The 60-40 portfolio is the epitome of passive investing. But what does it actually mean, and how easy is it to build a 60-40 portfolio that minimises fees and maximises return potential using ETFs?
We'll explain how this type of portfolio helps you achieve a good balance between stocks and bonds — and how it's easier than you think to build using ETFs.
What is the 60-40 portfolio?
Everyone who thinks about portfolio construction has probably heard of the 60-40 portfolio. But what does it actually mean? In the simplest sense, the 60-40 Portfolio with ETFs is an investment strategy that aims to provide a balanced approach to investing by allocating 60% of the portfolio to equities (stocks) and 40% to fixed-income assets (bonds).
This allocation is a popular default choice for any passive investor seeking moderate risk and long-term growth using ETFs, like VUSA, without getting too involved in the details.
The primary objective of this strategy is to achieve diversification without going too far in either direction, being too conservative or too risk-averse, which helps to mitigate the impact of market volatility on your overall ETF portfolio.
High long-term returns despite challenges in 2022
In 2022, however, the 60-40 portfolio faced some challenges: a typical mix of 60% equities and 40% bonds fell by around 16% due to poor investor sentiment in both asset classes.
https://corporate.vanguard.com/content/corporatesite/us/en/corp/articles/improved-outlook-60-40.html
However, it's important to put this into perspective: the annualised return for the 9 years prior to 2022 is 8.9% for a globally diversified 60-40 portfolio, according to Vanguard.
Advantages: Easy to construct and ideal for passive ETF investors
One of the main benefits of a 60-40 portfolio is its simplicity. You can construct the portfolio once and hold it for the long term with minimal maintenance other than occasional rebalancing and dividend reinvestment, most of which can even be automated on modern robo-adviser platforms.
It requires little knowledge other than a basic understanding of how stocks and bonds work and which funds to choose.
In addition to simplicity, building a 60-40 portfolio with ETFs can also save you a lot of fees: some ETFs have annual management fees of just a few basis points, 0.1 % or less while having virtually no tracking error against the index. As a result, the fees saved compared to other passive index investments, such as mutual funds, are significant and contribute to higher returns over the long term.
Downside: lack of inflation hedges
Despite its popularity, the 60-40 portfolio has been criticised for being imbalanced because it excludes key inflation-hedging assets such as Treasury Inflation-Protected Securities, gold and commodities.
To address this, you can include alternatives, gold and commodity ETFs as a separate portfolio allocation. If you do this, you should choose to include a portion of the equity allocation rather than the bond allocation so as not to introduce too much risk into the overall portfolio allocation.
How to construct a 60-40 portfolio using ETFs
Building a 60-40 portfolio is something that anyone can easily do themselves with an online brokerage account or with the help of a robo-advisory platform. Here's what you need to do to build a 60-40 portfolio using ETFs:
1. Identify your risk tolerance and investment goals
As you probably know, you should speak to a financial adviser or use an online advice service to properly identify the pros and cons, your risk tolerance and goals. However, the 60-40 portfolio is the universal answer for those who don't want to go into the details of personal financial advice. As such, it typically matches the risk tolerance and investment objectives of the average long-term passive investor.
2. Choose the right ETFs
To create a 60-40 portfolio, you'll need to choose suitable ETFs for both the equity and bond parts of your portfolio. With ETFs, it is important to be aware of management fees and tracking errors. For a passive 60-40 portfolio, it's a good idea to choose very broad market ETFs that track very broad stock indices, such as the MSCI World. For the bond portion, consider ETFs that track a diversified mix of government and corporate bonds with different maturities. A number of global bond indices are also available. When selecting ETFs, look for those with high liquidity, high assets under management and low management fees. Also, make sure that the ETFs are hedged for your local currency or, if you are choosing global ETFs, that they are best offered in your local currency. To help gage a better feel you can read our overviews on the following ETFs; VWRL, VUKE, VWRA, ACWI.
3. Allocate your investments
Once you've chosen your ETFs, allocate 60% of your investment capital to the equity ETF(s) and 40% to the bond ETF(s). You can either simply use two different well-diversified ETFs or you can go deeper. This allocation should reflect your desired level of risk and investment objectives. To further minimise risk, consider diversifying your investments within each asset class. For example, you could invest in several equity ETFs that focus on different sectors, regions or market capitalisations. Similarly, you could invest in several bond ETFs targeting different credit ratings, maturities or bond types.
4. Diversify within asset classes
To further minimise risk, consider diversifying your investments within each asset class so you have ETFs for different investment strategies. For example, you could invest in several equity ETFs that focus on different sectors, regions or market capitalisations. Similarly, you could invest in several bond ETFs targeting different credit ratings, maturities or bond types.
5. Monitor and rebalance your portfolio
Review your portfolio regularly to ensure that your 60-40 allocation remains intact. Market fluctuations can change the value of your investments, so it's important to rebalance your portfolio regularly to maintain your desired allocation. This may involve selling some assets and buying others to restore the 60-40 balance.
6. Consider alternative investment options
If you don't feel comfortable building a 60-40 portfolio on your own, consider other options such as buying into a fund or ETF that already uses the 60-40 strategy, or signing up with a robo-advisor that can help you achieve your desired allocation which could be looking into an ESG ETF portfolio. By following these steps, you can create a well-diversified 60-40 portfolio using ETFs that match your risk tolerance and investment goals.
To conclude
The 60-40 portfolio is the best-known way of passively investing in stocks and bonds to create a well-diversified portfolio that you can hold for the long term to build wealth. Using ETFs is a very cost-effective way to build a portfolio.
