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Fund Selector: Defining equity returns

Fund Selector: Defining equity returns

We often talk about how a fund aims to deliver an ‘equity-like’ return across an investment cycle, but with a smoother path. But what does this really mean?

There is broad agreement that equity-like in the long term translates to mid-to-high single figures, so somewhere between 5 and 10 per cent a year. But then what does a typical year look like?

While there is a general agreement on the overall outcome, there is clearly less clarity on the likely path.

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It is important to remember that many investors undergo risk profiling or outcome-oriented assessment processes, which aim to set return expectations that can be met in the long term, but that can also be measured every year.

That would imply that it didn’t matter when you started and when you finished – that is, your entry and exit points. We all know this isn’t true, but how important is it?

Since 1969, the annual total growth in the MSCI World index has only met the ‘expected’ 5 to 10 per cent figure in four out of 46 years – or 9 per cent of the time.

Looking at this another way, equities didn’t deliver an equity-like return in the other 91 per cent of the time.

However, as we all know equity investments are best held over longer periods, where the expected returns are more likely to be achieved – or so the story goes.

When we look at the same data set taking the average returns across rolling five-year annualised periods, the hit rate for the expected 5 to 10 per cent return improves but only to 17 per cent, or seven out of 42 periods.

So even when we look at longer periods, the chances are we will still have a very different outcome to the expected return.

The Targeted Absolute Return sector in the retail space, the Diversified Growth Fund sector in the pension fund market and the liquid hedge funds favoured by wealth managers and family offices are all seeking the same objective – make money whenever you can and don’t lose too much when you can’t.

The flexibility afforded to managers in these sectors provides them with the ability to smooth out the broad outcomes that are otherwise likely.

For many investors, cutting the downside risk is the most important characteristic and benefit of a smoothed return. But in reality, the range of possible equity-like outcomes is still quite extensive.

What the variability of returns highlights is that even with a medium-term time horizon, the risks of entry point – and exit point – are real.

These are the risks that investing in alternative strategies can help to reduce, but even then the expected path is likely to be different to the one predicted.

So coming back to my question, equities will of course give you an equity return, but equity returns are extremely hard to pin down.

While alternative strategies will still show variable returns – and often quite different to equities – their range should be much narrower and ultimately more equity-like than equities.