Key Takeaways:
- 60/40, or the common reference for the balanced portfolio, is set to have a positive outlook for the next 10 years
- Vanguard will share its latest market outlook for asset classes, and the global markets and hone in on investing in an inflationary environment
- How to work with your clients and investors to understand their risk appetite and best portfolio construction for long-term investment goals and success
- What's next for the 60/40 portfolio? What evolution will we see in the coming years?
Justin Mack (00:07):
All right. All right. Good afternoon everybody, and thank you for joining us for this session and for joining us here on day one of Invest 2023. My name is Justin Mack, Tech Reporter with Financial Planning and Host and Lead Editorial Producer of the Financial Planning Podcast. And we are going to talk about two things that you do not think go together. Bleeding edge technology in the 60-40 portfolio. One is old fashioned as it gets, and the other is well creating technology that its creators are warning us might one day take over the world. How do those two things converge? How do they come together? What's next for this good old fashioned approach and how is technology reshaping the way we approach that good old fashioned approach? Thankfully, we have someone way smarter than me to break down that topic and explain it all to you. It's my pleasure to introduce Roger Aliaga-Diaz, Vanguard's Global Head of Portfolio Construction and Chief Economist for the Americas. His areas of expertise are economics, macroeconomic forecasting and portfolio construction. His global research team develops multi-asset class strategies and conducts quantitative research on asset allocation, investment solutions and retirement topics. With his team, he's built two proprietary portfolio construction models, the Vanguard Lifecycle Investing model, and the Vanguard Asset Allocation Model that underpin the firm's global investment advice methodology. So it's safe to say he knows his stuff and he's going to share that with us this afternoon. So again, make some noise for your presenter for this session Roger Aliaga-Diaz.
Roger Aliaga-Diaz (01:35):
Thank you. Thank you very much for the intro. Really way to set up the session because as we were saying, it's the 60-40 is navigating basically both words, right? So really, really great sessions here. Technology is what makes portfolio construction fun. Really. I've been learning a lot from the sessions. I hope you're learning as much as I am from listening to some of the speakers. But at the core of any wealth tech experience, there has to be a solid investment methodology that powers the portfolio recommendation. And the 60-40, as you know has been the bedrock of investment advice for decades and a very successful one actually look at the simplicity, transparency, efficiency of the 60-40, right? The cumulative return of the 60-40 over the last 10 years, 80%. That's tough to beat for a strategy that has such a low level of risk, especially during years of zero yields, right before Covid.
(02:39)
But of course, as we know since last year, 60-40 has been facing increasing challenges. Actually, I think there are two main challenges that are facing the 60-40, one of course, as you know is the very complex market and macroeconomic environment of the last couple years. Many arguing that the 60-40 cannot do well in a regime of high inflation and many actually calling for a completely new investment paradigm to replace it, right? But I think there is a second challenge that I also want to speak about, which is more structural in nature and it comes from the increased demand and the almost expectation from investors to get a much more personalized investment plan. Something that is much more customized to the particular goals, risk profiles and characteristics of the investors. The one size fits all recommendation of the 60-40 tend to be too generic and too rigid to fit the different aspects of investors.
(03:45)
So those are the two challenges I would like to share with you today. Tell you how the 60-40 fits into that and see where we are heading headed with this basically foundational investment recommendation that is the 60-40, right? So let me dive right in. Let's start with the first challenge. The market and macro environment of the last couple of years, very high inflation as you know, when inflation increase, the fed increases rates that tends to affect the equity markets and the world markets. At the same time, the two engines of the 60-40 are down at the same time, something that is not normal and many of course were calling even from last year for pronouncing the depth of the 60-40 as a preview. Let me tell you, coming from Vanguard will offer a little bit more of an optimistic message on the prospects of the 60-40 and hopefully in the next couple of slides I will show you some evidence to see why actually the logic of the 60-40 at this score is alive and well.
(04:45)
So lemme start with some numbers here just to put this into context. When we talk about 2022 bad year for the 60-40, it lost 16% for the full year. These double digit losses are unheard of in terms of the 60-40. However, when you look at a little bit of a longer period of time, for example, the last 10 years including 2022, the average annualized return of the 60-40, about 6%, even if you look at the last four years from 2019 to 2022, that includes all the covid years. In addition to the market route of last year, again close to 6%. Going forward, Vanguard will use the BCMM, the Vanguard capital markets model to project some of the portfolios over a 10 year framework. So the last bar on the right we are projecting stocks and bonds such that the 60-40 will give about 6% also on average.
(05:43)
So this is striking the stability of the return projections both backwards and forward. In that sense is that we say the 60-40 is doing its job. Of course, the conviction that we have on the resilience of the 60-40 comes from our view that the 2022, what happened last year was more of a historical exception as opposed to the beginning to a new regime that is here to stay. Essentially, we do not think that there will be a repeat knock good of this increasing rates and increasing inflation year after year, year after year. And what happened last year starting in 2021 really was more of a one of adjustment of the global economy to the locations of covid and also to the massive policy stimulus that the governments around the world had to put in place to restart the global economy.
(06:41)
Of course, many argue that this speed of high inflation regime is here. This high inflation regime is here to stay. Many argue that the correlated losses between stocks and bonds are a particular feature of this type of period. And what you see there, that line chart is really the rolling correlation, 36 months, three year rolling correlation of stocks and bonds and you see how it spiked into positive territory after being negative for over 20 years. It went into positive territories. You typically see when inflation spiked, right? However, the point of this type of correlation between stocks and bonds that are so negative for the portfolio to stay for that to happen, we need to see not just high levels inflation. What needs to happen is inflation keeps moving upwards from current levels started moving from under 2 to 5, 6, 7 or in higher. Now we'll have to move another amount to get more positive correlation and that's where we think that for that to happen, it would mean that we will heading really into a more, what we call a fully blown 1970s style type of scenario with spiders of wages and prices.
(08:00)
Of course, central banks monetary policy is at the center of that. If it is true that we are heading a 1970 style type of scenario, it would mean the central banks are basically stagnant. They are ignoring the market around them, letting inflationary psychology to get entrenched into the actions of investors and workers. This is what central banker call an anchored inflation expectations. There are inflation continue to surprise the markets. There is price waste spirals. The Fed continues hiking rates trying to stop inflation and that leads to underperformance of stocks and bonds. We do not believe that that's what's happening. Certainly we are not out to the goods yet. As you can see there. Inflation have peaked recently last year and it's gradually coming down, much more work to do for the Fed. But if anything, central banks finally have been more decisive in terms of hiking rates and even at the risk of a global recession, inflation R is moving in the opposite direction. So one would expect that if inflation continues moving down, these correlations that are typically of those seventies style inflation scenarios are going to go back to normal. One last thing about this, which is interesting is that much of the debate of the 60-40 has been framed in terms of positive correlations hurting the diversification of the 60-40 portfolio.
(09:34)
It has been said, the idea is that with the correlation flips from negative to positive, then there's evidence that the 60-40 may not work anymore. But it's important to keep in mind that diversification really doesn't need negative correlations. Diversification needs imperfect correlations. Any correlation below one is good enough to produce diversification. So in fact, if you look to historical periods going back to the seventies or even go back to the twenties, the average correlation between stocks and bonds in the US has been positive, low but positive in order 25.25 25%. And I did the calculation there myself, that low correlation was worth about 1.8 percentage points or lower volatility in the 60-40 versus not having the ratification at all, right? One can even compute the return impact because geometric cumulative returns cumulate faster when the return stream is smoother. So if you is diversification, there is a return gain actually in geometric terms relative to no diversification at all at all, right? So there are between 28 to 44 basis points of portfolio worth of portfolio diversification. Of course, negative correlations are better than positive, no question, but positive correlations still work, right?
(10:54)
So from that first challenge of the two I was talking about the beginning, we still build the 60-40 is a sound long-term investment strategy.
Roger Aliaga-Diaz (11:07):
It truly embodies three principles of successful investing, which is portfolio diversification, discipline, exposure to asset risk premium or the long, long term. This is the key engine of portfolio value for the 60-40 and for any other balance invest in investment, it could be 70-30, 80-20 and cost efficiency. Having said that, there are different set of challenges also facing this one size fits all recommendation that are more secular nectar. And we think that there are, they're truly are here to stay.
(11:44)
And in fact, there are three trends that we think are important to address. One is that the sources of risk premium are extending beyond the stocks and bonds. That is availability with the rise, rise of passive indexing or passive investing availability of very cheap efficient indices such and ETFs. There are many more sub-asset classes and segments of the market that are available to build a portfolio beyond the broad stocks and bonds. So that's something that we need to keep in mind. Second, I would say evolving views over the last two decades, almost the, I would say clearer understanding of the drivers of asset risk premium over time across different market conditions. We know that equity valuations and inter rates really tells you something about the environment you're investing in. It's not the same to invest in 2010 than investing in post covid era, right? So a static 60-40 may no longer be the most optimal allocation.
(12:42)
And this is not about tactical investing, this is not about trying to perform the peers. It is simply recognizing the macro environment. Sometimes it lasts for 10, 15 years at a time that one is in right? And the third one, probably the most important one I was referring before, the hyper personalization. This team demand for more personalized investing for goal oriented portfolios. Portfolios that are designed to meet a specific goal as opposed to more generic well growth like the 60-40. So Vanguard, were well aware of those three trends. We are working hard to address them.
(13:17)
Obviously, as I will show you in a minute, doesn't mean that we need to dismiss the portfolio, the 60-40 portfolio. If anything, the idea is to build upon the foundations of the 60-40, but trying to preserve those timeless investment principles of the 60-40 while addressing these more structural trends. So how to do that, how to come up with something that keeps those three principles but address those three challenges. Turns out the answer to that quest or that question is technology. So at Vanguard over the last few years, we've been building a system of algorithmic, digitally based portfolio construction tools and models that basically allow us to address those three issues. In the next few minutes, I'll share two of these models. One is the Vanguard's capital market model and the other is the Vanguard asset allocation model. In general, these technological solutions to portfolio construction, not just for Vanguard in the industry as a whole, I think allow us to evolve in three different dimensions, which I think are important.
(14:26)
So we are moving from manual model free portfolios like the 60-40 that a model free portfolio has some limitations because the strategies building the portfolio has limited capacity. Mental accounting, how many assets can a person deal with in their head as they build a portfolio. Plus some of these ad hoc portfolios are based on abuse from the strategies that are either tactical or ad hoc, and that is very labor intensive and also the maybe key person risk. So we move from all three portfolios to model based portfolios that are based on rigorous quant methodologies that are more systematic, more repeatable, and they can handle large scale in terms of the number of asset classes used. Also, we are moving from one size fits all type of recommendation, generic recommendations that are just, they do not account for differences in investors to more customizable systems. And the third one is very interesting because really the economics of the 60-40 of model free one size fits all is scale.
(15:38)
You offer the same solution to a large number of investors and that's how you basically gain efficiencies in terms of management of the portfolio or even design of the strategy. But in economics, as we know, technology is the alternative to scale to drive efficiencies. The technology also sees the cost curve down and it does it, that's so without sacrificing the possibility to customize and to operate a large scale. So that's where technology is critical. So the banker capital markets model is our financial simulation engine. We produce through the model on a quarterly basis as a returns for a large number of markets globally. And then the Vanguard asset location model takes the inputs of the banker's capital. Marks model does those asset return forecast and it produces a portfolio optimization across different return tradeoffs, not just between equity and bonds, but also between active and passive or between public or private investments.
(16:42)
Let me tell you a little bit how those two models along tend to address at least those three structural trends. That is to illustrate a little bit for you how they work in practice. So with the bank capital market model, as you can see, we move well beyond stocks and bonds, which is the real of the 60-40, but following the same logic in the same way stocks and bonds harvest risk premium on top of cash over the long term. So does many factors on many emerging market bonds, high yield bonds, inflation link securities like tips, commodities and so on. They come in common that all these assets produce a source of value above and beyond cash. And by producing a systematic use, now you can beat portfolios that are much more nuance that basically can basically address all these possible sources of return. So moving to the modern balance portfolio is the same address.
(17:42)
Basically obtain compensated risk factors, but well beyond stocks and bonds. Also in the bank of capital markets model, we are moving to shorter horizons when we move, for example into 10 year frameworks. Now we can also produce returns that are more dependent on valuations. For example, US stock returns for the next 10 years are lower actually than over the long term due to where valuations are. And that means basically that we can reflect market conditions, valuations I rates in these portfolio recommendations. So again, as I said before, the difference with the 60-40 a modern balance portfolio doesn't need to be a static investing can be changing with market conditions.
(18:33)
Finally, the Vanguard asset allocation model, which is like I said before, our portfolio optimization engine is fully flexible in terms of the number of inputs and settings that it meets. So basically it can account for a higher degree of personalization. Think of the inputs as different levers, levers and knobs that can be tailored to each individual in terms of the goals, in terms of the risk profile in even in terms of even preferences and beliefs of investor. Then putting those inputs along with it. Asset return focus from the Vanguard capital markets model, the optimization would produce a solution that is really individualized to that particular investor goals. Beyond wealth growth could be either personal lifecycle goals like retirement funding or college saving or some other more common financial goals such as resurging for example. Some portfolios are set, try to optimize some sort of duration management or inflation hedging strategies.
(19:45)
We have portfolios that are trying to hit a certain return target when investors want to find a payout, for example, or some income stream out to the portfolio, even preferences such as ESG investing, right? Environmental social governance type of frameworks. So there is a way to tailor that particular preference into the portfolio to optimize along with the other risk, normal return trade offs in asset allocation. And of course risk profiles also can be tailored in many ways. So to conclude mean the general point here is that in some sense it's time to move of the 60-40 debate, to be frank for in terms of the 60, the logic of the 60-40, we know that it's has, it's more resilient to the macro environment than we think, especially as we think going forward, things should start normalizing. But of course there is a second set of challenges by which the CT 40 gives away to the modern balanced portfolio.
(20:51)
As I was saying, technology algorithm portfolio construction is really key to address those challenges that we are talking about. A higher dimension and more complexity of asset risk premium, the quantitative systematic drivers of risk stream as well and the need for portfolio customization. But at the same time, the 60-40 is kind of the bedrock. This is the foundation of those technological progresses in terms of preserving the successful investing principles. Just as a quick anecdote as a wrap up, a journalist asked me not recently about the origin of the 60-40. He asked who was the first person to come up with the 60-40? And I didn't have a good answer at the time. I was not happy with the answer that I gave the reporter. I went to do a little bit of research there and this is what I found. And of course I'm I, if you know about anybody else, I do not want to leave anybody out, but those are the four fathers of the 60-40 that I could come out with Walter Morgan, the Founder of the First Balanced Mutual Fund in the US in 1928, the Founder of the Wealth Management Company and the Vanguard Wellington Fund is still alive today with an allocation of 65, 35%. So it's almost the longest track record in history in the US, especially in terms of a live 60-40, right? Of course, Benjamin Graham, you may know out of the intelligent investor in 1949 recommending a 50-50 allocation between common stocks and bonds. We cannot leave out Harry Markowitz 1990 Nobel Price in Economics and out of the portfolio selection 1952, which is really what's called the father of Moral portfolio theory, because diversification was at the key of the papers that he published. And I added Jack Bogle there, the inventor of founder of Vanguard of course, but the first passive equity and bond funds as well as the first passive balance in index fund, I would say is double diversification in the census between stocks and bonds and also inside each one of them by giving a full exposure to the entire market. So as we move forward, as the slide says, we move stand on the shoulders of giants. And with that, let me wrap up and we love to hear if you have any questions or any comments.
(23:28)
Thank you.
Justin Mack (23:29):
Alright, thank you so much, Roger. Yes. Any questions, comments from the crowd? Anybody at all?
Audience Member 1 (23:39):
Thank you. I have a question about benchmarking, right? But because as you build more customized portfolios then the benchmarking question is harder to address, right? Because it is more unique to you. But what do you compare that to? So how are you guys at banger thinking about that problem in the context of persuasive?
Roger Aliaga-Diaz (24:01):
Now it's a great question because the way that the industry thinks about that, and even to be honest, even the internal risk management groups, we have a little bit of a battle there because obviously they want to put a benchmark track the performance track and error to that. But if you have a portfolio that it's a return target portfolio, and we have many of those where the objective is to generate 4% return on average per year or 5% return on average per year, and the location will be changing significantly depending on the inter rate environment you are or what equity relations you are. Not trying to perform the benchmark, but trying to stabilize that return stream. And as we compare to fixed benchmark, which is the way the industry works, sometimes as a points it will look all right, it will look like outperforming significantly when we didn't try or even underperforming.
(24:58)
So it does require a little bit of a change in mindset if the goals are so specific to the design of the portfolio. Another example is inflation hedging with the rising inflation has been a lot of interest on how to build a portfolio that tracks inflation closely. So now the metric to me in my design would be what we call the inflation beta. How closely you follow, no, not the correlation, but the actual movement, one for one with inflation, again, in nominal terms. So in real terms, the portfolio is doing this job is really tracking inflation in nominal terms, you're sitting on more volatility than you used to because you're using commodities, you're using real assets, assets that are really target inflation well. So if you look through the portfolio through the traditional lenses of a fixed benchmark, the portfolio will look bad, although it's doing what it's supposed to do. I think as you move into financial advice and personal advice is much better because the investor knows what they want and you can show the portfolio is achieving those goals. It's as it's difficult to fit in the malls of traditional basically risk attribution and performance attribution.
Justin Mack (26:13):
Alright, I got a question over here as well.
Audience Member 2 (26:16):
Hey, real quick, how do you deal with, piggybacking off of the same point, how do you deal with market impact when you're dealing with hyper customized portfolio or transaction costs?
Roger Aliaga-Diaz (26:33):
Yes, definitely. There are ways to actually, when we run the back tests to try to incorporate transaction costs, of course portfolios that because of the gold has a much higher turnover, we'll start eating into the return. So we try to incorporate that into the ES as much as we can. And I think it's important, right? Because again, as I was saying before, one of the key property of the 60-40, right, is that efficiency, the cost efficiency in part it comes from of course very simple index implementation with very low volatility and very low, particularly transaction costs compared to other more complex investment strategies. So it's important to keep that in mind, but it can be incorporated in back tests for sure.
Justin Mack (27:23):
Alright, another over here.
Audience Member 3 (27:27):
Hey sir, thanks for the great talk. I have a question regarding the, well the plot you have actually, you mentioned the trade up between alpha risk version and the matic risk version. So what is the Alphas version in Vanguard context? Could you explain a little bit more about that part? Yeah.
Roger Aliaga-Diaz (27:42):
Yeah, sure. Yeah, thanks for the question. So the Vanguard asset allocation model has basically compared to an efficient frontier, an efficient frontier, you deal with one source of risk, which is basically market risk, equity premium risk or bond risk premium related to cash. In the asset location model, we open a second dimension of risk, which is the risk of active versus passive. Although in theory you could argue risk is risk and no matter where it comes from, it's always the same. But the reality is that investors think about active versus passive in a different way. They think about equity versus bonds. So we have wealth investors of Vanguard have a hundred percent bond portfolios, but they're a hundred percent active. So the two things are not correlated, and that's why we have almost these two dimensions of risk. There is actually even a third dimension, which is private versus public because it brings other sorts of research II liquidity risk that also must be accounted for. So we'd like to think of the Bangla allocation models doing risk return trails along different dimensions all at once.
Justin Mack (28:54):
And any other questions? All right, well thank you again and please round of applause for our presenter, Roger Aliaga-Diaz as a Vanguard.