One of the biggest challenges that investors today face is how to build a portfolio that can deliver high single-digit, if not (in an ideal world) double-digit, returns. Many professional investors – especially US endowments, foundations and pension plans – have built up an expense profile which requires them to earn an eight to nine per cent return on their investable capital. These are among the largest and most sophisticated pools of capital globally — but anything less than this hurdle rate, and significant cash will have to be injected or spending plans put on hold.
Earning such returns has been possible, at least for US investors over the past 30 years, since most asset classes have had periods of very strong performance. For example, between 1982 and 2000, the S&P 500 delivered 15.6 per cent annualised real returns (source: BCA). Between 1981 and now, 30-year treasury bonds delivered 8.8 per cent annualised real returns (source: BCA). Even among real assets, we have gone through a real boom in commodities, gold, farmland and oil over the past few years. Thus, if investors had been able to take advantage of the equities boom till 2000 and then gradually tilted their portfolio towards bonds and real assets, they would have done quite well.
The problem for most investors today is that while it is still critical to try and strive for the eight to nine per cent returns, there is no obvious place or asset class from where such returns can be had.
Take the case of bonds, especially government securities, the largest weightage in many institutional asset allocations and the biggest driver of returns over the last decade. The primary driver of the secular bull market in bonds was falling inflation (accentuated by current hyper-easy monetary policy), though real yields have also dropped. Thirty-year bond yields (US government securities) declined from 14.7 per cent in 1981 to 2.7 per cent today. From here it is highly unlikely that yields will drop any further, effectively implying that the bull run in this asset class is over. Government securities (G-Secs) may still be the place to be until investor confidence is restored, but they are not going to give you anything like the 8.8 per cent annualised real returns of the past 30 years. At the moment, US 10-year treasuries are giving you a yield of about 1.65 per cent (with similar yields for UK gilts and core euro bonds). If yields rise to more normalised levels of four to five per cent over the coming couple of years, then buying G-Secs today will deliver you a negative return over a five-year horizon. There just seems to be no way you can suck any more returns from this asset class. To achieve any returns from here, a buyer of G-Secs has to implicitly assume the world will become another Japan, with yields stuck near zero for an extended period. The only other way to gain yield in the G-Sec space is to hold your nose and look at the stressed peripheral European sovereigns. If the euro holds together and the world becomes calm again, one can make reasonable returns holding Spanish, Italian and other peripheral country debt. Given the uncertainty surrounding the euro zone, however, few will be comfortable making this bet.
Given the generalised low yield levels across the fixed-income complex, even high-yield bonds in the US will be unable to deliver anything more than six to seven per cent annualised over the coming years. Thus, even going out on the risk curve will not deliver the return profile needed. The US is, by far, the most liquid high-yield market; even though returns are higher in Europe for high-yield instruments, there are limitations on market size and liquidity.
As for equities, based on work done by the folks at BCA, we get an expected return profile of about 6.5 per cent annualised for US stocks (total annualised return over the coming five years). While this is better than the potential negative return profile of US G-Secs, it is not enough to get you towards your eight to nine per cent hurdle.
Emerging market equities, based on the assumptions and modelling done by BCA in their base case, should deliver 8.6 per cent annualised total returns over the coming five years. This gets us near our hurdle, but the reality remains that most institutions have practical limits on how much they can invest in emerging market equities, based on liquidity and volatility thresholds. In BCA’s optimistic case for equities – wherein multiples expand, profit margins remain at current elevated levels and nominal GDP growth comes back to trend – US equities can deliver 14 per cent and emerging market equities 18 per cent annualised total returns. Great, if it happens, but this cannot be your base case. Again, one can get higher prospective returns from euro equities (compared to the US), given how badly some markets like Spain and Italy have performed over the last 18 months; but you need to be willing to make the bet that the euro zone holds together in its current form and economic conditions normalise.
In the world of real assets, it is once again hard to argue that you can see any serious value here. You may find pockets of real estate, or one particular commodity with a very favourable demand/supply dynamic, but value in a more generalised sense for the asset class as a whole is missing. The prices of gold, metals and oil are all high by historical standards and the commodity complex more generally is no longer under-owned, as exchange-traded funds have spread ownership much more broadly than the norm.
So what can an investor do? If you assume that the global economy muddles through, then interest rates have to normalise at some stage, making government bonds unattractive investments. If the global economy collapses, then all hell will break loose and you don’t want to be in any financial asset — cash will be king. The only way investors can get anywhere near their target portfolio returns is to increase the risk in their asset allocation and move more into equities, especially emerging market equities. While equities have had a horrible last decade (delivering negative returns) and have not outperformed bonds over the last 30 years, maybe their time will come soon. Companies with quality balance sheets and sustainable high dividends will be particularly attractive. In a low-returns world, with limited capital gains, dividends will once again become a major driver of returns. Globally, many companies are sitting on huge piles of cash and low payout ratios. As markets incentivise higher dividends through positive price action, companies can and will raise payouts. While it is fashionable to call for the death of equities, global investors may have no option but to once again look to this asset class for returns. No other broad and liquid asset class seems to be able to step up and deliver higher returns.
The author is fund manager and CEO of Amansa Capital
