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For decades, the 60% stocks/40% bonds split was the gold standard in portfolio construction and it served investors well time. Over time, asset allocators came to embrace other asset classes, such as real estate and commodities, driving evolution and increased adoption of multi-asset portfolios.
Still, stocks and bonds are the foundations on which portfolios are built, but there have been challenges to that thesis in recent years. Namely, growth stocks have driven equity markets higher while bonds have lagged. Granted a lot of this has to do with the Federal Reserve’s rate tightening campaigning of 2022 and 2023, but the widely observed Bloomberg US Aggregate Bond Index is off 4.4% over the past three years.
Potentially sparking increased need for advisors to scrutinize the need to devote 20%, 30% or 40% of client portfolios to fixed income assets is the following: bonds’ beta, or their sensitivity to broader market movements, is rising. That’s expected of stocks, which are supposed to be riskier than bonds, but when advisors and investors use bonds to buffer against equity risk, they can be left vulnerable due to that rising beta.
Other Factors to Consider Regarding Bonds
Smart money managers know not to get carried with fixed income allocations because bonds’ integration in portfolios isn’t used to drive returns. Rather, bonds have typically been used to provide support against declining equity markets.
Through much of the early part of this century, that strategy worked because bonds were negatively correlated to stocks. Said another way, bonds provided buffers and diversification. However, those negative correlations have waned.
“However, since the Great Recession, stock-bond correlation has oscillated based on whether the market has a palate for risk, whether investor concerns are tilting toward inflation or growth, or other trends, and has turned positive in many periods,” according to State Street Global Advisors (SSGA). “This decoupled relationship between stocks and bonds poses the following question: Do we need to adjust our thinking on bonds' typical role of diversifier in long-term portfolios?”
One way of looking at the current state of affairs with bonds is that they account for significantly larger portions of “average” portfolios than in years past at a time when bonds have rarely been as risky as they are today. Potentially, that’s a recipe for under-performance.
“Bonds are now providing less of a diversification benefit than in the past, but are also requiring a higher portion of investors’ risk budgets,” adds SSGA. “In our view, bonds’ diversification benefits — or lack thereof —and their rising contribution to returns do not justify the risk.”
Where to Search for Diversification, Income
The aforementioned “bond bashing” rightfully stirs questions about what assets can be effectively deployed to reduce portfolios’ dependence on fixed income. On the diversification front, commodities, including gold, broadly remain negatively correlated to stocks.
When it comes to income, private credit and private equity are more accessible than ever before and worth examining, though the latter in listed form has correlations to stocks.
“This close relationship is intuitive, as both are long-only equity exposures and are likely driven by the same fundamental risk factors, yet different in timing,” concludes SSGA. “Diversifying properties of private equity are the result of low volatility characteristics that are the product of performance smoothing due to the longer investment horizons they provide.”
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