Such dismal probabilities are sure to be met with skepticism by the “yeah, but…” crowd. But before we address some of their expected critiques, allow us to observe that these estimates may be, in fact, too optimistic. Each mix assumes 100% passive cap-weighted implementation with no management fees or trading costs.5 Granted, cap-weighted implementation tends to be (but is not always) fairly efficient on these fronts. To be conservative, clients may wish to lower their ranges by 10–30 basis points (bps) depending on their implementation choices.
The average portfolios we discuss in the previous section are not precise replicas of each category average. They differ in two primary ways, each worthy of discussion to better understand the influence the differences have on the rather daunting probabilities of reaching a 5% real return by the end of the next decade.
First, our assumptions are for cap-weighted market proxies, which means they include no excess returns from skilled active management. Active management, while under siege, still dominates the implementation of nearly every asset class. Might diligent fund selection bridge the gap between expected and targeted returns? Not likely.
We tack onto the cap-weighted market proxies the top quartile net-of-fee alpha over the last 10 years for each sleeve of the representative mixes used in typical retirement plans such as public pension funds and TDFs. The returns creep up by 60–90 bps. This more-positive result assumes investors can find skilled managers in the first place, and then hold on to them for the entire 10 years—which, as West and Ko (2014) and Hsu and Viswanathan (2015) explain, may prove quite difficult. Only under the most heroic, and in our opinion, completely implausible, assumptions can manager alpha make a meaningfully sufficient dent to profoundly change the conclusion.
Not unsurprisingly, we have high hopes for smart beta being able to close a portion—but not all—of the gap through lower management fees, lower trading costs, and reduced governance requirements. But we are hopeful only if, and it’s a big if, the smart beta program is employed to minimize performance chasing, or better yet, is executed in a disciplined, contrarian manner as discussed by Arnott, Beck, and Kalesnik (2016).
Second, the Research Affiliates 10-year forecasts do not (yet) cover illiquid or alternative strategies, such as hedge funds, private equity, and real estate. Recent studies conducted by Milliman (Wadia et al., 2016) and the National Association of State Retirement Administrators show that as of fiscal yearends 2015 and 2014, respectively, between 20% and 23% of private and public pension plans were invested in the alternatives categories, leaving 77–80% in the baseline liquid asset classes we model.6
If the vast majority of the portfolio is expected to produce a 2.5% real return, then the pie slice of alternatives has to earn closer to a 12.0% real return after all fees and expenses in order for the entirety of the plan to generate a 5% real return.
A look at eight well-known alternatives benchmarks—the NCREIF Property, Closed-End Value-Add, and Timberland indices; the Cambridge Private Equity and Venture Capital indices; and the Hedge Fund Research Index (HFRI) Fund of Funds Composite, Equity Hedge Total, and Fund Weighted Composite indices—shows that three (two real estate indices and the fund-of-funds composite) never earned a real return of 12% or higher over a 10-year period within the last three decades, and none hit that mark more frequently than in half of the 10-year periods.
Today, given the current starting cocktail of low-cap rates and high public-equity valuations in the United States and the substantial capital flowing into these markets, we are hard pressed to imagine an outcome in which a 20–24% alternatives allocation could push a portfolio over the 5% real hurdle. Although we’re certainly skeptical of the gap-closing potential of alpha and alternatives for most investors, a select handful will skillfully and/or luckily help them over the 5% hurdle rate. But planning on most investors netting such results seems a foolish assumption.