These Top Allocation Fund Managers Are Taking on Challenging Conditions

Editor's note: This article first appeared in the Q1 2022 issue of Morningstar magazine. Click here to subscribe.

Positioning a portfolio is more complicated than it used to be, what with inflation worries, low interest rates, high stock market valuations, and the growing popularity of sustainable investing. For guidance, we turned to three Morningstar Medalist fund managers who run some of our highest-conviction target-date and allocation funds. The trio shared their insights into how to build portfolios today for long-term success.

Erin Browne (top right) runs the Pimco RealPath Blend target-date series PDGZX, which skillfully balances the firm’s flagship active bond funds and passive Vanguard equity funds. Phil Green (top left) manages BlackRock’s LifePath Dynamic target-date series LPDIX, where he makes savvy tactical adjustments to portfolio exposures. Wyatt Lee (center bottom) manages a fleet of T. Rowe Price target-date series TRFGX, including the flagship T. Rowe Price Retirement Funds, where he consistently leads innovative changes.

Our discussion took place on Nov. 10 and reflects conditions as of that date. It has been edited for length and clarity.

Megan Pacholok: Do you think a conventional 60/40 portfolio will continue to perform well, or is it becoming an outdated concept?

Erin Browne: Over the last decade, 60/40 has returned in excess of 10% [annualized]. Every single year, there's a headline article asking whether 60/40 is dead. Yet, time and again, 60/40 portfolios continue to deliver better-than-expected returns. Even this year, 60/40 is close to a 10% return.

Going forward, though, it is hard to expect that same stellar level of returns, particularly with such a high Sharpe ratio. With the Barclays Agg Index right now at 1.25% or 1.3%, that’s a pretty low starting yield. You would have to expect a lot from equities to get you anywhere close to 10% total. Most capital market assumptions for equities across the Street right now are midsingle digits over the secular horizon. So, you might reasonably expect somewhere in the range of 3% to 4% from 60/40 portfolios over the next 10 years.

I think those equity numbers are probably a little too low, though. I also think that you can add alpha in an actively managed 60/40 portfolio.

Wyatt Lee: You probably have to go further out on the risk spectrum to get similar returns. That doesn't mean 60/40 is an outdated concept, but it may mean that your 60/40 should include more than an S&P 500/Aggregate Index mix. You can diversify your equity portfolio, make it more global. On the fixed-income side, you might be able to capture different moves in yield curves outside the U.S. You can also add more credit instruments and nontraditional strategies that aren't directly tied to yield curves. By creating that type of portfolio, you're still within the 60/40 concept, but you've modernized it.

Phil Green: It's likely that 60/40 won't repeat its past performance over the upcoming decade, but it remains relevant, perhaps with a few adjustments. Specifically, our capital market assumption for equities is lower than what they've achieved in the last 10 years, and our capital market assumption for bonds is low single digits.

However, despite lower expected returns, bonds still offer diversification to equities. In fact, bonds have been a great ballast over the past decade. There are a bunch of reasons for this, though a big one is that we’ve been living in an environment characterized by growth surprises. In such an environment, stock and bond markets are often negatively correlated.

That said, we may be moving into a different environment characterized by inflation surprises as much or more than growth surprises. In such an environment, stock and bond markets will likely be more correlated, mitigating bonds’ diversification benefit somewhat. If you think that you’re not getting as much ballast or return from bonds going forward, you may want to tweak the 60/40 allocation.

We think the return of a 60/40 portfolio is going to be somewhere around 5%. If you need to make 7% or 8%, like many institutional investors, I’d suggest shifting to 70/30 and making sure you have a healthy allocation to private markets. A portfolio consisting of 50% public equities, 20% private equity, and 30% bonds, with an extended duration, makes a bunch of sense. Obviously, if investors can generate alpha themselves, or through outside managers, and make prudent use of leverage, they can enhance their returns even more.

Pacholok: With interest rates at record lows, how do you think the role of fixed income has changed, and how do you think it'll continue to evolve?

Green: The role of fixed income is twofold: to provide return and to provide ballast to equities. I expect fixed income to provide both going forward, but to a less degree than the past decade, so you should lower your expectations for bonds.

Browne: Traditionally, fixed income has played three roles in portfolios. As Phil said, it provides a stable source of income and diversification to equities. And then there’s capital preservation.

The last two years have shown us that fixed income can still provide a pretty attractive risk and return profile, particularly during risk-off periods. Fixed income also provides a reasonable amount of equity diversification. In nine of the last 10 recessions, excess bond returns have been positive. There still is some room to run in particularly significant risk-off periods, and February and March of 2020 put that into focus. As a starting condition today, if we were to go into an extreme risk-off event where rates fell to zero, the 10-year Treasury index would return about 13%. As for capital preservation, I think that monetary policy over the secular horizon is going to be muted, so fixed income will still provide capital preservation.

Putting this all together, fixed income still plays an important role, albeit a maybe less significant role than in the past. Diversification is going to play an increasingly important role. You have to deploy active management and look at alternative assets that complement traditional fixed income—such as securitized mortgages or securitized ABS [asset-backed securities] products, private infrastructure or private debt, private real estate, REITs, and high-yield and emerging-markets credit.

Lee: I think of fixed income a little bit differently. The S&P 500 and emerging-markets equities may look a lot different, but they still tend to be highly correlated. The differentiation among fixed income is huge, though. The difference between short-duration U.S. TIPS [Treasury Inflation-Protected Securities] and emerging-markets credit is so wide, you can drive a truck through it.

I bucket fixed-income instruments by what they can achieve in the total portfolio construct. I have a core bucket that, to use an earlier term, is the ballast of the portfolio. That’s a low-volatility asset that complements equity. Another bucket is more defensive in nature—long-duration Treasuries, for example, which performed very well in the COVID sell-off. At current rates, they’re not going to provide as much defense as they did before COVID, when rates were higher. But they’re probably going to provide a lot more defense than they did in the first half of 2020, when rates were much lower. The third bucket is return-seeking fixed income: below-investment-grade and emerging-markets debt.

You can use these buckets differently in portfolio construction. Younger investors have very high allocations to stocks, so use more of those defensive fixed-income assets to diversify a growth-oriented equity profile. In a portfolio that is less equity-heavy, long-duration Treasuries don’t provide the same diversification benefit. Credit, though, does provide diversification against that core.

Inflation Debate Pacholok: Is inflation here to stay? Should investors be worried, and how should they shape their portfolios accordingly?

Lee: You can break this down into short-term views and long-term views. I'm in the camp that thinks the inflation episode we're seeing right now is relatively transitory. I saw a quote someplace that sums up my views: You can't shut down the world for 18 months and then expect it to restart perfectly smoothly. We're running through the bottlenecks now. As COVID continues to recede, inflation will start to recede. The inflation we're seeing now is being driven by labor shortages, supply shortages, and logistical constraints. It's hard for me to see those continuing at this level in the long term. For example, I doubt we will see used-car prices jump as much in 2022 and 2023 as they did in 2021.

That’s a short-term issue, and the way I handle it in portfolio construction is making sure we have assets that can react positively during shorter-term periods of inflation surprise. These types of assets don’t necessarily react to expected inflation, but they help you hedge against unexpected inflation. Real assets such as commodities, metals, real estate on the growth side of the ledger, and TIPS, especially shorter-duration TIPS, all work well during such periods. It’s almost like having an insurance policy on your house. You’re paying a premium for it when nothing happens, but you want it there when something does happen.

From the perspective of longer-term inflation, you have a liability that you have to fund, such as retirement or a corporate liability. How can I construct a portfolio that can grow in excess of inflation over the long term in order to hedge that liability? That means thinking about how much growth I need in that portfolio, which circles back to your first question: Do I need 65% or 70% in equities instead of 60%, based on current market conditions?

Browne: We also expect over the cyclical horizon that inflation is going to be higher but that core inflation will peak in the second quarter of 2022. As we close the year in 2022, we will see core inflation fall back into a mid-2% range. That said, I think that the risks are skewed to the upside, particularly if we see a more protracted period of labor shortages and supply chain shortages, as well as higher energy prices and demand for labor.

Over the longer term, though, I think that inflation expectations are going to remain quite muted and that realized inflation will fall back down from the high levels that we’re currently experiencing. A lot of the secular headwinds that existed prepandemic that dampen inflation are still in place: technological disruption, demographic changes, the move towards automation, a decline in bargaining power among labor unions, and central banks’ countercyclical policies. To think inflation is going to be perpetually higher, you have to believe that monetary policy has lost credibility, and I don’t think that we’re there yet.

During shorter-term deviations in inflation, not surprisingly, equities, shorter-duration TIPS, and REITs tend to do the best. But what’s interesting is that over longer-term periods of higher inflation, equities and REITs fade, while commodities and longer-duration TIPS tend to do much better, as do private assets. We’ve found that diversifying across different inflation strategies tends to be the best of both worlds. Deploying a strategy of commodities, equities, TIPS, and private securities (for those funds that can invest in privates) in a diversified inflation pool tends to provide the best Sharpe ratio as a hedging strategy.

Green: I'll take the other side to this: Get ready for higher inflation for longer. Inflation is just supply/demand imbalances, and demand has totally outstripped supply, particularly in the U.S., and particularly around goods. Fiscal stimulus unleashed massive demand. There was pent-up demand, too; people weren't out there consuming as much early on with COVID. But lots of money floating around from fiscal stimulus made its way into people's pockets.

The supply side can adjust to this demand over time, despite current supply chain issues. If that was the only thing going on, I would argue that inflation will come back down in a year or two. But there are structural forces as well.

One is sustainability. The transition to green is going to be disruptive. Just look at oil prices. The cost of moving toward more green energy is volatility for energy prices, which is going to mean volatility for asset prices. I think the disruption will creep into other elements of the consumption basket as well, like food. The pursuit of sustainable sources of energy and food, in particular, is going to cause higher volatility and higher prices.

A second is China and deglobalization. China exported deflation for years, but now they’re trying to deleverage parts of their economy, which will structurally constrain supply and, all else equal, push prices higher. Onshoring and deglobalization in general will likely lead to lower levels of growth in trade. There will be higher costs of doing business if globalization starts reversing.

It’s these structural forces that will keep inflation higher for longer. I’m not talking hyperinflation, but more than 2% in the U.S. and certainly more than we’ve had the past decade.

Lee: Is that necessarily a bad thing? We've had a central bank that's been trying as hard as they can to push inflation north of 2%, and they haven't been able to. The bigger question is how high does it ultimately get? Does it get to a point where it derails the real economy and causes more problems than we can control?

Green: Monetary policy is a blunt tool. If you're trying to pump up inflation, a better way of doing it is what happened during COVID, with a fiscal response. A monetary response tends to inflate asset prices and adds to wealth disparity. So not an ideal tool.

Browne: If the Fed sees inflation running for a protracted period of time in excess of its target, it is going to come in and taper faster. In addition to that, they could tighten rates faster. Also, we have a two-year election cycle in the U.S., and fiscal policy tends to be somewhat mean-reverting over time. We saw that coming out of the last two recessions, where an administration change changed the course for fiscal policy. I don't expect that fiscal policy is going to remain as loose as it has been in the last 18 months or so.

Yes, ESG adoption will create inflation in certain industries and certain sectors. But it’s too early to expect that it will drive higher inflation across the entire economy. Broadly, ESG adoption is happening at a glacial pace across the U.S. economy.

Risk Mitigation Pacholok: ESG has become a different lens for assessing risk. Has it changed the way that you're looking at different asset classes?

Browne: Pretty much all our institutional investors want to have a conversation about how we think about ESG in the portfolio. Some want explicit ESG monitoring. It started with international investors, but increasingly we're hearing it from U.S. investors as well.

We’re doing a lot of work on stranded assets: how ESG is going to affect the demand profile for assets going forward, whether certain asset classes are going to be stranded, or less investable, in the future, and ultimately what that means for valuations for those sectors.

Pacholok: Have you found asset classes that are going to be stranded, as you put it?

Browne: Older commercial real estate properties are going to require significant cost improve-ments to get up to ESG-friendly condition. They may not be stranded per se, but it will cost a lot to bring those assets up to par. That's an example in the private markets where some assets may not be as valuable as they have been.

You couldn’t have invested over the last 10 years without having at least looked at the impact of ESG on valuations in the energy sector. Certain natural resources, whether because they’re considered dirty or because there are cleaner, more efficient alternatives, may become stranded or at least be devalued because of increasing ESG adoption.

Lee: We have approached ESG integration from the bottom up across our entire investment process. It starts at the fundamental analyst level. Our financial models incorporate those factors, just like every other financial consideration. As our underlying portfolio managers are building their portfolios, they can make trade-offs across companies, sectors, and industries. Ultimately, that gives us a perspective on how ESG is fully integrated across our multi-asset portfolios.

The next question is how ESG affects the factors around why we want to invest in different areas of the marketplace. Commodities and energy are the most obvious place to start. We’re starting to ask whether these will serve as good inflation hedges going forward. If you have a world potentially awash in oil because of growing production, but a lot of the world is moving away from petroleum-based energy sources because of ESG considerations, will oil have inflation-protection power? Those are the important questions we need to ask as multi-asset allocators.

Green: ESG has definitely changed the way we invest. One way to think about ESG is as risk factors, which means you better understand your exposures. We also spend a lot of time thinking about ESG as an alpha opportunity. One example is that we've found that diverse hiring policies can lead to excess returns. We've also done research on climate change and found signals that help forecast excess returns.

Pacholok: Are there other risks out there that investors may be overlooking?

Lee: One thing that doesn't get talked about enough in the defined-contribution plan space is: What is risk? There's short-term market risk, like we saw in February and March of 2020. There are inflation risks, like we're potentially feeling right now. But there's also asset-accumulation risk or, in retirement speak, longevity risk. I don't think that gets enough attention from plan sponsors.

In my perspective, there’s been an overemphasis on short-term risks and an underemphasis on long-term risk. I deal primarily with retirement investors, and they look at drops in the market like we saw in the first quarter of 2020, and they make a broad assumption that an event like that is going to be ruinous for retirement. That ends up leading people to invest too conservatively because they underestimate the risk of not compounding their wealth over the long term.

Browne: Inflation is the biggest risk that retirees face at retirement. Most people focus on wealth creation, while overlooking how to preserve that wealth through inflation protection.

More broadly, the biggest overemphasis in terms of risk is the use of VaR [value at risk] as the singular metric by which portfolio managers measure the risk in their portfolio. VaR is very dependent on historical correlations, and correlations can be spurious, particularly during significant risk-off periods where correlations break. I think there should be more of an emphasis on more inclusive sources of volatility measures and other ways to measure risk in order to get a more complete and accurate picture of how a portfolio will behave in left-tail events.

Green: The biggest risk is lack of imagination. Stuff that we can't imagine happening happens. A second risk is stuff that we might be able to imagine but can't measure. COVID is a perfect example. I doubt many people imagined there would be a pandemic in their lifetime, and I doubly doubt that anybody had any idea how to measure the risk. A second example is the risks around the pursuit of sustainability. What kind of disruptions can we expect if the transition doesn't go smoothly? What will happen to markets and what will the impact be on individuals?

Geopolitical risk is another. How do you measure the risks around the tensions brewing between the U.S. and China? You can imagine a host of scenarios, but how do you measure their impact on capital markets?

Adding Alpha Pacholok: When should investors consider an active strategy versus a passive?

Green: A lot of people talk about active and passive in terms of market efficiency. Emerging markets are inefficient, for example, so do active management there. I don't view the world that way. My view is that active management is a zero-sum game, so find a good manager and go with them. It doesn't matter where they are operating. If someone knows more than the person on the other side of their trades, they have an edge. If you can't find anybody with an edge, just go passive.

Lee: I think that's right. The active/passive debate stacks up all the active managers against a passive benchmark, but that's not how good investors invest. Very few institutional investors are looking for the worst active manager. Look at a set of active managers who have built processes, resources, and fee levels in a way to set them up for success. There's the opportunity to add value in virtually any space. That said, when you start getting into fee budgets and risk budgets, areas that are more efficient are easy opportunities to get simple beta exposure cheaply. You can tilt your active risk budget to more fertile opportunities. Fixed-income markets are one of the key areas, especially as you move away from more liquid markets. Whereas in equity investments, it's easy to replicate the benchmark and get it for a very low cost.

Browne: Wyatt stole my thunder. What he said is consistent with our views: Spend your risk budget prudently, taking into consideration both cost as well as where you can source beta exposure cheaply without giving up alpha. Active management comes into play where there is more differentiation across instrument selection and where manager selection can make a significant impact in terms of alpha performance. You can blend both active and passive instruments to get to a better outcome overall.

Pacholok: What advice would you give a young investor—someone who's 25 and starting their portfolio—versus a 65-year-old?

Browne: This relates to how we structure target-date funds. Early in the lifecycle of an investor, early in the income-producing years, you're focused on getting beta exposure to the overall market. Being substantially weighted in equities, probably north of 90%, is the right position to be in, assuming that this is an investment for longevity, where you're not going to be beholden to the ups and downs of the market. Try not to look at your portfolio every day. If you're able to weather the storms, you should be in a pretty good place by having a higher equity allocation early on.

Green: My view, for both 25-year-olds and 65-year-olds, is to own more equity than you do today. If you're 25, allocate everything to stocks and don't mess with it, to Erin's point. If you're 65, it's the same advice. I wouldn't say 100% stocks, but chances are you've got another 25 years to go, which obviously is a pretty long time, so put a little more in stocks.

Lee: It's hard to give any advice for a 25-year-old other than save as much as you can, invest it for the long term, and don't ever look at your statements. For a 65-year-old: Understand your situation. If I'm a 65-year-old who's well funded, I may be able to afford to take less equity risk if I prefer a lower risk profile. But most 65-year-olds we see probably overestimate how well prepared they are. They need more equity exposure because they need that growth to help their assets last.

Pacholok: Thank you for taking the time to speak with us today and sharing your insights.

Megan Pacholok is a manager research analyst at Morningstar Research Services LLC.

Photography by Christopher Lane, Matt Roth, and David Zentz.