The 60/40 portfolio: Still a viable strategy?

Aggressive central bank rate hikes put the traditional 60/40 portfolio strategy into question in recent years. But with the prospect of lower interest rates ahead, is the 60/40 making a comeback? I had a chance to discuss that with noted hedge-fund manager Cliff Asness, Managing and Founding Principal and Chief Investment Officer at AQR Capital. And we started that discussion by talking about how his firm's strategy works.

AQR stands for "Applied Quantitative Research." Sometimes, I let people believe I'm the "A." I am one of the co-founders. We have our roots in academic finance as far back as the 1980s, where things that we now call quantitative investing, and we now call factor investing, really started.

And we were grouped together, at least a core of us, at Goldman Sachs in the '90s. We left to start AQR in '98. We trade quantitative models in just about every market. About the only thing quantitative we don't do are really high-frequency, real in-and-out kind of strategies.

Our strategies are more trading and investing horizons. But we've been doing quant for my whole career. I've never done anything else.

OK. So that's an interesting foundation to build this on. 60/40 portfolios-- I know you've written about them in the past. They had a bit of a challenging time because of the dislocations of the pandemic and low expected returns. What are you thinking about that kind of space right now in terms of the bond market, about a 60/40-- where should we be thinking?

Whenever I talk about the outlook for 60/40, my colleague-- his name is Antti Ilmanen, and I know it's a mouthful. He's finished. He's been a friend for 35 years. He's an AQR partner.

He's kind of our guru on long-term expected returns. He wrote a book on this-- about a low future return environment. At the end of 2021, it came out. Sometimes luck is better than skill-- not that Antti's not skillful. A global 60/40 portfolio has made about 4.5% over inflation over 100 years.

To some people, that doesn't sound like a lot. But it's 40% [? bonds, ?] and you're subtracting inflation. So it's a very healthy return. He thought at the end of 2021, it was poised to be, call it, 1.5% to 2%. Nobody knows exactly what this number should be. I come from academic finance, and no one there knows, but 1.5% seemed insanely low.

Now, he got very lucky because, of course, the worst year for 60/40 in about 50 years happened immediately after that book. You roll forward to today with the interest rate back up, his number is probably a little bit under, but closer to 3%. That's a pretty reasonable return on global 60/40.

I would not try to make a hero call. At 1.5%, no one has great market timing. I wouldn't say next Thursday it's going down, but I would say that's not going to last. At 3% we think 60/40 is not as attractive, maybe, as the last 100 years, but probably pretty reasonable.

Along those lines, I was on your website in recent days. There was some research paper published a couple of weeks ago-- it's actually taken some interest among our audience members about bonds having no value in a portfolio. I know I'm just paraphrasing. You took a run at that. Quickly, your thoughts on that.

Yeah. It depends what you can do. The standard logic that you hear, a logic I disagree with, is a long-term investor can tolerate volatility, so they should be all in equities. Academic theory can sometimes lead you astray. Sometimes the world is more complicated.

Sometimes, it can help. And this is a place I think it can help. If you take a finance class-- I mean, we're not talking about the hardest cla-- we're talking first-year finance in an MBA program-- you learn about this thing the efficient frontier. You're supposed to invest in the best combination-- if it's just stocks and bonds, let's limit it to that-- the best combination of the two, meaning the highest return for the risk taken.

And if you are an aggressive investor or can tolerate a lot of risk, you're supposed to apply some leverage to that. Turns out that theory actually has worked exceptionally well, practically, for 100-plus years. I wrote a paper on it in 1996. It's held up for the last 28 years.

So there are investors who can't lever. And there, the worry about 100% equities is they may be overestimating their own ability to stick with it. But I acknowledge if you absolutely can't lever-- but you need to borrow about $0.30 to lever up 60/40 to be pretty similar risk, and, in my view, a long-term higher expected return than equities, because you're starting with a better portfolio.

You're starting with a portfolio with more return for the risk taken. And particularly, when bull markets have been going on for a while, you see a proliferation of the "everyone should be 100% equity" papers. And not that it's terrible advice, but I think you can do better.

OK. Interesting stuff. AQR, of course, known as an innovator in the hedge fund space. Let's talk a little bit about that-- understand the benefits of hedge funds and the role that they can play in a portfolio.

Yeah. The key to any hedge fund-- and many of them don't do this, so this is what, I think, the key should be-- is, can you create a decently positive average return that's not very correlated, in fact, in a very good case, uncorrelated, to 60/40, to stocks and bonds? Geek speak, "uncorrelated" means you tell me what happened to stocks and bonds in a year. My guess is the same for what happened to us.

We made some money. Not that we'll make money every year, but I don't learn about it from the stock market. It's a diversifier. I think you can do that.

Now, I get a little on the one hand versus the other-- I equivocate a little on this, because the empirical research-- we wrote a paper. You notice I start a lot of sentences with "we wrote a paper."

You know what? But you've done your research, obviously.

Yeah. We wrote a paper in 2001 called "Do Hedge Funds Hedge?" showing that the average hedge fund in the published indices has, call it, a 0.8 correlation to stocks. That is very high. That means they're not doing what I said-- trying to create something uncorrelated. But we do think there are many things in the quantitative world-- quality, momentum, value, low risk investing-- that all can go long some stocks, short the other stocks, and, we believe, on average, create a premium and because they're long and short, be rather uncorrelated.

So we're not the only ones to do it, by any means. But we do think the hedge-fund industry generally isn't delivering this. But we think it is deliverable.

When I think about a hedge-fund strategy and long short strategies, basically, it's the fact that the market is not perfect, right? If the market was perfect, then you wouldn't need to go there. You're sort of taking a look at those imperfections and investing around that.

No. That's absolutely true. The co-chair of my dissertation committee was a guy named Eugene Fama. Gene is justifiably the godfather, demigod, whatever you want to call him, of efficient market theory. Gene's not an absolutist. He doesn't think markets are perfectly efficient, but he's pretty far on that spectrum.

And I wrote a dissertation for him. Maybe the scariest thing I ever had to do in a meeting was going to Gene's office-- and Gene was very nice, so it wasn't that that made it scary-- but tell him I want to write a dissertation, which I then did, on what's called the price-momentum strategy. This is a childish strategy.

You buy what's been going up over the last 6 to 12 months. You sell what's been going down. Annoyingly to fans of efficient market theory, it's also an effective strategy. It's not all you want to do. A lot a lot of strategies that are more, say, call them "rational," help also. But I had to tell Gene, I want to write a dissertation on price momentum.

And then I mumbled the second part. And I find it works really well. And he's like, what was that? I'm like, it works really well. And not that this is about Gene Fama, but to give him a prop, he said words that sounded religious to me.

He said, if it's in the data, write the paper, meaning I don't care if I like it-- that it's true, you write the paper. And my view on efficient markets is I don't think they're perfect. I think there are some systematic ways to exploit them not being perfect.

I probably think they're more perfect than the average active manager. That might be Gene's influence still on me. And I think they're less perfect than probably Gene thinks. Maybe my most controversial view is I think they've gotten actually less perfect over my career, which is, call it, 30 years. Most people assume with technology getting better, with data being instantaneous--

Yeah, that things should get a little more efficient. Yeah.

In some ways, they do. A strategy that's dependent on speed happens faster. Prices react faster to new information. But even 30 years ago, we were minutes after the announcement.

So now we're nanoseconds. It's not that big a difference in terms of brand efficiency. When it comes to actually pricing things accurately, though, I think more information can sometimes lead people astray. The most extreme example-- and I'm not saying this is the norm-- is the US meme-stock example.

That was, to a large part, driven by people's belief that they knew it all just from a web search. So I think we've seen this, probably the two biggest bubbles where you can record in the data-- and you can already tell I'm not a perfect Gene Fama student, because I do believe there have been bubbles-- he doesn't like that word-- was the end of the '90s, the dotcom bubble, '99, 2000, and then '19 and '20, culminating in COVID.

So we've seen the two most extreme differentials between cheap and expensive stocks, as we measure them, in the last 20-plus years, looking at about a 70-year history. So the data also supports this idea that maybe we've gotten a little less efficient. That is both good and bad news for active managers.

It's good news because if you make your money from inefficiencies and they're bigger, there should be more money to be made. But it also makes it harder to stick with. It means those deviations can be bigger and last longer. And that's the period where the whole world thinks you're dumb and your clients kind of get mad at you.

I find this to be, not that the world cares what I think is fair but a pretty fair tradeoff. It is harder to do but probably more lucrative going forward if I'm right.

So that's a nice opportunity for us to talk about the value opportunity in stocks. You've had views about that over the last while-- a good call over the last three-plus years, but bumpy at the same time as well. Let's talk about this relationship, what's considered cheap and expensive stocks and getting to, perhaps, more reasonable levels.

Sure. First, in the quantitative world, the academic world, value is, I think, kind of misnamed. It's almost always price compared to some fundamental-- price to book, price to sales, price to cash flow, price to earnings. To a Graham and Dodd old-school investor, that's not value.

That number matters-- they want to pay as little as possible. But it's in context of the profitability, the growth opportunities, how risky it is, a set of other things. The funny part is this has caused all kinds of arguments between the two when they're really doing the same thing. Quants and academics just have labeled this thing that I think probably should have been called the low-price factor, the value factor-- and then they have a profitability factor and a low risk. They get to the same place, but huge miscommunication. So when I say "value," I mean, do low multiple stocks beat high multiple stocks?

On average, they do. You can do better than that incorporating these other things, but, on average, they do. One thing you can measure which no one had-- I'm proud of this. We were the first to do this back in 1999, two or three bubbles ago-- was no one, to my knowledge, had looked at the magnitude of the difference, meaning the standard academic approach was to stocks on your favorite measure of value, go long the low multiples and short the high multiples and see how well you did.

No one had, at least publicly, to our knowledge, had asked to the point, all right, but sometimes those multiples might be all pretty similar. And sometimes, they might be very different. And is the opportunity better when they're different? We do find-- and this could be argued, but we believe the opportunity is better when they are bigger differences.

Go to the opposite extreme. Imagine everything was priced to near the same. Not a lot of value opportunities going on. The biggest we ever saw that differential was March of 2000, it peaked, blew away prior ones. And then a few months after COVID, October, November of 2020, blew away March of 2000. So it was the 100th percentile.

I sometimes joke it was the 120th percentile. You're laughing, I appreciate that, because a lot of people don't get the joke because it's a math joke. There is no 120th percentile. You're just the new 100th. But what I convey with that is it's substantially above the prior 100th percentile.

We have seen that number-- it's bumpy, some months it retreats, but it's rather steadily come in for the last three and a half years. Even last year, generally considered a very lousy year for value, was really about the Magnificent Seven. If you do value in a systematic way-- 1,000 stocks that you like, 1,000 stocks you don't like around the world-- it was actually still a good year for value. Last I looked, which was about three days ago-- so if anything radical happened while we started this, I may have to amend--

We're locked in this room here.

And I don't mean to be overly precise, but we were down to about the 83rd percentile versus history. That's not the same. We've come way down, because, remember, it was a new hundredth-- it was way up there. So we've had a substantial move in that spread, but it is still, certainly, on the very wide side versus history.

So it could retreat. These are not short-term predictors. We don't make giant calls on this. Even at the maximum, we did a rather small tilt to more value. We still like it. We still think it has a way to go. We would still do a little more value than you would normally do, because that spread matters.

You're getting a better deal than normal. The fact that we can have three and a half really strong years, on net, not every month-- for this value factor and it could still be the 83rd percentile is a testimony to how extreme it had gotten, where the starting point was really just-- I don't like using the word "crazy" too much about markets-- Gene Fama, again, I'm a little nervous he'll hear it and get mad at me, but I think it got pretty crazy by the end of 2020.

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