Cash is back – should target returns vary in this new era?
Interest rates look like they're staying higher for longer, meaning that cash is offering investors a return once again. We look at what this means for portfolios with a cash+ X% target: where should the X be set and should it be adjusted as the market environment evolves?
When investors set out to profit from markets, they will usually have a target in mind. In investment management parlance, the two most common types of portfolios are those which are benchmarked (investors try to beat the benchmark) and those that are benchmark-agnostic (a focus on absolute returns).
This paper will focus on discussing benchmark-agnostic portfolios, and more specifically, if a Cash+ target should vary over a market cycle.
X marks the spot: how do we chart a course for absolute returns?
Benchmark-agnostic targets are often measured in excess of cash returns or inflation numbers, also known as Cash +X% or CPI +X% targets.
These targets are independent from benchmark indices, which in theory grant investors a wider selection of investment opportunities without being tied to the benchmark. This comes with a drawback, as investors must expertly navigate choppy market conditions and they will be expected to deliver absolute returns regardless of market fluctuations. Also, asset owners often have investment constraints and risk limits to follow, so it isn’t as simple as buying the highest returning asset.
But what is an appropriate number to set X at? If X is too high, then investors will have a difficult time trying to achieve investment goals without taking excessive risk, and if X is too low then it might not meet longer-term financial goals. This specific question is gaining traction this year as cash targets have risen to due to global central banks tightening monetary policy (Figure 1).
Figure 1: Rolling cash returns have not been so high in over a decade
The sudden and sharp increase in rates has led to a shift in market narrative, with investors asking whether rates will stay higher for longer, and if so what might that mean for portfolio construction.
While we think that the bulk of the rate increases have already been priced in markets, there could be lasting implications on portfolios. One example is a shift in efficient frontiers (which are extremely important in portfolio construction). In Figure 2, we show how the efficient frontier flipped from the 1990s to 2000s, and what was once the optimal portfolio might not be the case going forward.
Figure 2: The efficient frontier is not static
We’re not arguing that the efficient frontier will shift significantly over the course of the next decade, but it’s undeniable that we’re seeing a regime shift. This is being driven by what we’re calling the 3D Reset (the 3Ds being deglobalisation, decarbonisation and demographics) leading to higher inflation and interest rates for longer.
The market environment plays an important part too – will the higher rate environment we see now challenge portfolios with absolute targets? How do we then address these challenges?
How have portfolios performed against these Cash+ targets over history?
Given the cyclical nature of financial markets, the starting point used in the following comparisons matter. Here we look at the classic 60/40 portfolio against a Cash +3% target. A 60/40 portfolio that incepted 30-years ago would have comfortably outperformed up to Cash +3% except during the global financial crisis years of 2008-2009 (red circle in Figure 3).
Figure 3: Small period of underperformance vs cash +3% during the GFC
If the portfolio was incepted in 2000, the portfolio would only start to outperform the Cash +3% target in 2013 (Figure 4). In other words, investors would have had their patience tested as the portfolio failed to meet their target returns for 13 years.
Figure 4: Portfolio only started meeting target 13 years after inception
The post-GFC recovery years are also important when we conduct historical analysis. For example, the 60/40 portfolio that incepted when markets were at their lows and recovering in 2010 would have only seen the rainbow after the storm.
Figure 5: Relatively smooth sailing for investors who bought in at 2010 rather than 2000
What about more recent years? The Covid pandemic derailed financial markets for a while, and tightening financial conditions meant to combat inflation also posed as headwinds for markets. A 60/40 portfolio that incepted right before the pandemic situation would have fared fairly well up until the end of 2021. It began struggling during the battle to tame inflation this year but still manages to display several periods of outperformance despite minimally underperforming the Cash +3% target at end-September 2023.
Figure 6: Volatile returns but ultimately remaining afloat
Is there a better way of looking at this? We calculated the monthly relative performance of the 60/40 portfolio against the various Cash+ targets and found that the 60/40 portfolio met targets more often than not (Figure 7).
Figure 7: 60/40 often outperformed Cash+ targets
How do we then determine what an appropriate Cash+ target is?
To set a target that is achievable, yet not too easy or requires taking unnecessary levels of risk, we take a step back and look at our capital market assumptions and what our return forecasts are telling us. Our return forecasts are based on risk premia in excess of cash returns over a full market cycle, which we assume to take place over 10 years. The 10-year return forecasts expect cash to be approximately 3%. Using a simple 60/40 portfolio consisting of US equities and US government bonds (Figure 8), the expected returns would be 6.0% per annum over the long term. Further assuming a 50 basis points value-add in alpha from active management would lead to a total of 6.5% expected returns per annum. If we expect cash to be 3% over the long-term, then a Cash+3% target, or roughly 6% per annum, would be appropriate.
Figure 8: Strategic asset allocation modelling based on our forecasts
If markets are smooth sailing, should cash targets be revised higher?
In other words, should the target vary depending on the phase of the market cycle? Although it is tempting to aim for a higher return like Cash+8%, we think that investors should keep a calm head and keep their targets. By changing return targets, managers must reassess their asset allocation and they then run the risk of adding risk or de-risking at inopportune times. For example, if you had lowered your cash target and subsequently de-risked your portfolio in the wake of the global financial crisis in 2008 with expectations that markets will remain depressed for a longer time, your portfolio would have missed the subsequent recovery (Figure 9). One could argue that managers would then re-adjust targets when markets were recovering, but if targets are adjusted so often, it eventually becomes a meaningless exercise.
Figure 9: Sometimes holding steady might be the way to go
By keeping the original objective, investors also inherently accept that sometimes (for example, during prolonged bull markets) it is relatively “easier” to hit targets than other times. The more important question for clients is to ask is if your active investment manager is doing a good job, and what the appropriate way to measure this is. One way to do this is to measure an actively managed portfolio against a passive comparator benchmark and determine if active decisions made have contributed to portfolio returns or if returns are merely arising from beta exposures. Some of our portfolios also have peer benchmarks, which allows our clients to measure fund performance and determine who is better at making investment decisions given the same constraints. Taking things one step further, returns attribution can dissect returns and show the strengths of the manager, whether it is through underlying stock picking or tactical asset allocation decisions.
But there are still moments where adjusting the target makes sense
On the more technical side, an example of when we adjusted the Cash+ target was the discontinuation in the London Interbank Offered Rates (LIBOR) that took place in June 2023. We had clients whose portfolio referenced LIBOR as their short-term target and were forced to switch out to risk-free rate alternatives such as the Secured Overnight Financing Rate (SOFR). When portfolios transitioned from a LIBOR to SOFR benchmark, both rates had been trading relatively close with each other but were not identical (Figure 10). LIBOR was a rate based on bank credit, so it had historically higher rates than the SOFR (which is a risk-free rate) of the same tenor. To ensure that portfolios effectively have the same target after the transition, a small spread adjustment can be implemented when portfolios shift from using the LIBOR to SOFR as the reference rate.
Figure 10: Spread between LIBOR and SOFR 1-month rates have been stabilising
On the same note, we understand that meeting short-term return targets is as important as meeting them over the long-term. It’s important to recognise that while using a 10-year forecast provides a useful long-term view, they may not provide significant insight into short-term market movements. Therefore, these expected return assumptions are merely a guidepost for setting the hurdle rate. This ensures that the level of risk premium we deem sufficient and achievable over a market cycle for a given level of portfolio risk is met. On a day-to-day basis, our focus is on managing the portfolio risk and the efficiency of risk allocation to capture returns in the current opportunity set. This approach of managing from a risk perspective gives us the flexibility to adapt the portfolio over different phases of the cycle and stay on course to achieve the investment objectives over the long-run.
Does a choppy interest rate environment put a dent in absolute return portfolios?
Dynamic asset allocation and flexible implementation help us address the challenge of managing absolute return mandates in a high interest rate environment when the characteristics of asset classes change.
It is crucial to identify two distinct stages that result in significantly different risk premia behaviour in a high interest rate environment. In the first stage, which is similar to the past 18 months, high inflation has driven central banks globally to raise interest rates to levels not seen in the past decade. As a result, we have observed widening risk premia and unstable cross-asset correlation in the market. Specifically, in the case of multi-asset portfolios, traditional diversifiers in a low inflation regime, such as developed market government bonds, are no longer effective as the bond/equity correlation has increasingly become positive. To address this challenge, dynamic asset allocation remains key and investors have to rethink the way they use government bonds in portfolios. If bond/equity correlation stays positive, it means that both asset classes face the risk of falling at the same time. Managers have to seek out asset classes that will tactically provide benefits in these scenarios. If this persists in the long-run, then investors should consider adjusting their structural asset allocations too (read: Commodities, a structural allocation for the next decade).
Fortunately, after the rapid interest rate reset in both emerging and developed markets over the past 24 months, we believe that most markets have reached or are nearing peak rates. As we enter the second stage of the high-rate environment, interest rates are expected to remain stable or even retreat to lower levels due to falling inflation. From a multi-asset perspective, this presents an opportunity to capitalise on the widened risk premia across different asset classes following the interest rate reset.
Benchmark-agnostic portfolios are independent from benchmark indices, allowing investors a wider selection of investment opportunities. However, this also requires investors to navigate market conditions expertly as they are expected to deliver absolute returns irrespective of these conditions. The X in the Cash +X% target should be set at an achievable level without necessitating excessive risk. As market conditions evolve, the Cash+ target should not be frequently changed unless there is a structural change in financial markets; dynamic asset allocation and flexible implementation are levers for investment managers to pull to effectively manage assets.