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The new 60/40: risk exposure trumps correlations

Galina Pozdnyakova
Deutsche Bank Research Management
Stefan Schneider

The terrible returns of 60/40 portfolios in 2022 revealed that risk and exposure are two different things. As investors rebuild in 2023 and ponder the change in correlations, the composition of portfolios is likely to change.

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Amongst the breakdowns in tried and true portfolio heuristics this year, none has stood out quite so much as the spectacular drop in the 60/40 portfolio. Indeed, many investors now wonder if the once-normal negative correlation between equities and bonds will ever return. That adds to concerns over several other market correlations that have not worked out as many investors expected, such as gold and inflation.
What investors miss in the correlation debate will become more apparent in 2023 – the correlation between stocks and bonds may matter less to the 60/40 portfolio than asset classes’ volatility contribution amid a more uncertain macro regime. The market drops this year mainly highlight the fact that while the market weights of equities and bonds are split as 60/40, the risk exposure within the portfolio is much more highly weighted towards equities – often close to 90 per cent.
This mismatch is why the drop in 60/40 portfolios and their high volatility this year more closely resembled that of the broader equity market, although bonds also heavily sold off (see chart on the left). As the chart on the right shows, although the correlation between equities and bonds became positive this year, the magnitude of comovement (beta) is still low relative to other assets.
As investors rebuild their 60/40 portfolios in 2023, risk management will therefore be front of mind as the return of beneficial cross-asset correlations can be hard to predict. First and foremost, this will involve better diversification of equity risk. The point here is to reduce the portfolio’s equity market beta for a world of lower growth, higher inflation and more frequent left tail events that lead to the type of turbulent cross-asset repricing experienced in 2022.
Assuming US large-cap technology stocks no longer outperform as they once did, equity returns will become more meagre and potentially revert to long-term averages. That means that the nearly 90 per cent of equity risk in the classic 60/40 portfolio may extend its drag on performance, especially relative to
the heavily repriced fixed income markets. The 60/40 portfolio will therefore need to include more lowly-correlated and less volatile assets – in other words, those with a low equity beta.
In 2023, less correlated stocks and bonds will be found in new places. Consider the themes that have accelerated this year, such as waning globalisation, geopolitical jitters, and diverging monetary policy cycles. These are all decoupling international assets and thus will favour geographic diversification.
For those who construct portfolios, ensuring the risk exposure of 60/40 portfolios is closer to 60/40 than 90/10 requires placing volatilities at the forefront of portfolio construction. This will keep bonds firmly as the backbone of a portfolio and emphasise the value of active duration management as central banks fight inflation. For equities, this will imply a move from growth to quality stocks and a shift to coupon clipping in credit from high-yielding stocks. And finally, it will raise further questions about whether 60/40 portfolios should be increasingly allocated to private capital.

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