What is a neutral portfolio?

John Rekenthaler, Morningstar’s vice president of research, shares some guidelines and busts the 60/40 myth.
By Morningstar |  30-10-20 | 

The bold favour stocks. The cautious favour bonds. Those in the middle own balanced funds (60% stocks and 40% bonds).

The commonly used 60/40 arrangement is entirely arbitrary. If the approach ever was supported by an investment argument, that explanation was lost long ago. Portfolio managers create 60/40 portfolios for moderate investors because 60/40 portfolios are what moderate investors receive. Ask no questions, receive no lies.

Let’s consider three alternate strategies for determining a neutral allocation for middle-of-the-road investors.

1 divided by N

If investing by rule of thumb, then why not simplify the rule, by placing equal amounts in each asset class? This tactic has various names, including 1/N, uniform investing, and the naïve diversification strategy.

Allocating half the portfolio to stocks and half to bonds seems more logical than using the traditional 60/40 mix, unless the investor has six fingers on one hand and four on the other.

Notably, the highly rational Dr. Harry Markowitz adopted such an approach when beginning his investment career. Said Markowitz, “I visualized my grief if the market went way up and I wasn’t in it—or if it went way down and I was in it completely. My intention was to minimize my future regret. So I split my contributions 50/50 between bonds and equities.”

Should lowering the portfolio’s stock exposure feel too conservative, investors can compensate by adjusting the bond allocation. Switching from investment-grade to high-yield bonds effectively increases a portfolio’s equity position. In the U.S., holding 50% stocks, 25% high-grade bonds, and 25% junk bonds or lower-rated debt would lead to performance closely matching that of the Vanguard Balanced Index.

The 1/N approach can be further expanded by using additional asset classes. For example, one could buy equal shares of six investments:

1) large-cap stocks

2) mid-cap stocks

3) international stocks

4) high quality debt

5) lower rated debt

6) gold

Maths is hard

If this all seems absurdly amateurish, rest assured: There are scientific methods. While working on his doctorate, Markowitz published the paper that would latter serve as the bedrock for his Nobel Prize in Economics Science, on portfolio allocation. That article provided the framework to allocate assets analytically.

Unfortunately, while Markowitz’s recommendation is mathematically sound, it is devilishly tricky to implement. Forming portfolios based on the interplay of each asset class’s returns, risks, and correlations requires knowing those returns, risks, and correlations—easy enough when evaluating the past, but an impossible task for what matters: the future. Consequently, institutional investors typically observe the spirit of Modern Portfolio Theory, by embracing individually risky assets that benefit a diversified portfolio, without relying on the underlying math.

In other words, they coat a base of arbitrary decisions with scientific polish. This is how it should be. As researchers have since discovered, when put into practice the 1/N investment strategy outperforms most allocations that are analytically derived. For example, in a 2009 study, three professors measured the out-of-sample performance of 14 models based on Markowitz’s mean-variance optimization, and found none to be superior to investing by 1/N. The authors concluded that “the errors in estimating means and covariances eroded all the gains” that the models attempted to deliver.

Another systematic approach is risk-parity investing, which applies the 1/N mindset to portfolio risk. That is, rather than divide the allocation equally among each asset class, the risk-parity tactic equal-weights the risk of each asset class, so that each allocation is equally volatile. In practice, this leads to many fewer stocks and many more bonds; in fact, risk-parity portfolios often leverage their bond positions. Whether such a stance is theoretically superior can be debated, but I think not the timing. Now would not be the ideal moment to load up on bonds.

Choosing to index

Rather than attempt to outthink the marketplace, one might instead mimic it, by defining a neutral portfolio as being that allocation which occurs in real life. Calculate the total market capitalization of stocks and bonds, along with potentially other assets, then create portfolios that replicate those exposures.

That’s not a bad idea, but it does face three challenges. One is whether to address home-country bias. A second problem is how to treat real estate and commodities. The third is a theoretical difficulty.

Whereas the logic behind a stock-market index is indisputable, it’s not so clear that indexing makes sense across asset classes. For example, if bonds outgain equities, should one really hold tight, as cap-weighted indexing suggests, or should one rebalance, as suggested by standard asset-allocation counsel? (I do not know the answer to that question.)

Wrapping up

There’s no defending the popularity of the 60/40 portfolio, except that as standards go, it is not clearly worse than the alternatives. The 1/N heuristic and marketplace capitalizations (both domestic and global) suggest that splitting assets equally between stocks and bonds might make more sense. With that I agree, although not strongly.

There doesn’t seem to be an ideal neutral portfolio--a reality that no doubt explains why balanced funds remain the benchmark.

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