The Case Against the Traditional 60/40 Portfolio

Jeff Ptak: Hi, I'm Jeff Ptak, global director of manager research at Morningstar, coming to you from the 2016 Morningstar ETF Conference here in Chicago, Illinois. I'm very pleased to be joined today by John West. John is managing director, head of client strategy at Research Affiliates.

Welcome, John. Thank you so much for joining us today.

John West: Nice to be here.

Ptak: So, you're participating today in a Best Ideas panel with several other distinguished panelists. And so, we thought we can make that the focus of a couple of questions first of which is, I think that many investors today would consider the traditional U.S. 60/40 portfolio to be a best idea by sheer virtue of the fact that it's beaten the pants off of most other more diversified allocations. Would you concur with that assessment? Do you consider the U.S. 60/40 a best idea right now?

West: I don't, and the reason why is wonderful performance typically comes with some downside. And that is, if that performance comes with great rising valuations, it feels really good when P/E ratios go up and yields go down as they have for U.S. assets. But they are to a point now where if we take a look at from today with high P/E ratios and relatively paltry yields, the chances of 60/40 repeating are virtually nil in our minds over the next five to 10 years what it's one in the last five years. And so, we would really caution against extrapolating that future performance. As a matter of fact, if you actually go to our website and look at our asset allocation expectations, our expected real 10-year return for a 60/40 U.S. portfolio is about 1%. That's not going to cover a lot of retirement obligations.

Ptak: So, what should investors do if the U.S. 60/40 can't be counted on? If we were to look to a global asset allocation that your firm had constructed, what would figure prominently into it?

West: So, if you go with that same line of thinking, that the things that have disappointed us over the last five or seven years have underperformed in price to such a level where they are cheap today, they offer high forward-looking returns. So, anything that's missed our expectations or the things that we want to get rid of in our portfolio are actually priced fairly reasonable today. That would be anything that has a link with inflation, anything that has a link with commodities, anything that has a link with emerging markets. All of those collectively, what we call third-pillar assets, just take a simple equally weighted average of emerging-markets, commodities, high-yield bonds, TIPS priced to give us today probably something closer to about 4% real. Now that's quite an improvement. It comes with a little bit more volatility, but I think investors need to think about their volatility these days because the classic no-volatility asset class, cash, is going to give us zero percent. Maybe we should take some volatility if it means over a 10-year period we're more likely to meet our obligations.

Ptak: You alluded to inflation expectations earlier. I know that figures prominently into the portfolio construct that you just described. Since 2013 up until earlier this year it seemed that investors' fears of ramping inflation greatly receded. Some of those third-pillar assets you described suffered as a result. So what gives you conviction that investors will reset their inflationary expectations higher and those sorts of assets will benefit as a result?

West: So, generally, if you look at the course of break-even inflation rates, which we've had since the inception of TIPS in 1997, it's a pretty mean-reverting asset class. It typically floats between 1.5% at the low side and maybe high 2s at the higher side, and that's pretty consistent with inflation. We have a central bank that actually wants inflation, that's targeting inflation. On a CPI basis, they are targeting 2.3%. They are begging for more inflation. And we think that they have the tools to eventually do that. And if anything, if they get up to their target inflation level, do you really think they are going to stop immediately and put the brakes on? No. This central bank, I think, has shown the propensity to actually somewhat dovish. And so, they are likely to let inflation really stick at higher levels for a period of time.

And when we look at the assets I just mentioned, they have about a 70% to 80% correlation with changes and break-evens, and that's the reason why the last, call it, three years when we've gone from break-even inflation rates of 2.5% to 1.5%. Think about that. That's a 40% decline in inflation expectations. So, these asset classes got savaged. So it doesn't take a lot, call it, 50, even 25 basis points over rising inflation expectations, and these asset classes can rally relatively substantially. And that's exactly what we've seen from about mid-February of this year through today where we've seen many of these assets with break-evens only going up 20 or 30 basis points have gone up 15%, 20% in a relatively short period of time. And so we tell people that say to us, yeah, I get it, but I'm going to wait to see really evident signs of inflation expectations pick up. It usually happens much faster than a typical advisor or fiduciary can make portfolio changes. So the time to own those things we think is today.

Ptak: That's a great perspective. We'll leave it there, John. Thanks so much for your time and your insights today.

West: My pleasure. Thank you.