60/40 is Still Resilient for Allocator Portfolios

The ideal allocation to stocks and bonds for institutional investors changes very little in response to a shift in correlation and that history and investment theory both continue to support the value of a balanced portfolio, according to new research from PGIM.

Bonds and stocks have historically been uncorrelated, specifically in times of low inflation and volatility. This was the case for large parts of the 20 years prior to 2022. The 60/40 portfolio was meant to be a stable balance between strong equity returns and the stability of fixed income. However, since 2022, both asset classes have become positively correlated.

The latest in a series of research papers from PGIM’s Institutional Advisory and Solutions group’s Noah Weisberger, managing director, and Xiang Xu, senior associate, seeks to address what this positive correlation means for institutional CIOs and their portfolios.

The optimal allocation to stocks and bonds changes very little in response to a shift in correlation from negative to positive, according to PGIM’s research. Bonds continue to play an important role in the portfolio and still provide a tail hedge to steep stock declines.

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According to PGIM, the performance of a 60/40 portfolio has become more volatile, leading to a decline in risk-adjusted returns, and deeper portfolio drawdowns.

“We cannot emphasize enough that positive correlation, in and of itself, did not cause dismal portfolio performance–indeed, 2023 was a strong year for the 60/40 portfolio despite the prevailing positive correlation regime,” the paper states. “Both history and theory point to the enduring value of a balanced portfolio regardless of correlation regime, with little to suggest that periods of positive stock-bond correlation are particularly challenging for multi-asset investing.”

According to the paper, over the past 50 years, the returns of a 60/40 portfolio are higher in times of positive stock-bond correlation, however risk-adjusted returns may end up being worse.

Effects of Monetary Policy

It is hard to predict when a negative correlation regime would ever come back into place, however monetary policy can give us some insights into where correlation between the asset classes is going.

“I can’t predict how long positive correlation will last but it does seem to me that many of the macro risk factors related to historically positive correlation are very much at play,” Weisberger says in an interview, “Should the macroeconomic landscape evolve the way it looks right now we could well see a persistent period of stock-bond correlation.”

Monetary policy is somewhat responsible for the current positive regime, Weisberger and Xu write. “The current conduct of fiscal and monetary policy has led to an increase in interest rate uncertainty, pushing rate volatility to multi-year highs,” they write in the report.

If interest rates stay elevated, the positive correlation regime is likely to continue, according to the report: “To the extent that fiscal sustainability and Fed independence and discretionary policymaking remain on the minds of investors, interest rate uncertainty may remain elevated too. This has direct implications for stock-bond correlation as short-term interest rate volatility is an input into our models of stock-bond correlation. Indeed, elevated interest rate volatility is responsible for a good deal of the uptick in stock-bond correlation and its shift from negative to positive.”

Bonds Still Have a Place

The ‘new’ 60/40 portfolio has been described by some as a portfolio that is 60% public markets assets and 40% private. Institutional investors and allocators are increasing their allocations to alternatives, like private equity and most recently private credit, in search of higher returns.

Still, fixed income still has a role to play in institutional portfolios and should not be overlooked, the PGIM team said.

“Even if stocks and bonds are positively correlated, bonds still play a diversified role in the portfolio. They are a liquid asset class, and they still have some risk protection characteristics even in a positive world,” Weisberger says.

Bonds can also still provide a hedge against stock declines, PGIM writes, as the two asset classes are not 100% positively correlated. “Positive correlation between stock and bond returns means that when one asset class experiences above or below average returns it is likely –depending on the strength of the correlation–that the other asset class will as well. Positive correlation does not imply that both asset classes will experience simultaneous declines.”

Bonds can also be more attractive on a risk-adjusted basis than stocks, and they can still be an important staple of institutional portfolios.