Over the next decade, the traditional 60-40 portfolio will post average lower annual returns than many online bank accounts do today, according to a web tool from Newport Beach, Calif.-based Research Affiliates.
A portfolio consisting of 60 percent equities and 40 percent bonds will post average annual real returns of just 50 basis points over the next decade, said Jim Masturzo, Research Affiliates’ senior vice president, asset allocation, on a Wednesday webcast.
“Investing is hard, and this market will kick you in the teeth,” said Masturzo. “The focus should be on how do we create portfolios well-positioned for the future that are able to meet our future spending obligations. For a majority of investors, risk is failing to meet their long-term spending needs.”
Masturzo explained that most of the firm’s assumptions lie on projections for 50 basis points of annual growth from large-cap stocks. The S&P 500 is projected to produce an average annual dividend yield of 2 percent and long-term earnings growth of 1.3 percent, but lose 2.8 percent in valuation annually.
By comparison, annual percentage yields of 1 percent or more are available in online savings accounts from Ally and Synchrony, and online checking accounts from Aspiration.
The low return estimate might come as a shock to some investors, admits Masturzo. In equities markets, earnings growth has failed to keep up with rising stock prices, while fixed-income returns will continue to be muted by low short-term interest rates and monetary tightening by central banks.
Yet a 60-40 portfolio had returned 4.9 percent net of inflation year to date through May 31, said Masturzo, with the Bloomberg Barclays U.S. Aggregate Bond Index yielding 1.2 percent, while U.S. large-cap stocks have returned 7.4 percent—a “spectacular rise in the markets.”
“The most common question we hear is: ‘Can this continue?’” said Masturzo. “I don’t know, but history tells us that it is unlikely.”
During the webcast, Masturzo used Research Affiliates’ newly updated Asset Allocation Interactive (AAI) tool to visually demonstrate the firm’s projections for future returns across asset classes, geographies and factors.
Research Affiliates predicts that there is a less than 1 percent chance that a traditional 60-40 portfolio will be able to post real returns of 5 percent or more over the next decade. The company assumes that the portfolio will generate a 2.4 percent average annual net yield, but an average annual valuation change of 1.9 percent.
A portfolio offering a 5 percent average annualized return is still possible, said Masturzo, but advisors would be better off optimizing returns through diversification and rebalancing than by adding risk.
Masturzo said that advisors and investors will have to think beyond traditional investments to generate yield and growth.
“Opportunities do exist beyond mainstream stocks and bonds to take advantage of asset classes with lower valuations or attractive cash flows,” Masturzo said. Yet most advisors are diversifying within highly correlated areas of the market and not across asset classes. Higher returns might be found in credit markets, commodities, REITs and private investment opportunities, and within non-U.S. markets.
Investors might also consider active strategies to produce differentiated returns, said Masturzo.
“Alpha is an important part of this discussion, especially when you’re talking about expensive asset classes,” he said. “We’re big believers in adding value through contrarian trading.”
At the heart of the tool is a scatterplot of risk and return demonstrating historical data or expectations from Research Affiliates projecting an efficient frontier defining a normal distribution around a portfolio’s probable returns.
The AAI tool is an interactive web tool that provides expected return data across more than 130 assets and model portfolios. The tool allows advisors to create and customize their own portfolios, or to blend existing portfolios to view expected and optimized returns and risk across five different currencies, and to discover correlations within their portfolios.
AAI also allows users to view cyclically adjusted price-to-earnings (CAPE) ratios across equity markets and compare them with each other, or compare current valuations against the historical range for each market.
During his demonstration, Masturzo used the AAI tool to show that, based on the Research Affiliates projections, increasing the volatility of a 60-40 portfolio by 14 percent by diversifying away from bonds and U.S. stocks is still not enough for it to reliably post 5 percent average annualized returns.
“Increasing volatility tolerance is a bad approach to achieving 5 percent real returns,” said Masturzo. “For those who want to do so, we believe you should approach a maverick approach to risk and add value beyond a passive approach by accessing contrarian advice within asset classes.”