Bringing together our series on Model Portfolios, we show how a balanced 60:40 Portfolio of Equities and Bonds based on our Global Bond Model Portfolio combined with either our Global Equity Factor Model Portfolio (Portfolio 1) or our Global Equity Theme Model Portfolio (Portfolio2) show different risk return profiles, but both show better returns with much lower risk than the benchmark.

In the last three posts on Model Portfolios, we have looked at Global Bonds, Global Equity Factors and Global Equity Themes. In each case we have made the case for applying the principles of Market Thinking in terms of our Confidence Scores combined with disciplined and dynamic allocation (between bonds, Factors and Themes respectively) to achieve a better risk return profile than the benchmark indices. In particular the ability to allocate higher amounts to cash (in reality ultra short dated bonds) has enabled us to manage the downside risk and considerably reduce volatility.

The model portfolios have also enabled us to get a better understanding of what has been going on in markets at a broader level. Back in late December/early January, in a series of posts titled Four Problems and a solution, we initially looked at the Real Problem with Bonds, which we suggested were no longer fit for purpose in long term portfolios (the TLT ETF is currently down 27% year to date). We then considered the problem for Passive Equities, in particular the skewed exposure of an S&P500 index to US Mega Cap tech. Here we would note an outperformance of equal weighted index to market cap weighted index year to date. In addition of course, the passive index itself is currently down over 15% year to date. The third post we looked at was the problem for the 60:40 portfolio, the bedrock of many long term savings plans in the problem for balance funds, reflecting the underlying issues with both passive equities and bonds.

Chart 1 shows that the Bloomberg Index of 60:40 strategy had its biggest quarterly loss since before the Global Financial Crisis

Chart 1: Biggest quarterly loss in 20 years for 60:40 Strategies

Here of course we see recent reports of serious issues facing these portfolios illustrated by this Goldman chart published in the FT.

In the light of this, we thought it worth looking at a blend of our Bond and Equity Model Portfolios, to give us our own variant of 60:40, either with Global Equity Factors as our Equity component (Portfolio 1) or Global Equity Themes (Portfolio 2)

A 60:40 fund allocation, with Equity provided by the Global Factor Model Portfolio (discussed in detail here) and the Bonds from our Global Bond Portfolio (discussed in detail here) has delivered similar longer term returns to the benchmark, with a considerable uplift this year in particular due to the outperformance of the Bond component.

Portfolio 1: Factor/Bond 60/40 Balanced Portfolio (Data as of 31 Aug 2022)

A second Portfolio, this time using the Equity component from our Global Thematic basket, (discussed in detail here) has a considerably better performance, due to the higher beta strategy during periods of string equity performance.

Portfolio 2, using Global Bonds and Global Themes, has better performance than either Portfolio 1 or the Benchmark

Portfolio 2: Thematic/Bond 60/40 Portfolio (Data as of 31 Aug 2022)

Thinking about Risk – drawdown and Volatility

We can therefore see that return is better than benchmark in both portfolios, driven over the last 2 years mainly by the downside protection offered by the cash component. Meanwhile we note that the Theme Portfolio did better in equity positive periods as might be expected. The other side of the equation is, of course, risk. So here, we display the three classic risk measures, Volatility, Downside risk and Maximum Drawdown. All three show up considerably better for our 60:40 blend than for the benchmark.

Portfolio 1: Factors and Bonds

Portfolio 1: Cash Management a key driver on risk side

The chart above illustrates the exposure over time to the underlying ETFs, both bonds and equities, versus cash. Over the last 12 months, both Bonds and Equity Factor ETFs have had very low levels of conviction and as such the ‘cash’ level has been high. This has been a key driver to the downside stability. This is exactly as it is designed to be. Note, this is not a Top Down decision to be in cash – we are not attempting a Market Timing Model. This is a bottom up approach based around conviction scores. if we have little or no conviction, we have little or no exposure to the markets.

Both Portfolios offer considerably lower Risk than the Benchmark in terms of Volatility, Downside Risk or Max Drawdown

Portfolio 2: Themes and Bonds – higher risk/reward

Thematic based equities offer higher return and slightly higher risk than Factor based, but still much lower than benchmark. Here we can see a similar Risk profile – i.e lower than the benchmark across all three measures, albeit slightly higher than the Factor portfolio. This of course is consistent with the higher reward side of the equation.

Portfolio 2: Different Cash Management profile for Themes than Factors

The chart shows a slightly different Cash/ETF profile than portfolio1. Obviously the Bond component is the same, but we would suggest that the longer duration nature of the thematic equities makes them more vulnerable to rising discount rates, driving the conviction scores lower – and thus cash allocations higher – than might be the case for the Global Factors, which have a more defensive element to them (including Value, Quality, minimum volatility).

To Conclude

Both Portfolio 1 and Portfolio 2 have better returns and lower risk than the standard 60:40 benchmark. The use of Global Themes as the lens through which to capture exposure to Global Equities offers a slightly higher risk profile than does the lens of Global Factors – albeit still much better than the benchmark – but in return offers greater upside, suggesting that this would be the more optimal approach.

NB, the terminology used here of Model Portfolios is not to be confused with that used by wealth managers and Independent Financial advisors, i.e. that these are provided as solutions for investors. Market Thinking is not a licensed investment manager and does not make investment recommendations. These are, literally, representations of internal portfolios based upon our models. Also, all references to ‘cash’ are actually expressed through ultra short dated bond ETFs.