap U.S. equity (when a large-cap U.S. equity fund is used as the 60% piece); non-U.S. equity (which includes both developed and emerging markets); real estate; commodities and natural resources; non-U.S. bonds, Treasury inflation-protected securities (TIPS); and cash.
As shown below in "Equity Core Differences in a 60/40 Portfolio," a balanced portfolio that used large-cap U.S. equity as the 60% piece (in this case, the Vanguard Index 500) and the Vanguard Total Bond Index as the 40% piece produced a ten-year annualized return of 1.90% as of December 31, 2008. (By comparison, the Vanguard Balanced Index-which used the 60/40 allocation model-had a nearly identical ten-year return of 2.07%). However, the balanced portfolio got hammered in 2008 with a loss of more than 20%.
When the Vanguard Total Stock Market Index was used as the 60% piece, the ten-year return improved slightly to 2.42%. This index has an allocation of approximately 70% large-cap U.S. equity, 20% midcap and 10% small cap. Still, despite the inclusion of the latter two, there was only slight improvement in the overall performance of the 60/40 portfolio. This is because true diversification is not achieved by simply adding more classes of U.S. equity. And investors using the total stock market index in the balanced portfolio would have done nothing to protect the performance in 2008 (when it lost 20.2%).
Only when investors add a truly diversified "core" component does the performance of the 60/40 portfolio markedly improve. The ten-year return in this case jumped to 6.62%; risk (as measured by standard deviation) was reduced by about 30%; and the final account value, starting from a base of $10,000, was more than $6,000 higher than the other two 60/40 portfolios. Moreover, the performance of the 60/40 portfolio was "less bad" in 2008-losing only 12.83% while the other two portfolios lost more than 20%.
The secret is using a broadly diversified portfolio as the 60% piece. One such solution is an equally weighted, multi-asset portfolio called the "7Twelve Portfolio." This vehicle offers investors exposure to seven distinct asset classes (U.S. equity, non-U.S. equity, real estate, natural resources, U.S. bonds, non-U.S. bonds and cash) by using 12 different mutual funds and/or exchange-traded funds. Each of the 12 sub-assets is rebalanced annually. Beyond that, there are no tactical attempts to add alpha. Instead, alpha is actually achieved by design. Think of it as "design-driven alpha."
Different Equity Components In A 60/40 Portfolio
The 7Twelve Portfolio is itself a 60/40 portfolio. Therefore, when investors use it as the core equity component in a 60/40 portfolio they actually end up underweight in equity and overweight in fixed income. Yet the performance is significantly better over the past three-, five- and ten-year periods. Investors using the 7Twelve portfolio as the core equity position will see performance lag slightly when the U.S. equity market is buoyant (like it was in 1999 and 2003) but it will offer them dramatically better performance when the U.S. equity market is weak (like it was in 2000, 2001, 2002 and 2008). The long-run performance will be superior when investors use a truly diversified core in a balanced portfolio. (See Figure 2, "Growth of $10,000.")
Balanced mutual funds meet the requirements of a "qualified default investment alternative" (QDIA) under the provisions of the 2006 Pension Protection Act. The other QDIA is a target-date fund. In addition to their built-in "glide path" (the dynamic asset allocation model that changes as the funds approach their target dates) another common attribute of target-date funds is their broad diversification across many asset classes.
Balanced funds don't have a glide path because their allocation stays at or near the 60/40 level over time. However, balanced funds should still contain multiple types of assets to gain the benefits of true diversification. The current reality is that most balanced funds are not broadly diversified but instead stick to an outdated model that typically employs only two assets: U.S. large stocks and U.S. bonds. It's time for a better blueprint for "balanced" funds.
Craig L. Israelsen, Ph.D, is an associate professor at Brigham Young University. He is a principal at Target Date Analytics (www.TDBench.com) and the designer of the 7Twelve Portfolio (www.7TwelvePortfolio.com).