60/40 Portfolios and the Need for Smart Diversification

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A key question of any institutional investor in times of high equity valuations and record-low yields is: What are the most effective diversifiers for a balanced 60/40 equity/bond portfolio? Despite its simplicity, a typical 60/40 portfolio has been able to deliver persistently strong risk-adjusted returns over the past decades. Still, because of its dominant risk exposure to equities, and the limited risk diversification potential of the bond component, such portfolios have not always been immune to larger drawdowns in times of equity market stress. During the recent Corona crisis, typical 60/40 balanced equity/bond portfolios have suffered from greater than 20% declines, from their peak values, in a short period of time. Although not a new topic, improving drawdown protection without compromising long-term risk-adjusted returns is more important than ever. A common approach to achieving greater diversification is to look at complementing alternative investment solutions that display a low correlation to the 60/40 portfolio. However, all too often this approach fails, as it does not take into account the behavioral differences during different market regimes.

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Artur Sepp
June 1, 2020