The challenges of owning a ‘balanced’ portfolio consisting of equities and bonds is front of mind given the broad market volatility that has occurred in 2022. ‘Balanced’ portfolios can differ in the proportion of growth assets they hold, anywhere from 50% – 70% growth and 30% to 50% defensive assets. For the purposes of Lonsec’s analysis in this thought piece, we have used 60% growth and 40% defensive assets as the benchmark portfolio, consisting of 30% S&P/ASX 200 TR Index, 15% MSCI AC World Index ex Australia NR Index (AUD Hedged), 15% MSCI AC World Index ex Australia TR Index (AUD), 20% Bloomberg AusBond Composite 0 Year Index AUD, and 20% Bloomberg Global Aggregate TR Index (AUD Hedged). This represents a broad and fairly vanilla exposure to 60% equities and 40% bonds.
The so called ‘death of the 60/40 portfolio’ has been raised many times following the GFC. That being said, this portfolio has performed exceptionally well over this period. The average calendar year return from 2009 to 2021 has been 9.3%, with the highest returning year being 17.8% (2019) and the lowest returning year being -0.5% (2018). With volatility mostly at the lower end of historical norms, risk adjusted returns have also been strong. Those adopting a buy and hold, static approach to portfolio construction have generally been well rewarded.
That has all changed this year. ‘Balanced’ portfolio returns have been challenged by the war in Ukraine and central banks that have pivoted more quickly than expected to raising interest rates in response to inflation. Figure 1 shows the extent of the sell-off in 2022. For the calendar year until the end of May, the ‘Balanced’ portfolio is down -7.1%. This is the worst start to a calendar year over the 20-year period assessed. Of course, 2002 and, in particular, 2008 ended with deeper drawdowns and at this stage it is highly uncertain how the rest of 2022 will shape up.
Figure 1
Source: Lonsec iRate, data is calendar year returns for a 60/40 portfolio consisting of 30% S&P/ASX 200 TR Index, 15% MSCI AC World Index ex Australia NR Index (AUD Hedged), 15% MSCI AC World Index ex Australia TR Index (AUD), 20% Bloomberg AusBond Composite 0 Year Index AUD, and 20% Bloomberg Global Aggregate TR Index (AUD Hedged). YTD 2022 as at 31 May 2022.
What is different in the 2022 sell-off is the performance of bonds and the breakdown in diversification benefits that they typically offer to a balanced portfolio. While the concept of diversification, the idea of not putting your eggs all in one basket, is fairly well understood, the concept of correlation is less so. If the returns of two asset classes are correlated it means they move up and down together. If assets are negatively correlated it means when the value of one asset rises, the other falls. Ideally, portfolios should be made up of asset class constituents that have a low correlation to each other so that when parts of the portfolio fall in value, other areas of the portfolio rise in value. A negative correlation between risky assets, such as equities, and risk-free assets, such as bonds, has tended to hold for much of recent history, especially in market stress events. However, in 2022, the correlation between equities and bonds has been positive. As depicted in Figure 2, both asset classes have sold off together this year, whereas in 2002 and 2008, bonds offered diversification benefits to falling equity markets.
Figure 2
Source: Lonsec iRate, 2022 correct as at 31 May 2022.
While the negative correlation between equities and bonds is often written about as if a universal law of investing, figure 3 shows that correlations between the two asset classes certainly aren’t static through time and can be highly sensitive to changes in market conditions and regimes. Rolling one-year correlations have been quite volatile over the 20 year period under assessment. A more medium-term representation, as shown by the rolling three year correlation, shows that the two asset classes were generally negatively correlated in the period from 2002 to 2012, but turned more positive in the last several years and spiked early in 2022. The takeaway from this is that positive correlations between equities and bonds are not necessarily anything new, rather the correlations are time varying in nature. Of course, a positive correlation between the two asset classes is less acceptable when markets are falling as they have been this year.
Figure 3
Source: Lonsec iRate, for the period January 2022 to May 2022. Equities consists of 50% S&P/ASX 200 TR Index, 25% MSCI AC World Index ex Australia NR Index (AUD Hedged), 25% MSCI AC World Index ex Australia TR Index (AUD). Bonds consists of 50% Bloomberg AusBond Composite 0 Year Index AUD, and 50% Bloomberg Global Aggregate TR Index (AUD Hedged).
What does the future state hold? ‘Regime change’ has become the topic de jour, a term used to describe a structural shift in the economic environment. For much of the last 20-30 years, the environment has been dominated by low inflation (and falling interest rates) and moderate growth, an environment which, all else equal, is favourable for both equities and bonds. Importantly, bonds have been a great diversifier while delivering positive returns.
Conversely, a backdrop of higher inflation (and rising interest rates) and low growth is less favourable for equities and bonds. It is this environment that is dominating markets this year. The duration of these changes is never certain and one can never be certain how long a certain regime will persist. High valuations in both equity and bond markets at the start of this year had certainly made markets more susceptible to a correction when sentiment turned. That being said, markets can be fast moving and naturally reset themselves after periods of extreme market performance. 10 year bond yields in the US and Australia have already priced in a number of rate rises and some multi-asset managers, after a period of little exposure to bonds, are now talking about them offering better value in some circumstances.
While stress in financial markets can be worrying, it is important to focus on your long-term investment strategy and ensure portfolio asset allocations are aligned with your goals and objectives. Figure 5 shows that the variance of shorter-term returns can be wide, however the range of potential outcomes tends to narrow over longer-term time horizons. This highlights the time diversification inherent in many multi-asset portfolios.
Figure 4
| Rolling one-year returns | Rolling three year returns p.a. | Rolling five year returns p.a. | Rolling 10 year returns p.a. | |
| Average annualised return | 8.07% | 7.77% | 7.51% | 7.60% |
| Best annualised return | 24.62% | 15.82% | 12.94% | 10.00% |
| Worst annualised return | -20.26% | -4.21% | 1.29% | 5.31% |
Source: Lonsec iRate using monthly time series of 60/40 Balanced portfolio from 2002 to May 2022 consisting of 30% S&P/ASX 200 TR Index, 15% MSCI AC World Index ex Australia NR Index (AUD Hedged), 15% MSCI AC World Index ex Australia TR Index (AUD), 20% Bloomberg AusBond Composite 0 Year Index AUD, and 20% Bloomberg Global Aggregate TR Index (AUD Hedged).
Note, the average annualised return of the ‘Balanced’ portfolio is between 7.5% and 8.1% p.a. over each rolling timeframe. For those investors with shorter term time horizons, the range of potential outcomes has been exceptionally wide. An investor withdrawing in November 2008 after one year invested experienced a loss of -20.3%. Somewhat unsurprisingly the strongest 12-month return was in the aftermath of the financial crisis in February 2010 with a return of 24.6%. While an obvious lesson here is that investors tend to be well rewarded for investing at the bottom of the cycle (notwithstanding the difficulties of picking the bottom), a major takeaway is that those invested over longer time horizons have a much narrower range of potential outcomes (somewhat easier than picking when to invest). Rolling 10-year periods over the 20 year time period assessed were in the range of 5.3% and 7.6% p.a. The 5.3% p.a. return was for the 10-year period ending December 2011 and included the drawdowns of 2002 and 2008, highlighting that staying the course can be a valuable strategy in itself when correctly aligned to your risk profile and overall objectives.
The multi-asset universe is exceptionally broad consisting of static asset allocation approaches as referenced in the analysis above, in addition to those taking active asset allocation and/or active security selection decisions. If the forward-looking environment continues to be challenged, multi-asset managers will have to lean on these asset allocation and security selection levers to enhance the risk and return profile of their portfolios. Many multi-asset funds have the flexibility in their mandates to tilt portfolios away from their reference asset class benchmark, in addition to introducing other asset classes within their portfolios to support diversification benefits. Forward looking scenario testing and testing of correlation assumptions may also be part of their investment process. Theoretically, this increases the level of diversification and potential return sources available and allows active managers to be more dynamic in responding to changing market conditions or regimes. Funds with greater asset allocation tools can be useful for investors who require greater certainty in outcomes, are close to or in retirement, or have a specific goal suited to the fund in question.
Key takeaways for multi-asset investors
- Investing in the right asset allocation for your risk profile and goals is highly important. This may well be a static asset allocation approach, as is the one described in our analysis, or one that is much more dynamic and tactical in its approach.
- Return outcomes over shorter term time horizons can be wide. Investors who are willing to invest over the longer term have tended to be well rewarded for taking risk.
- The correlation between equities and bonds is time varying and dependent on market regimes. To date, 2022 has been an exceptionally unusual year in the last 20 years with both equities and bonds selling off together.
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