The new deal for asset allocation

If gold can deliver you just inflation appreciation post-purchase, then despite paying no income it has a legitimate role as a bond substitute with yields so low.

For many years the perfect retirement portfolio was considered to be a mix of 60 per cent shares and 40 per cent bonds. The former giving you growth and the latter income and defensiveness.

At the start of this year when US Treasury bond yields broke below 2 per cent (and that was before COVID-19 arrived), Professor Jeremy Siegel, author of the investment classic Stocks for the Long Run, remarked: “We believe the old 60/40 model just won’t be able to cut it anymore.”

His concern was that low interest rates are going to persist and especially the bond part of the portfolio won’t deliver.

With US (and Australian 10-year) bond yields now below 1 per cent, I’m sure Siegel would be even more convinced.

Sadly, it is uncertain moving from 60 to 75 per cent in equities is going to get you the returns you’ve earned in the past.

First, let’s be optimistic and hope past annual equity returns of 10 per cent are still achievable. Earning a 2 per cent rather than 6 per cent bond yield means the combined total return on a 60/40 portfolio would be 6.8 per cent and not 8.4 per cent annually. Increasing the mix to 75/25 gets you close, but only to 8 per cent.

However, most institutions forecast lower equity returns ahead, worried about high valuations and profitability. If shares earn 6 per cent rather than 10 per cent as some guess, then a 60/40 and 75/25 portfolio in a world where bonds only managed 2 per cent would return only 4.4 and 5 per cent respectively.

With deposit rates so low you might say that earning 2 per cent on bonds is also optimistic, but we can allow for future rate rises over the length of your retirement and taking some yield enhancing credit risk.

If your conservative retirement calculations assume you can earn 7 per cent annually, as I have seen many use in the past, then maybe it would be worth considering that as well as 75/25 being the new 60/40, 5 per cent is the new 7 per cent!

The need to take on more risk is widely understood and seems to be encouraged by our Reserve Bank governor. Unfortunately, not all investors can cope with the extra volatility and many have to plan instead on spending less or working longer.

A 75/25 portfolio in a downturn as bad as the GFC would fall 30 per cent, versus 20 per cent for a 60/40 mix. What’s more, with bond yields so low, we shouldn’t expect bond prices to be able to rise to counteract equity price falls like they used to.

Even without increasing equity, I expect multi-asset portfolios to be more volatile. Of course, a lucky few are overfunded for their desired spending and so lower returns just mean they will be eating into their buffer instead of their steak and shiraz.

Equally interesting, Siegel also offers that “dividends on stocks are going to be the new bonds” and he contends they have an even more important role in retirement funding.

No wonder in Siegel’s recommendation (in conjunction with Wisdom Tree) more than half the equity Exchange Traded Funds they recommend are high dividend types. By using also quality and multifactor (including value) funds, an attempt is being made to moderate the required increase in volatility.

I have created an example of an Australian 75/25 portfolio using local ETFs to illustrate the concepts Siegel puts forward: This includes replacing a US equity overweight with an Australian one.

However, though our local range of ETFs is getting better, it doesn’t match more than a 1000 types in the US. For instance we have no Emerging Market Small Cap Dividend or US Small Cap Quality funds.

Applying the Siegel model locally would throw up other issues: for instance, the 25 per cent defensive-bond allocation includes preference shares (US), here hybrid securities, for extra yield. While I get the intent, I don’t consider them defensive.

In a repeat of a GFC market decline, this portfolio could easily fall a third in value which only a few brave retirees could stomach. By the way, if gold can deliver you just inflation appreciation post-purchase, then despite paying no income it has a legitimate role as a bond substitute with yields so low.

If “dividends are the new bonds” then I am comfortable in suggesting “that franked dividends are even better bonds”. Franking credits amplify the yield of already higher yielding Australian shares by 40 per cent for nil taxed investors. They’re super!

Douglas Turek is the principal adviser at Professional Wealth  

www.professionalwealth.com.au