Vanguard’s Economic and Market Outlook for 2025 reveals plenty of insights, ranging from potential supply-side interruptions to the impact of AI on productivity. But one of the most interesting takeaways is its asset allocation recommendations for valuation-aware investors. ¹

While most investors are familiar with the standard 60/40 allocation consisting of 60% equities and 40% fixed income, Vanguard’s time-varying asset allocation flips the script, recommending a 40/60 portfolio consisting of 40% equities and 60% fixed income for investors comfortable with active risk.

Let’s dive into the justification for being overweight in fixed income and why active funds might offer the best way to capitalize on these trends.

A Deeper Dive

The latest U.S. inflation figures came in at 2.9% in December 2024, up from a recent low of 2.5% in September and higher than the Federal Reserve’s long-term 2% target rate. Meanwhile, the S&P 500 index’s cyclically adjusted price-earnings ratio is 38x — significantly higher than the 17x mean.

These above-average interest rates and lofty equity valuations imply a narrow equity risk premium. In other words, investors aren’t being paid much extra to assume the risk of investing in stocks versus safer fixed income. This means that valuation-aware investors may be better off allocating more to fixed income.

Vanguard’s model flips the 60/40 allocation on its head, suggesting it might make sense to be overweight in U.S. intermediate bonds. Source: Vanguard

Vanguard’s model suggests overweight allocations to value, small-cap and developed markets in the equity space. In the fixed-income arena, it recommends being overweight in U.S. credit, given its more favorable expected returns despite stretched valuations and U.S. long-term bonds.

Active vs. Passive

There’s little doubt that most active managers underperform their passive benchmark over the long term. But active managers have a strong track record of beating their benchmarks in some markets. And according to Morningstar data, one of these markets is fixed income. ²

During the 12 months leading up to June 2024, nearly two-thirds of active bond managers beat their passive counterparts, led by a 72% success rate in the intermediate core-bond category. These portfolios have the flexibility to adjust duration and credit risks based on prevailing market conditions.

Morningstar’s Active vs. Passive Barometer shows strong excess returns among active fixed-income funds. Source: Morningstar

Vanguard’s model suggests a 22% allocation to U.S. intermediate credit bonds within its 62% allocation to fixed income — the same category in which active bond managers outperformed the most last year. With the same flexibility to adjust duration and credit risk in 2025, investors may want to consider them.

Funds to Consider

Investors typically access actively managed fixed-income strategies through mutual funds. However, ETFs may offer a more cost-effective and tax-efficient vehicle for investors interested in these strategies.

Active Bond ETFs

These ETFs are sorted by their 1-year total return, which ranges from 2% to 3.8%. They have AUM between $2B and $17B, with expenses running between 0.15% and 0.71%. They are currently yielding between 2% and 6.3%.

The Bottom Line

Vanguard’s value-focused asset allocation recommendations flipped the 60/40 model on its head, suggesting a 40/60 allocation focusing on intermediate U.S. bonds. Interestingly, this is an area where actively managed fixed-income ETFs outperformed over the past year, making active ETFs a compelling option.

¹ Vanguard (December 2024). Economic and Market Outlook for 2025

² Morningstar (March 2024). Active vs. Passive Funds by Investment Category