Beyond the 60/40 Portfolio: Why this Classic Model Faces Challenges Today
Intro — What is the 60/40 portfolio?
A 60/40 portfolio is a simple, classic asset allocation model that seeks to balance upside and safety and provide a degree of asset non-correlation. For most “mainstreet” investors this will mean 60% to a broad range of stocks — typically index funds or ETFs — and 40% to bonds (typically 10-year treasury bonds or other mainstream investment-grade bonds). The simple 60/40 portfolio has yielded stable returns during most periods in U.S. financial history and, up until 2020, recent performance has been particularly strong: in the decade before the COVID-19 crisis, a simple U.S. 60/40 portfolio delivered three-times its long-run average for risk-adjusted returns.
As of 2022, however, market conditions have presented severe headwinds for the 60/40 portfolio, once again driving home the potential benefit of diversification to illiquid alternatives like private real estate.
How Market Conditions in 2022 Challenge the 60/40 portfolio
In most down cycles, bonds provide a counterweight against stocks. This is due to the typically inverse relationship between bonds and interest rates. If the Federal Reserve Bank lowers interest rates to stimulate the economy, bond yields typically stand to gain. In other words, economic headwinds are usually bad for stocks and may benefit bonds.
This diversification dynamic has been challenged by present market conditions. Geopolitical tensions, supply-chain issues, and inflation concerns have led to a stock market correction and heightened volatility. Meanwhile, the Fed is increasing interest rates to battle persistent inflation, challenging bond yields. Due to these factors, the 60/40 portfolio is having one of its worst years on record. A 60/40 portfolio built on the S&P 500 and 10-year treasury bonds has fallen 20% in the first half of 2022.
As Christian Muller-Glissman — head of asset allocation research at Goldman Sachs — put it recently, “In an environment where you have both growth risk and inflation risks, like stagflation, 60/40 portfolios are vulnerable and to some extent incomplete. You want to diversify more broadly to asset classes that can do better in that environment.”
Going Beyond the 60/40 Portfolio
To recap: 60/40 portfolios rely partly on the negative relationship between bond yields and stock performance. This has held true through most phases of the business cycle through much of U.S. financial history, but it is not failsafe. In 2022, market conditions have severely challenged the 60/40 portfolio for well-understood reasons.
In mid 2022, the economy entered a “quasi-stagflationary” period. The Fed has been spurred into action, raising interest rates several times to combat the persistent inflation that followed the monetary stimulus and supply chain issues caused by COVID-19. At the same time, a combination of rising rates, geopolitical volatility, and high energy costs have caused an economic slowdown and contributed to a stock market selloff. The S&P 500 lost nearly 20% of its value in the first half of the year, with many major tech stocks trading at below pre-pandemic levels.
With recessionary fears, rising rates, and lower economic growth forecasted, the expectation now is that forward returns on public equities will be lower than in recent years. At the same time, history tells us that rising interest rates are likely to adversely impact bond yields. In other words, in this “quasi-stagflationary” environment, we expect to see the correlation between stocks and bonds strengthen, and for bonds to provide less of a counterweight against poor stock market performance. At the same time, the return potential of both these major asset classes may be challenged. Forward-looking investors may be wise to seek alternative sources of yield, alternative sources of appreciation, and new ways to diversify their portfolios.
How Real Estate Can Supplement the 60/40 Portfolio
REITs, in part due to their fairly strong correlation to public market investments, tend to perform poorly during recessions. However, illiquid alternatives — and particularly private commercial real estate — can provide near-term yield, long-term appreciation, and a higher degree of non-public asset correlation.
Private real estate investment performance is comprised of three interrelated components:
- Recurring cash flows from rents
- Property value appreciation
- Skilled management (capital structuring, business plan execution, and exit timing)
Let’s break down these three components in the context of market conditions in 2022
Cash flow from rents (yield)
Rents can provide stable income to real estate investors as long as leasing activity remains strong and vacancy rates remain low. For illiquid, non-traded real estate assets (discrete properties) the cash flow from rents depends on rental demand in the individual market, as opposed to yields from bonds or dividend stocks, which may fluctuate due to sentiment in the public markets. Property managers can structure leases to capture overall price increases, which is the primary reason that real estate tends to perform relatively well during inflationary periods in terms of real returns. According to an analysis by the Pension Real Estate Association (PREA) based on data spanning 1979-2021, net operating income across various real estate sectors increased 0.50% for every 1.00% in inflation increase, with shorter-leased sectors such as residential even more responsive at ~0.80%.
While news headlines may be focused on recession fears, many economic fundamentals remain strong, including job growth. Multifamily in particular tends to perform well during both recessions and inflationary periods due to the essential nature of the product and relatively short leases.
At this moment, cash-flowing real estate may provide a great supplement to the traditional 60/40 portfolio as a diversified source of yield.
Property value appreciation (upside)
Property values move predictably as multiples of rental cashflow and as a function of supply versus demand of similar properties in the market. Market conditions as of mid-2022 may favor many types of commercial real estate assets. Let’s look at both components:
- Rents tend to move upward predictably alongside overall inflation. In fact, average rents (especially in the apartment sector) are part and parcel of inflation. Apartment rents in the US rose at the fastest pace in June 2022 of any month since 1986. As rents increase, property values rapidly respond in kind. Hence, the long-term appreciation of real estate assets may be naturally hedged against inflation. According to research by PGIM, global real estate has provided a virtually perfect hedge against inflation, with all property real rental growth (vs. unadjusted nominal rental growth) at precisely zero in the past 40 years. Moreover, research by PREA based on data spanning 1979-2021 indicates that real estate can capture inflation in property values, with residential properties appreciating by ~1.1% for every 1% increase in inflation.
- Supply vs. demand — job growth remains strong, and despite plenty of talk of a recession, the economy remains fundamentally stable. Rising interest rates may cool off the single-family housing market, further contributing to demand in the apartment rental market. Generally, demand remains strong across most real estate asset classes in most markets (though office may face challenges due to the increased adoption of remote work). At the same time, increased cost of capital and high construction costs may suppress supply, creating opportunity for real estate developers and sponsors who can leverage a competitive advantage in financing and/or executing on their business plan. Although impactful, a rising interest rate does not have to be catastrophic for commercial real estate values – PGIM research indicates that the impact to valuation by a 1.0% increase in bond yields can be offset by a consistent 0.50% increase in rental growth.
For both these reasons, private real estate investments may currently provide an attractive alternative to the traditional stock portfolio in terms of generating appreciation and upside potential.
How EquityMultiple Investments Can Supplement a 60/40 Portfolio
Market conditions as of mid-2022 challenge the appreciation potential of a traditional stock portfolio, the yield potential of bonds, and the classic diversification thesis of the traditional 60/40 portfolio. Specific types of EquityMultiple investments may provide an excellent substitute or complement to the traditional 60/40 portfolio to mitigate all three challenges:
Short-term notes, which target a 5-6% annualized yield over a six or nine-month term, can provide an alternative source of yield at a time when real returns from savings accounts may be challenged by inflation.
Debt and preferred equity offerings may provide a source of near-term, predictable yield (typically monthly or quarterly distributions and target annual returns in the 8-12% range) to help offset challenges facing income stocks and bond yields. With terms ranging from nine months to three years, these types of investments can also help investors ladder maturities and benefit from relatively attractive liquidity (versus other illiquid assets). EquityMultiple’s preferred equity investments, in particular, often give investors the potential to earn additional accrued preferred returns at the end of the investment’s term. Hence, these investments may provide a compounding benefit and flexibility at a time when the impact of inflation could be more damaging to lower-return fixed-rate investments.
Common equity offerings on EquityMultiple may provide a great alternative to and non-correlated diversification against stocks, and a potentially superior risk-adjusted return profile, which investors typically rely on for long-term appreciation.
For a comprehensive look at EquityMultiple’s offering types in the asset class landscape, please refer to this guide.
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