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Rethinking the 60/40 Portfolio in a Changing Market Environment

The Auour Regime Model is a unique approach to portfolio management that constantly measures the risk profile of the market and blends fundamental investment principles with quantitative analysis to determine which assets are best to include.

In the recent webcast, Evolving the 60/40 Mentality: A Risk-First Portfolio Approach, Matthew Bartolini, Head of SPDR Americas Research, State Street Global Advisors, outlined the current market conditions, pointing to investor confidence that fell below the neutral reading across regions in February amid the bond market rout. Despite the recent drop, the one-year moving average continues its positive trend.

Meanwhile, as long-term treasury yields spiked, rates implied volatility picked up in February and equity volatility remained above its historical median.

Looking at the global equity markets, small caps continued to lead momentum while short-term momentum in large cap and growth stocks has waned recently. Despite a strong rally over the past few months, small caps valuations do not appear overly stretched relative to their historical norm and to large caps. Bartolini also noted that emerging market commodity exporters such as Russia and Brazil have also seen improvements in price momentum on the back of the commodities rally.

The main focus last month was on the spike in rates. Higher inflation expectations fueled the rise in long-term yields above 1.4% and expanded the 10- and 2-year yield spreads to their widest level since 2016. Consequently, Bartolini argued that in this low-yield environment, investors may want to target bond exposures with attractive yield per unit of volatility. For instance, preferreds, mortgage-backed securities, and senior loans exhibit some of the highest yield per unit of volatility.

In an ever-shifting market environment, investors will have to adapt their traditional portfolio mixes to meet the challenges ahead. Joseph Hosler, Managing Principal, Auour Investments, noted that over every 15-year window, the traditional 60/40 stock/bond portfolio has produced an average annualized return of almost 8% with the lowest 15-year period being a 5% annualized return.

However, Robert Kuftinec, Managing Principal, Auour Investments, highlighted Morgan Stanley’s warning that we could face a 2.8% average annual return over the next 10 years. The average since 1881 has been nearly 8%. Investors face a lower and flatter frontier compared to prior decades and will need to accept greater risk to generate smaller incremental units of return.

Hosler also underscored the shortcomings of the traditional 60/40 mix in volatile market conditions. For example, during the recent coronavirus pandemic, the correlation of equity and fixed income markets spiked, or exhibited lower benefits in diversification across the asset classes.

Meanwhile, equity investors face extreme valuations after the recent run-up in prices, with the S&P 500 index trading at historically high cyclically adjusted P/E ratios, with few places to find solid valuation support.

On the fixed income side, investors are faced with current yields that offer little reward due to the extended low-rate environment. Income-generating assets that produce attractive yields also come with much greater downside risks.

As a way to better-handle shifting market risks and still maintain market exposure, Hosler outlined the Auour Regime Model, which is based on a combination of momentum, valuation, economic, and global interactions. He explained that momentum plays an important role in understanding the emotions within the market. Valuation factors act as a mean-reverting component in the Auour model. Economic factors are critical to the health of markets, and credit markets stand as an important gauge to the future economic growth. Additionally, interactions of world markets help separate localized market trends from more important global events.

Auour Investments utilizes its Auour Regime Model to create a dynamic 60/40 allocation that shifts a heavy equity and low fixed income portfolio during periods of low risk to an incrementally lower equity and higher fixed income portfolio as risks mount. During periods of high risk, the model will take on only cash.

Financial advisors who are interested in learning more about risk management can watch the webcast here on demand.

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