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- Over the last year, we’ve written about how low interest rates and high equity valuations point to a low return rates for traditionally allocated portfolios.
- In a State Street survey of over 400 institutional investors, the expected return rate for stocks and bonds was 10.0% and 5.5% respectively: significantly higher than we would expect.
- The survey also reports that the average expected portfolio return is 10.9%, a level inconsistent with the empirical evidence that many institutions tend to be larger purchasers of corporate fixed income, which is expected to have a much lower rate of return.
- These higher expectations likely represent that investors have embraced riskier approaches in order to meet their return needs.
In May 2015, we wrote an article titled The 60/40 Forecast: 0% through 2025. Since then, we’ve seen the same math outlined in countless industry articles: in a lower for longer environment, low interest rates and high equity valuations imply near-zero expected annualized real returns over the next decade.
So we were a bit surprised to see the results of a survey conducted by State Street of 400 large institutional investors. Most striking to us are the extremely high 5+ year expected returns: 10.0%, 5.5%, 10.9%, and 8.1% for stocks, bonds, real estate, and commodities, respectively.
The investors surveyed also expected their overall portfolio to return 10.9% annualized over the same period.
Where to even begin…
Unrealistic Portfolio Return Expectations
The expected return for a portfolio is a weighted average of the expected returns for the asset classes held. Correlations matter on the risk side of the equation, but the return side is pretty straight forward.
Which means that in order for the portfolios to be returning 10.9% while remaining consistent with the above views, one of the following must be true:
- The portfolios are all 100% real-estate;
- The portfolios all hold some other, unlisted asset class with very high return expectations;
- The investors have very high expectations for their active returns;
- The investors surveyed don’t understand math (Occam’s razor would probably lead us to this conclusion).
With known future obligations, institutions like to use bonds to immunize their portfolios, meaning they tend to be large purchasers of corporate debt (e.g. New York Life Insurance Co. reportedly has 89% of its $220 billion in bonds). Therefore, it is highly likely that the survey respondents hold a fair amount of fixed income among them. Given that their own expected return for bonds is only 5.5%, any allocation to bonds is a drag on portfolio expected return.
For example, a portfolio with a 50% allocation to fixed income would require that the other 50% of the portfolio have a combined expected return of 16.3% for the entire portfolio expected return to remain at the 10.9% level.
Realistic? Maybe if we lived in a world with cheap equity valuations, growth in the labor force, and technological innovation. While technological innovation may very well remain strong, making a case for the first two elements (low valuations and favorable labor force demographics) is nearly impossible.
Today? Low interest rates in core fixed income means very high hurdles for other asset classes to clear for investor’s to meet their high expectations.
Speaking of bonds…
Bad Bond Math
We’ve shown numerous times in the past that current yields are a good estimate for forward expected returns in fixed income. Therefore, with 10-year U.S. Treasuries offering 1.59% today, we can expect about a 1.59% annualized nominal return for a constant maturity 10-year U.S. Treasury index.
The implications of rising and falling rates matter less when bond maturity lines up with the horizon we are forecasting over, since any changes in value of the bonds is really just changes in future expected return.
Yet somehow the professional investors surveyed expect to get a 5.5% annualized return over a 5+ year horizon.
How in the world could that happen? We see a few ways, some more plausible then others.
- Everyone surveyed has moved their entire fixed income portfolio entirely to high yield corporates, high yield municipals, emerging market debt and riskier asset-backed securities;
- “Fixed income” really now includes directional bets using derivatives like the credit index futures and interest rate swaps (e.g. those employed by PIMCO’s Income fund);
- Everyone is maintaining super-short duration and an expectation that rates are going to normalize back to 4%+ on the short-end really, really soon;
- Active returns save the day again.
Reality is likely a combination of #1, #2, and #4, which raises an interesting point: while these approaches may technically still be fixed income, the risk profile is exceedingly different than what most would consider to be appropriate for core bonds.
“Technically fixed income” can be a very risky gamble.
In both cases above, we mentioned that active returns may be what these investors are relying upon. The results of the survey hint at this: many investors are looking towards a rules-based and/or outcome-oriented approach to active management to help solve any expected return short-fall within their portfolios.
Perhaps most flabbergasting, however, was the horizon over which those surveyed would tolerate underperformance in these new approaches.
At this point, we’ve written so much about the topic of active returns and appropriate expectations around them, we’re just going to link to a few of our articles on the subject. Even if you don’t read them, the titles should be enough for you to know why we’re rolling our eyes at the above numbers.
- Alpha is hard to measure.
- Even 3-years of performance data may not be meaningful.
- Active strategies should be an allocation, not a trade.
It’s Just a Riskier World
While interest rates may have come down over the last decade, the required (or desired) rate of return for most investors has not.
Twenty years ago, pension funds needing a 7.5% annualized return could simply buy investment grade corporate fixed income. Today, the risk landscape has changed, but their requirements have not.
A recent Wall Street Journal article touched upon this very point with a rather depressing graphic:
The reality for investors today is that we’re not living in a world of easy 7.5% returns. The above graphic shows us that compared to 20 years ago, our portfolios need to be nearly 3x more volatile, at least if we adhere to a static approach to asset allocation.
This is particularly troubling for institutions with fixed obligations or retirees trying to beat inflation while still generating enough income to live off of.
Retirement will be far less carefree if portfolios need to be nearly 90/10 equity/fixed income to meet return objectives, an allocation that could easily lose 50%+ during a recession.
Active returns may be part of the equation, but at Newfound we’d advocate that active risk management may be much, much more important in a world where investors must take increased beta risk to even come close to their investment goals. Buy and hold or static allocation works best when forward return estimates are high. In a world where forward returns look to be depressed, but investor expectations remain high, a more dynamic and flexible approach to asset allocation may be one of the only options.