If I offered you equity returns at half the risk, you would bite my hand off, wouldn’t you? Yet that is exactly what even the simplest mixed-asset strategy has been able to deliver over the past 20 years
For illustrative purposes, we built a performance simulation using a basket of six indices over the past 20 years, equally weighted and annually rebalanced. These were the Bank of America Merrill Lynch US High Yield Cash Pay (great British pound hedged), IPD UK Monthly All Property, FTSE All-Share, MSCI World, Barclays Global Aggregate (GBP hedged) and Bloomberg Commodity, all on a total return basis. These indices were selected as representative of broad asset classes. Some have done better than equities, notably US high yield, while some have done substantially worse, such as commodities. The results are revealing, yet not altogether surprising. The multi-asset portfolio has produced better returns at less than half the risk.
If I worked for an investment bank, then this article would probably end now. I have shown you a back test, so you have seen incontrovertible proof that I am right and you should now go away and buy whatever it is I am selling.
Smart investors know better than that, they know to ask the tough questions. What makes these results sustainable? What does the future hold? Unfortunately, when we examine the strategy in this way we do not get the answers we are looking for.
The first difficulty is that the results are inconsistent with long-term performance data and research. Those who have studied how equities perform over long periods observe an equity risk premium of between 2 per cent and 5 per cent a year – in other words, equities perform better than bonds, reflecting that they are riskier and investors should be compensated for the extra risk. In our 20-year simulation this has not happened.
Global equities returned an annualised 6.55 per cent, while global bonds delivered a return of 7.24 per cent. Just as we thought the status quo might be restored after equity-friendly years in 2012 and 2013, 2014 is turning out to be another year where bonds are beating equities.
The second problem is that historic returns in fixed income are much higher than are likely to be achieved. Excluding some technical factors, the current yield is a pretty good indicator of future returns in fixed income. After all, the very premise of the asset class is that we get our capital back plus any coupons. The current yield on an investment grade bond portfolio is under 3 per cent, while the yield on lower grade bonds is less than 6 per cent. This compares unfavourably with historic returns of over 7 per cent in investment grade and nearly 9 per cent in high yield. So the future is likely to be very different from the past in this asset class.
A third difficulty is that correlations are higher than they used to be. Assets such as commodities are still valuable diversifiers, but they are not as uncorrelated as they once were. Extending this point outside our simulation, the same is also true of other alternative assets and strategies – our markets have become more ‘risk on-risk off’ and diversification is harder to find.
Therefore, in the future, if it is unrealistic to achieve equity-like returns without taking equity-like risks then what are the benefits of a multi-asset approach? Why have they become so popular and why are they likely to remain so?
The answer lies in a different direction. There are three things that affect the outcome of an investor’s return – the investment they buy, the performance of that investment, and when they buy and sell it. There is a lot of evidence that investors’ most significant problem is that they make big behavioural mistakes when they invest. The US research firm Dalbar has published some revealing data as to the scale of this problem; on average, individuals investing in US equity funds over a 20-year period experienced returns nearly 5 per cent a year worse than the market. Contrary to what the index fund managers would have you believe, this was not because the funds these investors picked underperformed, but rather because they often bought and sold at the wrong times.
This negative market timing by investors was not because their rational decision-making was poor. If it were as simple as that, then good education or strong financial advice would be enough to mitigate the problem. As humans, our emotions impinge on our rational mind – scientists call this an empathy gap. Fear and greed are some of the most powerful emotions, so they are powerful enemies to successful investing. The only way to break the cycle is to match the risk level of a portfolio to an investor’s attitude to, or tolerance for, taking risk. This is where multi-asset solutions come into their own by being able to aim for as much return as they can achieve from the risk budget that they are given.
In order to do this we need to stop looking in the rear-view mirror at back tests and start to drive by looking at the road ahead of us. The way forward has some harsh truths, bond returns will not be what they have been historically, but they still provide some return and, significantly, diversification benefits from assets dependent upon economic growth for their success. Investors will have to continue to search for diversification – assets such as infrastructure and commercial property can continue to provide that.
Crucially, this is not about guesswork. Markets often tell us a lot of valuable information about future returns if we are disciplined enough to read the road signs, but much more importantly, they tell us about the spread of possible future returns. In other words, they tell us about the risk that we are taking when we invest. We can use this information to deliver returns in a way that matches an investor’s tolerance for potential losses.
This can be thought of as an evolution in its own right. Rather than spending our time on an unrealistic quest through the investment world for the holy grail of equity returns without equity risk, we can settle down for the less glamorous task of delivering returns in a package which our investors can hold through the cycle, using them to build wealth. That is a true holy grail. It is here today, right in front of us, if we are wise enough to embrace it.
John Ventre is portfolio manager of Old Mutual Spectrum Fund Range
Key points
* A multi-asset portfolio based on equities has produced better returns than a basket of six indices at less than half the risk.
* Historic returns in fixed income are much higher than are likely to be achieved.
* Fear and greed are some of the most powerful emotions so they are powerful enemies to successful investing.
