What is a 60/40 portfolio?

In order to achieve some diversification and reduce volatility, a common approach is to create a portfolio containing both equity and bonds. A 60/40 portfolio, in particular, is one where we invest 60% in equity and the remaining 40% in bonds.

In this balanced combination, the bonds have often provided a partial offset to losses generated by the equity component thus reducing the overall volatility of the portfolio.

Why 60/40 portfolios are suffering right now?

What has worked in the past seems to have changed this year and the reason is that, after a very long period of declining interest rates, we have entered into a rising rate era.

Bonds prices depreciate when interest rates go up and viceversa. So it shouldn’t come as a surprise that in the past bonds have generally performed quite well overall, given the general downtrend in rates. It should also be noted that when interest rates are generally high, bonds also provide higher income in the form of higher coupons hence adding to the total return of the instrument. This is why, until recent past, having a portion of the portfolio in bonds has provided positive total return that has helped to absorb losses generated by the equity investment during stressed periods.  

Since we are now in low rate regime with rates starting to rise, this is a double source of headwind for bonds prices which helps to explain why 2022 has seen a very bad performance in this asset class.

But, as we all know, we are currently experiencing also a bear market in equity. So both bonds and equity are falling at the same time. Very bad for a pure 60/40 type of exposure that is based on the idea that diversification between bonds and equity should help reducing the overall volatility.

How about an actively managed 60/40 portfolio?

The general idea behind 60/40 allocation is a valid one but as markets change so does the effectiveness of that idea. A buy & hold in a 60/40 would have performed relatively well in the past but quite terribly in 2022, due to rising rates. 

In the chart below we are comparing the performance of such portfolio traded actively using our strategy (in blue) vs a simple buy and hold (in red).

In both cases, the 60% invested in equity is using UPRO and TQQQ (in equal portion, i.e. 30% of total capital each) while for the bond component we are using TMF (with 40% of the capital).

While buy & hold keeps this exposure throught the entire period, in our actively managed allocation we follow our signals to decide how much exposure to have on any single day. For example, given that 30% of the capital is allocated to TQQQ, if our system suggests an exposure of 50% on a given day, 15% of our capital is invested in TQQQ for that trading session, with the remaining 15% kept as cash.

We can see that a buy and hold of this portfolio would have generated an annualised performance of -4.2% while actively trading the portfolio using our signals would have boosted the annualised performance to 56.1%. But the core of our strategies is to achieve superior returns with much less risks so let’s look at the VaR and expected shortfalls.

We can see that with a 1% probability a buy and hold would have exceeded a daily loss of 8.88% and in such cases the expected loss would have been 13.15%. By trading using our signals, we managed to reduce the VaR to just 4.14% and during those 1% of days experiencing losses higher that the VaR, the expected loss was just 5.1% (vs 13.15% for the buy and hold).

Did volatility drag penalise the performance when trading the leveraged ETFs?

In one of our articles we have described the mechanics of leveraged ETFs and how volatility drags could impact their performances. In the context of leveraged ETFs, a volatile market is directionless, with frequent swings that keep eroding the performance of the instrument.

This makes these instruments somehow problematic to trade, because it might happen that even if you get the direction right, excessive volatility in the path will have partially reduced the overall profitability of your trade.

One of our conclusions was that leveraged ETFs can still be used successfully as trading vehicle in an active trading strategy, i.e. not as buy and hold investment. In particular, a strategy like Trading Mate that tries to increase exposure to the markets only when a directional move is expected, should not suffer as much from volatility drags in leveraged ETFs.

To quickly understand how much the volatility drag has impacted on perfomance we can look at the performance obtained using non-leveraged products (here using SPY, QQQ and TLT) and compare this against the performance using leveraged ETFs (as per previous section). 

The buy and hold position on the non-leveraged portfolio has obtained 11.5% while the 3X leveraged version has obtained -10.9%. This is much less than 3 times the non-leveraged performance and it’s actually an overall loss.

Let’s look at our active strategy now. Using non-leveraged ETFs the strategy performance is 47% while using the 3X leveraged ETFs we achieved 229.4%. This is much higher that the 3 times performance we would expect to see. Here we can see that the daily rebalancing of the leveraged ETFs provided further boost to the performance we obtain by actively managing our exposures.

This was one of the conclusions we drew in the previous article and we are happy to see it confirmed here by numbers, even after the recent period of high volatility.