Last month we used the term "Pollyanna" to describe the optimistic return scenarios that need to occur for institutions and plan participants to cover their liabilities. The term originated with the 1913 children’s book of the same title by Eleanor Porter. In it, the young Pollyanna plays the “Glad Game” where one finds something to be glad about in any situation. As an orphan growing up with a strict aunt, Pollyanna finds a reason to be optimistic even as she faces obstacle after obstacle in her new surroundings.
Investors today would do well to play a bit of the Glad Game. Despite a world of low single-digit yields and high single-digit return targets, there are ways that investors can span this seemingly irreconcilable gap. Let’s descend from our wall of worry and see what steps we can take on the bridge between reasonable prospective market returns and the aspirational returns needed to meet our liabilities.1
As we outlined in the October 2010 issue of Fundamentals, the easy—and wrong—way to get long-term return expectations of 7.5–8.0% is to use aggressive return assumptions.2 In so doing, we risk allowing our return assumptions, not relative investment merit, to drive our asset allocation choices. Our preferred approach is to build a strategy using conservative long-term return assumptions that we think can be achieved without exceptional manager skill or outsized alpha. Our current return assumptions are shown in Table 1, with a summary of our rationale presented here.
Stocks: Combining U.S. stock yields of 2% with long-term historical growth rates for earnings and dividends of 1% provides a real return expectation of 3%. Add in 2% for inflation (roughly today’s break-even rate for long TIPS) and investors can expect about 5% on domestic stocks. International developed market stocks offer a higher yield, but likely slower growth, so it’s dangerous to assume more from those allocations. Emerging markets likely offer higher growth and dividend yields but are expensive relative to their own historical returns. On top of the broad equity market returns, we are assuming an additional 2–3% for using the Fundamental Index™ approach in the developed markets and 4.5% for emerging markets.3
Private Equity: We assume a higher private equity return with a little trepidation. High fees and hidden volatility can make these strategies more profitable for the manager than for the investor. Still, we presume that the best private equity managers can deliver moderate alpha. Those relying on this asset class have to be very confident that (1) their selected managers have a competitive advantage which exceeds the fees, and (2) they themselves have superior skill in choosing the managers.
Global TAA, Alternative Assets: To achieve a 7.5% return, we’re assuming programs that emphasize alternative assets (anything outside of mainstream stocks and bonds) and target real returns can earn a bit less than private equity. Furthermore, a real returns focus should deliver sharp reductions in volatility, especially relative to liabilities.
Investment Grade Bonds: We assume investors can achieve about 1% over the current Barclays Aggregate yield of 2.5% by taking on a bit of duration and a bit of investment-grade credit risk. Moving away from cap weight adds another 0.5%.
High Yield and Emerging Markets Bonds: Riskier bonds have higher yields (5–8% yields now), but they also carry higher default risk, so we think 5–6% makes sense. Adding 2% for moving away from cap weight—empirical data suggests that this is conservative—brings us to the 7.5% estimate.
Liability-Driven Investing (LDI): Duration extension is cheap (today) given the steep yield curve. If 20-year bonds give us 3.5% at a time when cash yields are zero, and if we leverage an LDI slice two-fold, we get an implied yield of 7%—until the yield curve flattens. The nice thing is that the yield curve slope will tell investors when this opportunity is no longer available. This strategy is also an inflation policy against sustained deflation in which current yields would seem too rich, not too low.
Long TIPS: This is the safe haven that best matches a true risk-free investment for most institutions and individuals. Unfortunately, TIPS are not priced to offer much real return at the moment. A low real yield might be fine—better than most assets—if inflation kicks in, as we think is reasonably likely. We also think that the long TIPS yield (currently 1.7%) will fall below 1.5% at some point in the next three to five years. What PIMCO terms a “New Normal”—an extended period of reduced economic growth—is consonant with lower real yields. TIPS would deliver capital gains, on top of the yield, which itself rides on top of an inflation rate that may prove daunting in the years ahead. Even with a modest return, this is an inflation policy against severe bursts of future inflation.
Hedge Funds and Real Return Strategies: Hedge funds—like most lock-up strategies—offer a certainty of higher costs and usually hidden risks in exchange for the possibility of higher returns. We assume that these funds will offer 4–5% real returns, net of their lofty fees. In fact, we believe that poorly chosen hedge funds will do far worse than this, while a well-selected portfolio of hedge funds may do somewhat better. Real return strategies include a roster of ideas as diverse as timber partnerships, direct real estate, and infrastructure. These asset classes are mostly illiquid, with hidden risks, but are often more sensibly priced than hedge funds.
With this conservative (but, in our view, realistic) roster of return assumptions, the classic 60/40 blend gets investors just over half of their 8% expected return target. Apropos of our Fundamentals from October, “Hope is not a Strategy,” we think it’s very important to recognize that if we expect 8% at a time when conventional balanced investing is priced to deliver 4% long-term returns, our plans are ruined. Reciprocally, if we expect 4% and find ways to earn 8%, our plans are sound and we wind up richer than we expected.
This dilemma prompts two suggestions and a critical distinction between expected returns and aspirational returns.
- Our expected returns should be reduced, systematically and steadily, to a more realistic level. These expectations should be deliberately conservative, reflecting a high level of confidence. We should never expect alpha derived from manager skill, nor should we set returns by extrapolating the past. Past is not prologue.
- Our aspirational returns can be considerably higher, reflecting the fact that thoughtful investors, willing to stray far from mainstream, can—and often do—capture much higher returns. But we dare not depend upon earning the aspirational returns until after they’ve been achieved!
In effect, investors should hope for the best while planning for the worst.
The (Maverick) Risk and Return Trade-Off
Merely aspiring to higher returns is not sufficient. One must painstakingly craft strategies and portfolios that can achieve these aspirational returns without undue reliance on manager skill and without sharply higher risk. Here, it’s important to return to the risk paradigm that I proposed in the Financial Analysts Journal in 2003,4 recognizing that there are several distinct risk measures, each of which has independent relevance and each of which can hurt us. There’s conventional volatility in returns, which introduces a risk of poor investment returns. There’s the asset/liability mismatch, which leads to a risk that we cannot cover our future obligations. And, there’s maverick risk, in which investors choose a different path than their peers, exposing them to criticism, especially when performance suffers. All three risks are hugely important. Yet, we typically focus our analytics on the first of these, simple volatility, and our behavior on the last of these, maverick risk.
In today’s low yield environment, investors can take steps to earn higher returns than the classic 60/40 allocation with reasonably high confidence in their return advantage. Table 2 outlines a series of steps investors can take to boost their long-term expected portfolio returns. Each step improves our prospective returns, and most serve to reduce both volatility and asset/liability mismatches.5 No single step is radical and no single step gets us to our aspirational returns. But if we continue down the progression as outlined below, we discover 7–8% is achievable… as long as we are willing to cut ties with the peer group and accept substantial “maverick risk.”