Reinventing the 60/40 portfolio – an all-weather approach

​The traditional 60/40 balanced portfolio is facing a structural breakdown as resurgent inflation and soaring government debt turn nominal bonds into an unsafe asset class. When asset correlations rise and real returns turn negative, traditional diversification methods fail to protect client outcomes. Discover the three strategic levers asset allocators must pull to reinvent their bond allocations and build true all-weather portfolio resilience.

What is the 60/40 portfolio

The classic “Balanced” multi-asset portfolio is known as the 60/40 portfolio, representing a 60% allocation to equities and a 40% allocation to bonds.
The idea was that equities provided long-term growth, whilst bonds provided a stability, income and diversification.
From an asset allocator's portfolio construction perspective, this meant that:

• Volatility: equities were traditionally higher volatility and bonds lower volatility – a mix gave a balance
• Correlation: equities and bonds traditionally had a low correlation, thereby enabling “true” risk-based diversification from combining low correlation/uncorrelated assets
• Positive Real Returns: bonds were traditionally the “sure thing” part of a portfolio delivering a certain return set by a predefined set of cashflows, which were unaffected by stable inflation expectations.

Why does the 60/40 portfolio matter?

The 60/40 portfolios is important because approximately 2/3 of investors select or are recommended a “balanced” risk profile based on their risk preferences.  This is evidenced by the AUM distribution across multi-asset funds.

What has changed?

In a normal low inflation regime (prior to December 2021), the 60/40 principle worked.
However there were three major macro pressures on Bonds since 2008

1. Near Zero Interest Rate Policy (“ZIRP”) 2008-21: that followed the Global Financial Crisis drove real (inflation-adjusted) yields negative: nominal bonds ceased to protect value in real terms
2. The level of government indebtedness 2008-21: massively increased following 1) the Global Financial Crisis and 2) COVID. This raises the risk of “debt indigestion” – where there insufficient appetite from investors to invest in more government debt, and concerns rise as to how and whether governments can repay that debt.
3. Resurgent inflation 2021-26: post Covid, and related to the Russia/Ukraine and US/Iran conflicts and associated energy supply shocks has reignited inflation in the developed world.  Inflation erodes the value of nominal assets such as cash and bonds.

How do these macro regime changes impact bonds as an asset class?

This led to the altered behaviour of bonds as an asset class in a multi-asset portfolio context.
From a portfolio construction perspective, this meant that

• Volatility: the uncertainties around bonds from these changing macro factors, meant their volatility has increased. The one year volatility of UK Bonds and Equities was actually identical in 2022.  Thus Equity/Bond portfolios can be a combination of two high-volatility asset class.
• Correlation: the greater riskiness of bonds and their greater relationship with broader market risk means that the correlation between equities and bonds has increased.  This thereby dilutes the diversification effect of combining two volatile, increasingly correlated assets.
• Negative Real Returns: the total return of bonds (particularly longer-duration bonds) in a rising interest rate and rising inflation environment is necessarily negative.  A bond allocation has therefor introduced structural weakness into portfolios instead of structural strength.

 
This can be summarised in the table below:

How can asset allocators ensure portfolio resilience?

Asset allocators are realising that once again, as in 2022, Bonds do not have the defensive diversifier characteristics they traditionally should have.  So what are the alternatives? Well, Alternatives!  But what kind of alternatives.
As we outlined to our asset allocator clients in 2021, we believe that asset allocators have the following levers to pull to ensure portfolio resilience to create an alternative to Bonds in a multi-asset portfolio:

1. Reduce overall bond allocation in favour of volatility-constrained “all-weather” diversified asset/absolute return strategies, which can have similar volatility to bonds, but a differentiated return pattern that can be positively correlated with inflation
2. Within a residual bond allocation, actively manage duration to focus on rate sensitive assets, to avoid long-dated nominal bonds and consider Emerging Market debt (there is a role reversal as emerging markets are in better fiscal shape than developed markets).
3. For long-run inflation hedging, consider UK equity income where total returns are underpinned by progressive dividends from cash-generative, reasonably valued companies which can pass-through inflation.

​Risk budgeting

When implementing the above, asset allocators must all the time being mindful of overall volatility contribution (in absolute terms, and adjusted for correlation).
That way, portfolio volatility can be maintained within the levels explained, recommended and expected with clients, whilst altering the underlying structure to remove the risk of weakness from “soggy” bonds that struggle to hold their value in inflationary times.
In 2022, the importance of risk budgeting was critical and unfortunately, some asset allocators failed to do this properly. 
We made the call for incorporating (volatility-constrained) Liquid Real Assets into a portfolio where the aggregate volatility was similar to Bonds: this way overall risk budgets were not blown out.  The key was in the words “volatility-constrained”.
Some investment managers, got this wrong by only implementing half of our suggested playbook.with a resulting set of poor outcomes.  Managers who in 2022 added liquid real assets (such as Commodities, Gold, and Infrastructure equities), but did not introduce the volatility constraints meant that they knowingly swapped out a low volatility asset (bonds) and swapped in and equity-like high-volatility asset, thereby inadvertently increasing the overall risk profile of a balanced portfolio with 60% equity risk, to a 100% equity risk strategy!  If this was done with poor timing, the higher-volatility real asset exposure ended up being a performance detractor, rather than a source of resilience.
So risk budgeting (understanding raw volatility of selected funds, and portfolio volatility contribution, adjusting for correlation) is essential.  That’s where our proprietary MINERVA™ portfolio risk analytics system helps out.

How is this different to what we said about the 60/40 portfolio in 2021?

In April 2021 we wrote an article Rethinking the 60/40 portfolio, which outlined our recommendation to our investment manager and financial adviser clients to rethink the bond allocation in their portfolio prior to bonds’ failure to protect in 2022, and on which basis we helped our clients weather that storm.
As you can see from the table below, the thesis has not changed much, but we are trying to use more accessible wording to explain our thinking.

Our 2021 call to rethink 60/40 portfolio helped our client protect their clients in 2022.  Our 2026 call to reinvent the 60/40 portfolio should help create resilience going forward.

Conclusion

With inflation on the rise once again, and nominal bonds – particularly UK Gilts – under pressure from debt indigestion, it’s time to revisit this playbook for 2026 to ensure portfolio resilience.