The 60/40 Portfolio Is Dead

Thanks for the memories, 60/40. A mix of 60% stocks and 40% bonds, or something close to it, could for decades be expected to produce enough stable growth and steady income to meet retirement goals. But sky-high stock prices, rock-bottom interest rates and an increasing tendency for the two asset classes to move in lockstep has prompted most advisors to ditch the formula. What are they doing instead? That’s the topic of this Big Q, our weekly feature where we ask advisors to weigh in on important questions.

Brenna Saunders, partner and wealth planner, Creative Planning: With longer and longer life expectancies, the typical retiree depends on their portfolio to meet their needs for decades, so we’ve never believed that large bond allocations are appropriate for them.We typically recommend having enough invested in bonds to get through a prolonged bear market and invest what remains in investments with a higher upside than bonds.

For most clients, the assets that would typically be invested in bonds under the 60/40 formula are directed to publicly traded equities instead. While stocks are inherently more risky than bonds in the short run, there is a long-run risk that a client outlives a portfolio that is positioned too conservatively in a low-interest-rate environment. When you add in the impact of inflation, a 60/40 portfolio may actually be less likely to achieve their goals. On paper, the portfolio may appear to be further out on the risk spectrum, but in reality is positioned appropriately when considering all of the risks to a client’s financial independence. For some clients, adding the private equivalent of publicly traded stocks or bonds may be appropriate and improve long-term expected performance. This should be balanced against the client’s needs for liquidity and concerns around complexity.

Jay Winthrop, partner, Douglass Winthrop Advisors: We only view bonds as an alternative to cash, not as an offensive weapon for seeking investment return. Alternatives have, in our view, substantial drawbacks for the average taxable investor. That leaves us with a default position of being overweight equities. That’s always been our approach, but now, with where interest rates are, we are at the very high end of our allocation to equity.

If we are mandated to be 85/15, let’s say, we are at 85% for equities. We have a fairly concentrated portfolio of about 30 companies, and all of them meet five or six core tests: They all have wide economic moats, pristine balance sheets, abundant reinvestment opportunity, they trade at valuations we believe represent discounts to their intrinsic value, and they’re run by managements that are very shareholder oriented. In the current environment, where you have high equity prices but even higher bond prices, we are adding a few other factors. We’re really favouring businesses that have a high degree of pricing power, that have a low degree of capital intensity—meaning they don’t require external financing to fund operations—and that are addressing large global markets.

Andrew Burish, advisor, UBS: Based on UBS’s capital market assumptions, we prefer a 45%-25%-30% allocation: 45% is in U.S. and foreign equities, 25% is in short-duration fixed income, and 30% is in alternative investments. Most of our clients are either accredited investors or qualified purchasers; they either have a net worth of $2 million minimum or $5 million minimum. That gives us a lot more flexibility for the 30% that we use in alternatives.

[By using alternatives], we reduce risk while maintaining projected returns, or we enhance projected returns while maintaining the same risk. That 30% alternatives sleeve could be a blend of private equity, hedge funds and private real estate. For people who need income, we utilize a liquidity strategy. We’ll take out one to three years of income that they’ll need and we keep that in a separate strategy with short-duration fixed-income investments. This allows a client to go out further on the risk spectrum within their 45-15-30 investment strategy if needed to meet their financial planning goals.

The 45% that’s in stocks would probably be split with 30% in U.S. stocks, diversified across small-cap, mid-cap and large-cap, and 15% in foreign—developed markets and emerging markets in a pooled vehicle of some kind. It’s a little bit overweight the U.S., but there’s a big dose of foreign stocks in there.

Matt Gulbransen, president, Pine Grove Financial Group: The first thing we’re doing is resetting expectations. For that client who is used to making 7% or 8% this past decade, and thinks that will continue in retirement, we’re rethinking that. We’re not completely abandoning bonds in that 60/40 model, but we’re definitely taking 20% of that allocation, give or take, and trying to find alternative, non-correlated asset classes that can generate bond-like returns without the interest-rate and credit risk. We’ve done some real estate-type investments like data centres and cellphone towers. Things like that might be a little bit different, but they still provide stable fixed income. A lot of open-ended ETFs or mutual funds will invest in companies that own those types of real estate. There are real estate trusts that are designed specifically to buy data centres that have long-term corporate leases and then kick out [income] just like an industrial property or an office property.

We’re also going more into hedging-type strategies. We’re trying to put a fence around the volatility of your portfolio: If the market’s up 20% or 30% you’re going to hit the top of that fence and you’re not going to make more than that. But if the market goes down 30% or 40%, you’re not going to have that downside volatility. We are outsourcing that to managers. For us it’s well worth the 30 to 50 basis points that you pay for a good ETF or mutual fund that can do a covered call or some sort of options strategy to hedge out of the volatility of the stock market.

Scott Tiras, advisor, Ameriprise: As we build our allocations, we continue to consider the unique challenges of the low-yielding fixed income market. While we strongly believe in keeping a good portion not in stocks for most of our clients, we also recognize the need for this portion to contribute to the portfolio’s returns. We sometimes tell our clients that stocks are for capital appreciation purposes and bonds are more for capital preservation purposes.

One strategy we employ is to add a bit more exposure to non-traditional equities and reduce the fixed-income exposure to about 30%. However, we then need to turn the volume down on the risk in the equity portfolio to offset the additional market risk. We do this by looking at higher quality large-cap dividend stocks and REITs that do not have exposure to shopping centers or office buildings and provide a good yield. We are also keeping a close eye on the availability of shorter-term—less than three-year maturity—equity structured notes that provide a limit or buffer on the downside, but leverage on the upside. For fixed income, we’re including more Treasury Inflation Protected Securities (TIPS) and ETFs or funds with a bit more credit risk than interest rate risk.

After years in the doldrums, European banks have cleaned up their balance sheets, cut costs and started earning more on loans.

The result: Stock prices have surged and lenders are preparing to hand back some $130 billion to shareholders this year. Even dealmaking within the sector, long a taboo topic, is back, with BBVA of Spain resurrecting an approach for smaller rival Sabadell .

The resurgence is enriching a small group of hedge funds and others who started building contrarian bets on European lenders when they were out of favour. Beneficiaries include hedge-fund firms such as Basswood Capital Management and so-called value investors such as Pzena Investment Management and Smead Capital Management.

It is also bringing in new investors, enticed by still-depressed share prices and promising payouts.

“There’s still a lot of juice left to squeeze,” said Bennett Lindenbaum, co-founder of Basswood, a hedge-fund firm based in New York that focuses on the financial sector.

Basswood began accumulating positions around 2018. European banks were plagued by issues including political turmoil in Italy and money-laundering scandals . Meanwhile, negative interest rates had hammered profits.

Still, Basswood’s team figured valuations were cheap, lenders had shored up capital and interest rates wouldn’t stay negative forever. The firm set up a European office and scooped up stock in banks such as Deutsche Bank , UniCredit and BNP Paribas .

Fast forward to 2024, and European banking stocks are largely beating big U.S. banks this year. Shares in many, such as Germany’s largest lender Deutsche Bank , have hit multiyear highs .

A long-only version of Basswood’s European banks and financials strategy—which doesn’t bet on stocks falling—has returned approximately 18% on an annualised basis since it was launched in 2021, before fees and expenses, Lindenbaum said.

The industry’s turnaround reflects years spent cutting costs and jettisoning bad loans, plus tougher operating rules that lifted capital levels. That meant banks were primed to profit when benchmark interest rates turned positive in 2022.

On a key measure of profitability, return on equity, the continent’s 20 largest banks overtook U.S. counterparts last year for the first time in more than a decade, Deutsche Bank analysts say.

Reflecting their improved health, European banks could spend almost as much as 120 billion euros, or nearly $130 billion, on dividends and share buybacks this year, according to Bank of America analysts.

If bank mergers pick up, that could mean takeover offers at big premiums for investors in smaller lenders. European banks were so weak for so long, dealmaking stalled. Acquisitive larger banks like BBVA could reap the rewards of greater scale and cost efficiencies, assuming they don’t overpay.

“European banks, in general, are cheaper, better capitalised, more profitable and more shareholder friendly than they have been in many years. It’s not surprising there’s a lot of new investor interest in identifying the winners in the sector,” said Gustav Moss, a partner at the activist investor Cevian Capital, which has backed institutions including UBS .

As central banks move to cut interest rates, bumper profits could recede, but policy rates aren’t likely to return to the negative levels banks endured for almost a decade. Stock prices remain modest too, with most far below the book value of their assets.

Among the biggest winners are investors in UniCredit . Shares in the Italian lender have more than quadrupled since Andrea Orcel became chief executive in 2021, reaching their highest levels in more than a decade.

Under the former UBS banker, UniCredit has boosted earnings and started handing large sums back to shareholders , after convincing the European Central Bank the business was strong enough to make large payouts.

Orcel said European banks are increasingly attracting investors like hedge funds with a long-term view, and with more varied portfolios, like pension funds.

He said that investor-relations staff initially advised him that visiting U.S. investors was important to build relationships—but wasn’t likely to bear fruit, given how they viewed European banks. “Now Americans ask you for meetings,” Orcel said.

UniCredit is the second-largest position in Phoenix-based Smead Capital’s $126 million international value fund. It started investing in August 2022, when UniCredit shares traded around €10. They now trade at about €35.

Cole Smead , the firm’s chief executive, said the stock has further to run, partly because UniCredit can now consider buying rivals on the cheap.

Sentiment has shifted so much that for some investors, who figure the biggest profits are to be made betting against the consensus, it might even be time to pull back. A recent Bank of America survey found regional investors had warmed to European banks, with 52% of respondents judging the sector attractive.

And while bets on banks are now paying off, trying to bottom-fish in European banking stocks has burned plenty of investors over the past decade. Investments have tied up money that could have made far greater returns elsewhere.

Deutsche Bank, for instance, underwent years of scandals and big losses before stabilising under Chief Executive Christian Sewing . Rewarding shareholders, he said, is now the bank’s priority.

U.S. private-equity firm Cerberus Capital Management built stakes in Deutsche Bank and domestic rival Commerzbank in 2017, only to sell a chunk when shares were down in 2022. The investor struggled to make changes at Commerzbank.

A Cerberus spokesman said it remains “bullish and committed to the sector,” with bank investments in Poland and France. It retains shares in both Deutsche and Commerzbank, and is an investor in another German lender, the unlisted Hamburg Commercial Bank.

Similarly, Capital Group also invested in both Deutsche Bank and Commerzbank, only to sell roughly 5% stakes in both banks in 2022—at far below where they now trade. Last month, Capital Group disclosed buying shares again in Deutsche Bank, lifting its holding above 3%. A spokeswoman declined to comment.

U.S.-based Pzena, which manages some $64 billion in assets, has backed banks such as UBS and U.K.-listed HSBC , NatWest and Barclays .

Pzena reckoned balance sheets, capital positions and profitability would all eventually improve, either through higher interest rates or as business models shifted. Still, some changes took longer than expected. “I don’t think anyone would have thought the ECB would keep rates negative for eight or nine years,” said portfolio manager Miklos Vasarhelyi.

Some Pzena investments date as far back as 2009 and 2010, Vasarhelyi said. “We’ve been waiting for this to turn for a long time.”

The 60/40 Portfolio Is Dead

Here’s how advisors are replacing it.

Shares in European banks such as UniCredit have been on a tear