Return expectations: Is 5% Real “pie in the sky”?
In a global environment of low interest rates, narrow credit spreads and demanding equity valuations, we ask the question “Is a 5% real return achievable without undue risk?” This paper suggests that while the re-engagement of the Fed has been a big driver of recent returns, this is unlikely to continue at the same pace. Managing beta actively will be paramount, as will be extracting alpha from a broad array of sources including interest rates, currencies, style biases (value v growth) and active stock selection. It concludes that while there are risks to both the upside and the downside “real 5%” remains an achievable, but nonetheless challenging objective over the next 3 years.
We last formally documented our views on achieving a “5% real” return in June 2016¹. At the time, there was growing debate about the challenges of achieving this target given low nominal bond yields and elevated equity valuations.
Our conclusion was that achieving “5% real” would be “tough” but achievable on a 3-year horizon. We doubted “beta” in core assets alone would be enough. We also argued that it would require an episodic bias to equities over bonds, active asset allocation and active management at a strategy level for additional alpha contributions. We also argued that avoiding drawdowns (like 2018) would be important.
Returns to “beta” over this period have exceeded expectations (both ours and the markets). The Real Return strategy has achieved a return of 4.3% real before fees over the 3 years to June 2019, admittedly below its return objective, but not miles away as was the prevailing concern at the time. From a risk perspective, volatility has remained exceptionally low (2.6%) with a maximum drawdown of -2.6% (vs -9.4% for the ASX 200).
Despite clear headwinds and ongoing questions about the achievability of “5% real”, this return was achievable. For the Real Return strategy, more equities in 2017 and less in 2018 would have made the difference needed. Slightly better timing and we would have hit our return target. Certainly traditional “balanced” type funds with a more structural equity exposure have done well.
Today, the outlook is more problematic. Cash rates and bond yields are low, including now in Australia where they are around 0.5% lower than 3 years ago, credit spreads are narrow (in Australian investment grade credit almost half the level they were 3 years ago), and equity valuations, especially in the US are still demanding. Base yields for bonds and equities alone won’t get to 5% real, meaning, from a core asset beta perspective capital appreciation will be required.
Achieving “real 5%” will also likely require more than “beta” alone can deliver. While there is no silver bullet, managing increased volatility through more active and potentially aggressive asset allocation will be paramount. In addition, extracting alpha from adjustments to interest rates, currencies and style biases (value v growth for example) will need to contribute, as will active stock selection in key areas. Passive beta could be problematic in this context. The risks here are bifurcated suggesting problems for fixed SAA structures (just because they’ve worked well recently doesn’t mean they will going-forward). Increased turbulence will likely be a feature with a US led recession within a 3-year window our base case.
Our conclusion is that “real 5%” remains an achievable albeit challenging return target over the next 3 years. It is not “pie in the sky”. While there are risks to both the upside and the downside, the arguments laid out in this paper suggest they are more skewed to the downside. With a US recession a likely scenario within this timeframe, managing downside risk will be paramount and more important than it ultimately proved to be in recent years.
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