• Henry Mason

Low yields and the 60:40

Updated: Dec 31, 2020

As mentioned on a previous post, the idea behind the 60% stocks and 40% government bonds portfolio is that you have a significant exposure to the equity upside, combined with a steady coupon return from (and the hedge of) the government bonds. So, should equities sell off, you have the added benefit of some capital appreciation on the government bonds you own as investors may wish to move to safer assets.

We decided to take a look at the numbers, to see the dynamics between stocks, bonds and the 60/40 portfolio, to see if there is some factual basis for the portfolio composition. We used the S&P 500 and a US government debt ETF. Please see below for a brief summary of the findings:

Happily, albeit unsurprisingly, the results seem to agree with what you might expect, namely:

  1. Stocks returned the most, bonds the least.

  2. Stocks returns were more risky / volatile, with a much higher standard deviation than that of bonds.

  3. The 60:40 portfolio produced the best Sharpe ratio. I suppose if one were to interpret this, it shows that whilst the 60:40 portfolio did lag behind the pure stock returns, the allocation into bonds more than proportionally decreased the volatility of the portfolio – leading to a better risk adjusted return. This, as one would expect, shows the efficacy of the equity / bond portfolio.

Now, the question is: would the 60/40 perform similarly in a low interest rate environment?

Leading on from the previous post, the issue of low interest rates (and low returns on government debt) is two-fold: (1) you no longer receive a significant return from the government debt coupon, and (2) the possibility of capital appreciation is limited – so the hedging effect of this asset versus equities is less.

This is all in theory, so in order to look at this question, we decided to have a look at the data from Japan. Owing the fact that interest rates there have been at 0% (+/- 0.5%) for two decades, perhaps this can lend some insight into the future for the US and European financial markets. We used the Nikkei 225 and a Japanese government debt ETF.

Some things to note, as before:

  1. Stocks returned the most, bonds the least.

  2. Equity was also riskier.

  3. The 60:40 portfolio did have the best Sharpe ratio – again providing the same basis for the original interpretation: although exposure to debt reduced the overall return, it also more than proportionally decreased volatility, leading to a better Sharpe ratio.

However, unlike last time where the increase in the Sharpe was significant, the increase here is much smaller. Whilst this is not definitive statistical proof of the negative effects of a low interest rate environment on the 60:40 portfolio, if definitely does speak to the underlying logic that government bonds at lower yields causes problems.

Here, this can be expounded upon by the facts that (1) the return on government debt was much lower, which must increase the drag on the return performance of the 60:40 portfolio, and (2) the risk-return measures were less favourable for the Japanese market – suggesting that the decrease in volatility of the 60:40 portfolio in the Japanese market did not compensate for the reduction in performance that including the Japanese government debt has on the portfolio.

In other words – this would suggest that it is true that government debt in a low yield environment does in fact damage the risk-return metrics of a 60:40 portfolio. This can confirm the fear outlined in the previous blog post, and leaves one asking: well what can you use instead?

This answer to this question will be attempted in subsequent blog posts and starts with an interesting candidate: Bitcoin.

Side notes on the above

The Sharpe ratio here used was the average monthly excess returns / standard deviation monthly returns. From research, this “time period” question is actually one of the drawbacks of this metric – apparently the Modigliani risk-adjusted performance statistic is better.

We re-weighted the 60:40 portfolio at each time period interval, which here means every month.

For American markets, the State Street S&P 500 ETF (SPY on Yahoo Finance and reference 1 below) was used for stock returns, the iShares U.S. Treasury Bond ETF (GOVT on Yahoo Finance and reference 2 below) was used for government bond returns and the 3-month LIBOR statistics used were from the Federal Reserve Bank of St. Louis website (reference 3). The time period used was from Q1 2013 to Q2 2020.

For Japanese markets, the iShares Core Nikkei 225 ETF (1329.T on Yahoo Finance and reference 4 below) was used for stock returns, the Vanguard Japan Government Bond Index Fund (0P00009UMU.T on Yahoo Finance and reference 5 below) was used for government bond returns and the 3-month Libor statistics were from the Federal Reserve Bank of St. Louis (reference 6 below). The time period, as above, was from Q1 2013 to Q2 2020.








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