New Look for a Clas­sic Port­fo­lio

The con­ven­tional wis­dom is that a 60/40 mix is highly ef­fec­tive. But there could be a bet­ter part­ner for large-cap U.S. stocks than U.S. bonds.

Financial Planning - - CONTENT - By Craig L. Is­raelsen

The con­ven­tional wis­dom is that a 60/40 mix is highly ef­fec­tive. But there could be a bet­ter part­ner for large-cap U.S. stocks than U.S. bonds.

LET’S TALK ABOUT THE VEN­ER­A­BLE 60/40 PORT­FO­LIO. This is the con­ven­tional way to pro­vide mod­er­ate-risk longterm growth in a re­tire­ment port­fo­lio. The clas­sic mix is 60% large-cap U.S. stocks and 40% U.S. bonds.

At the mo­ment, I won’t mess with the 60% stock por­tion, but how about the 40% com­po­nent? If you were build­ing a 60/40 model from scratch, you might won­der if that 40% piece has to be U.S. bonds. Or is there an­other as­set class that would work even bet­ter?

The chart “Po­ten­tial Large-cap Part­ners” shows the re­turn and risk met­rics for large-cap U.S. stocks and for 11 other ma­jor as­set classes that could be part­ners for large-cap U.S. stocks in a 60/40 port­fo­lio. In­cluded among the 11 are U.S. ag­gre­gate bonds, the typ­i­cal 40% part­ner for large-cap

U.S. stocks. In this anal­y­sis, the per­for­mance of large-cap U.S. stocks is rep­re­sented by the S&P 500.

The 11 ma­jor as­set classes are listed in or­der of their 15-year cor­re­la­tion with large-cap U.S. stocks — from low­est to high­est. The first po­ten­tial part­ner is U.S. TIPS, with a 15-year cor­re­la­tion with large-cap stocks of 0.02;

15-year av­er­age an­nu­al­ized re­turn of

5.3% from 2002-2016; a 15-year stan­dard de­vi­a­tion of an­nual re­turns of

6.69%; and a 2017 YTD re­turn of 1.94% through Oct. 31, 2017.

Re­call that in most cases the de­sired cor­re­la­tion co­ef­fi­cient is zero (or close to it), in­di­cat­ing a com­pletely ran­dom cor­re­la­tion. So, a co­ef­fi­cient of 0.02 is a very low cor­re­la­tion.

The as­set class with the next low­est cor­re­la­tion with large-cap U.S. stocks over the past 15 years was U.S. cash at mi­nus 0.04. Cash pro­duced a 15-year re­turn of 1.25% with very lit­tle volatil­ity (the stan­dard de­vi­a­tion was 1.64%). Next were non-u.s. bonds with a 15-year cor­re­la­tion of 0.06, then U.S. bonds with a 15-year cor­re­la­tion of mi­nus 0.09, and fi­nally com­modi­ties with a 15-year cor­re­la­tion of 0.32 and a 15-year re­turn of 4.85%.

Un­like the fixed-in­come as­set classes (TIPS, cash, bonds, and non-u.s. bonds), com­modi­ties had a very large stan­dard de­vi­a­tion of re­turn at 21.68%. But the 2017 YTD re­turn of com­modi­ties was only 1.19% as of Oct. 31.

The re­main­ing six as­set classes in the chart all have much higher cor­re­la­tions with large-cap U.S. stocks. All but one of the higher-cor­re­la­tion as­set classes out­per­formed large-cap U.S. stocks in 2002-2016.

The ex­cep­tion was de­vel­oped nonu.s. stocks (MSCI EAFE in­dex). How­ever, it is worth not­ing that as of Oct. 31, 2017, the year-to-date per­for­mance of the EAFE In­dex was 21.78% — well ahead of the 16.9% re­turn of the S&P 500. The 2017 YTD per­for­mance of emerg­ing mar­ket stocks, how­ever, was the clear win­ner at 32.64%.

The cor­re­la­tion of non-u.s. de­vel­oped stocks and large-cap U.S. stocks over the past 15 years was 0.86 — only slightly lower than the 0.91 cor­re­la­tion be­tween large-cap U.S. stocks and mid-cap U.S. stocks.

This sug­gests that non-u.s. stocks — par­tic­u­larly in de­vel­oped non-u.s. economies — are no longer a re­li­able di­ver­si­fier for U.S. in­vestors. In the 1970s and 1980s, de­vel­oped non-u.s. stocks had much lower cor­re­la­tion with U.S. eq­uity mar­kets and, as such, were a use­ful di­ver­si­fier for U.S. in­vestors. How­ever, the eco­nomic in­ter­twin­ing of the globe has syn­chro­nized mar­kets to a high de­gree over the past 10 to 15 years.

Now, on to the real is­sue: Which of these 11 as­set classes was the best part­ner when teamed with large-cap stocks over the last 15 years? The an­swer de­pends on your goal: Do you

want lower volatil­ity or en­hanced per­for­mance? A sum­mary of the 15-year risk and re­turn mea­sure­ments for var­i­ous 60/40 port­fo­lio com­bi­na­tions is pro­vided in the ta­ble “60/40 Com­bos.”

If your goal was to re­duce volatil­ity be­low that of the S&P 500, the five low-cor­re­la­tion as­set classes (U.S. TIPS, cash, non-u.s. bonds, U.S. bonds and com­modi­ties) achieved that.

For ex­am­ple, a port­fo­lio that con­sisted of 60% large-cap U.S. stocks and 40% TIPS had a 15-year stan­dard de­vi­a­tion of re­turn of 10.92%, com­pared with 18.16% for large-cap U.S. stocks by them­selves. Yet, the 15-year re­turn dropped by only 4 ba­sis points — from 6.69% to 6.65%.

Note in the pre­vi­ous ta­ble that the 15-year re­turn of TIPS alone was 5.3%, so you might think that adding TIPS as the 40% com­po­nent would have de­graded per­for­mance by far more than 4 bps. The key is in the 0.02 cor­re­la­tion of TIPS to large-cap U.S. stocks. TIPS and large-cap U.S. stocks do not march to the same drum­mer — and that’s a good thing.


Thus, the per­for­mance of a team­mate of large-cap stocks can have a lower re­turn than large-cap U.S. stock, but if it also has a low cor­re­la­tion to U.S. stocks, the net re­sult can be a 60/40 port­fo­lio that has nearly same re­turn as large-cap stocks by them­selves — but with far less volatil­ity.

If your ob­jec­tive was to max­i­mize re­turn, the high cor­re­la­tion in­gre­di­ents ac­com­plished that goal — with the ex­cep­tion of de­vel­oped non-u.s. stocks. In fact, let’s ex­am­ine the im­pact of blend­ing de­vel­oped non-u.s. stocks with large-cap U.S. stocks in a 60/40 port­fo­lio. You will no­tice that de­vel­oped non-u.s. stocks (specif­i­cally the MSCI EAFE In­dex) had a 15-year re­turn by them­selves of 5.28% — al­most iden­ti­cal to the 15-year re­turn of TIPS.

How­ever, de­vel­oped non-u.s. stocks had a high cor­re­la­tion of 0.86 with large-cap U.S. stocks. Thus, un­like TIPS, com­bin­ing the MSCI EAFE In­dex with the S&P 500 re­sulted in a 15-year re­turn of 6.23% — or 42 ba­sis points be­low the re­turn of a

60% U.S. large stock/40% TIPS port­fo­lio.

Here is a key take­away: In build­ing port­fo­lios, we need to know if a fund we are con­sid­er­ing will be a good team­mate to the other funds in the port­fo­lio, rather than its stand-alone per­for­mance.

Un­der­stand­ably, cor­re­la­tion in the past is not a per­fect pre­dic­tor of cor­re­la­tion in the fu­ture, but it is a log­i­cal start­ing point to eval­u­ate when you are build­ing mul­ti­as­set port­fo­lios.

Note that the Bar­clays U.S. Trea­sury U.S. TIPS In­dex and the MSCI EAFE In­dex had nearly iden­ti­cal re­turns in 20022016. But, the TIPS in­dex was a bet­ter fit for large­cap U.S. stocks due to its lower cor­re­la­tion with the S&P 500. Blend­ing low-cor­re­la­tion funds isn’t a guar­an­tee that per­for­mance will im­prove, but it al­most al­ways re­sults in a re­duc­tion of volatil­ity. And that alone makes it worth do­ing.

As a fi­nal note, as shown in the last row of the chart, if all 12 as­set classes (large-cap U.S. stocks through mid-cap U.S. stocks) were blended to­gether in equal por­tions of 8.33% and re­bal­anced an­nu­ally, the 15-year stan­dard de­vi­a­tion of re­turn was 13.22% (27% lower than the S&P 500 by it­self), the 15-year re­turn was 7.6% (91 bps higher than the S&P 500 by it­self), and the per­for­mance in 2008 was mi­nus 25.5% (31% bet­ter than the 37% loss ex­pe­ri­enced by the S&P 500).

More­over, the 12-as­set port­fo­lio (which is a 65% growth/35% fixed-in­come model rather than 60/40) out­per­formed the tra­di­tional 60/40 model by 124 bps in 20022016, al­beit with some­what higher volatil­ity (13.22% stan­dard de­vi­a­tion ver­sus 10.43% stan­dard de­vi­a­tion).

Now, as for my core ques­tion, is there a bet­ter part­ner for U.S. large-cap stocks in a 60/40 port­fo­lio? De­pend­ing on your ob­jec­tives, there are sev­eral that you might find bet­ter. But, be­yond that, con­sider more than two as­set classes.

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