The principle behind a traditional 60/40 investment portfolio is balancing two asset classes - large-cap U.S. stocks and U.S. bonds. The rationale is that U.S. stocks and bonds have low performance correlation - historically, bond funds seldom have had negative annual returns, while stock funds lost money in a calendar year nearly 30% of the time.

All bond funds, of course, are not created equal in terms of their raw performance or correlation to the stock fund with which they're teamed up in a 60/40 portfolio. Investors understandably may seek a bond fund with the best performance. But if the performance of the "best" bond fund is highly correlated with the performance of the stock fund it's paired with, the logic of a 60/40 portfolio is thrown out of whack. The goal is to add an asset class that behaves differently than stocks to provide a counter-balance when stocks tank, not to find a bond fund that produces returns that mimic a stock fund.

Investors would be well served to emphasize the rebalancing premium - the extra return generated when a 60/40 portfolio is regularly rebalanced. It turns out that the size of a rebalancing premium is related directly to the correlation between the stock fund and bond fund, which in turn predicts whether a particular bond fund is the right fit for a balanced portfolio.

A DEEPER LOOK

Think about how a typical 60/40 portfolio operates by considering the performance history of large-cap stocks (S&P 500) and bonds (Ibbotson U.S. Intermediate-Term Government Bond Index) over the 85-year period from 1926 to 2010 (see "Yin and Yang?" on page 130). Bonds had a negative annual return on eight occasions, about 9% of the time. The losses were relatively small, never exceeding 3%. Over the same period, stocks were in the red 24 times, or 28% of the time. Six of the annual losses exceeded 20%.

The motivation to hold stocks in a balanced portfolio is based on the higher expected return. Indeed, the average annualized return for large-cap U.S. stocks over the 85-year period was 9.9%, versus 5.5% for U.S. bonds. During the period, the worst three-year slide for the S&P 500 was a 61% free fall, but for bonds the worst cumulative return over any three-year period was 1.6%, illustrating the pragmatic difference between stocks and bonds.

There is another important element to a balanced portfolio: low correlation between return patterns. The key to harvesting the benefits of low correlation between assets in a portfolio is systematic rebalancing to the 60-40 ratio. This process involves a flow of funds between the two kinds of assets, meaning rebalancing is most profitably done in tax-sheltered accounts. Alternatively, cash inflows can be used to accomplish rebalancing.

CORRELATION EQUATION

In reviewing the behavior of the U.S. equity markets and U.S. bonds over the 10 years ending Dec. 31, 2010, the 10-year average annualized return of the Vanguard Total Stock Market Index (VTSMX) was 2.5%, which reflects a U.S. portfolio of 70% large-caps, 20% mid-caps and 10% small-caps. By comparison, the 10-year annualized return of the Vanguard Total Bond Market Index (VBMFX) was 5.6%.

The correlation of annual returns between these indexes was -0.37. Recall that the range of correlation coefficients is -1.0 to +1.0, where -1.0 represents perfect negative correlation and +1.0 indicates perfect positive correlation. The correlation of the monthly returns of these two funds was -0.09 over the 10-year period. One of the goals of asset allocation is to build a portfolio with low correlation, such as between -0.5 to +0.5. A reading of -0.37 indicates low correlation.

A 60/40 portfolio comprised of 60% VTSMX and 40% VBMFX achieved a 10-year annualized return of 3.7%, assuming each position wasn't rebalanced over the 10 years. If, however, this two-asset portfolio was rebalanced to 60/40 allocations at the end of each year, the 10-year annualized return was 4.35% - demonstrating the rebalancing premium. In this case, it was 65 basis points. It turns out that the size of a rebalancing premium is related directly to the correlation between the two assets; not all bond funds are created equal.

Bond funds with higher correlation to stock funds (in this case, VTSMX) tend to have a smaller rebalancing premium, whereas bond funds with lower correlation to the stock fund they are paired with have a higher premium. That means when combining a stock fund and bond fund in a portfolio that you intend to rebalance, you'll get better risk-adjusted performance by selecting a bond fund that's demonstrated lower correlation to the stock fund.