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Investors follow the 60/40 rule because they are told bonds will protect capital while equities grow it. Why recent drops in bond prices should make us reconsider that rule.
By Paul MacDonald, CIO, Harvest ETFs
(Sponsor Content)
From the moment they start putting money in the market, investors are told to follow the 60/40 rule. It is the broadly accepted wisdom that, for an average retail investor, a 60% allocation to equities and a 40% allocation to bonds will result in a robust portfolio. Equities should deliver growth prospects in the long term while bonds will offset downsides in equities by delivering uncorrelated returns. Bonds preserve capital, and equities grow capital. That’s the accepted wisdom.
Countless investment fund issuers have packaged this logic into their balanced funds. These funds offer a specific allocation to equities and bonds, usually in line with the 60/40 rule, forming the core of a retail investor’s portfolio.
The problem with accepted wisdom is sometimes circumstances turn it upside down. In the past months we have seen volatility in equity markets and a significant drop in bond prices. That is because the investment landscape has changed.
Why are bond prices dropping?
After over a decade of historically low interest rates, followed by massive rate cuts by central banks at the onset of the COVID-19 pandemic, inflation has begun to set in. With rising inflation comes pressure on central banks to raise rates and market expectation that rates will rise, which is itself pushing interest rates higher.
As interest rates rise, the prices of bonds drop. According to S&P Global, the S&P Canada Aggregate Bond Index returned -8.63% between January 1st and April 18th, 2022. The S&P U.S. Aggregate Bond Index returned -8.16% in the same period.
That drop in bond prices has dragged down performance in many Canadian balanced funds. Investors have been getting their statements and realizing that the traditionally safe side of their portfolios is not acting the same way in other market corrections.
The unique combination of inflation and rising rates after a decade of historically low interest rates and bond yields has undone some of the capital preservation for which investors rely on bonds. They can take some consolation in the fact that income yields from bonds are beginning to rise, but those rates still remain below inflation and can’t compete with a key asset class in this moment: equity income ETFs.
Why equity income ETFs have replaced some bond utility
The other key advantage of bonds, aside from the idea that they protect capital, is that they pay out a fixed-income yield at the end of their term. For retirees and income seekers, that fixed income was a key mechanism for generating much needed cashflow once they stopped working. However, a decade of near-zero interest rates have all but erased that utility. Over that period equity income ETFs have started to fill that cashflow void on the market.
Equity income ETFs use a range of strategies to deliver cashflow to investors. Some simply offer a basket of dividend-paying stocks and use those dividends for their yield. Others enhance that yield with a covered call strategy, generating premiums on their equity holdings. Covered call strategies can also offset some volatility in the short term, as the premiums sold on equity holdings protect against capital depreciation.
Harvest Portfolios Group’s Equity Income ETFs use covered call strategies to deliver cashflow that investors used to rely on from bonds to enhance the yield over and above the underlying dividends from their equity investments. The portfolios held in these equity income ETFs are also constructed of companies that meet very high quantitative standards for financial reserves, resilience, and overall investment quality. While these are equity portfolios, the combination of cashflow, quality companies, and the short-term volatility offsets from covered calls combine to create an asset class that can deliver some of what investors used to turn to bonds and balanced funds to provide, high and consistent cash flows.
Equity income ETFs are just one piece of a huge range of complex investment strategies now available to retail investors. As bond prices fall and yields stay relatively low, it may be time for assets like equity income ETFs to be factored into the new accepted wisdom of investing.
What should replace the 60/40?
Every investor is different, their goals are unique, and their needs are complex. A one size fits all solution rarely works, and almost every asset class has some value for some people. Despite all the pressures they’ve faced, bonds will remain a key asset class for retail investors. However, the short-term pressure they’ve faced amidst a challenging macro environment, combined with the as the rise of new product sets like equity income ETFs should prompt investors to reconsider their allocations across the portfolio.
It may be time to rethink the accepted wisdom of investing, and reconsider what ‘balanced’ really means.
Paul MacDonald is the Chief Investment Officer and Portfolio Manager with Harvest Portfolios Group Inc.
Commissions, management fees and expenses all may be associated with investing in HARVEST Exchange Traded Funds (managed by Harvest Portfolios Group Inc.) Please read the relevant prospectus before investing. The funds are not guaranteed, their values change frequently and past performance may not be repeated. All comments, opinions and views are of a general nature and should not be considered as advice and/or a recommendation to purchase or sell the mentioned securities or used to engage in personal investment strategies. Tax, investment and all other decisions should be made with guidance from a qualified professional.
