We need to talk about…

That’s never a good line to hear. It’s the sort of line that always means a difficult conversation. A child’s behaviour in the playground. The amount of wine you’re drinking a week. The result of a medical test. Terrifying... We need to talk about guideline returns for investment portfolios.

You can breathe out now. But perhaps you shouldn’t. It’s not the conversation at the top of everyone’s “fear list”, but it should definitely be there. However, we frequently don’t see much engagement from advisers.

And it’s obvious why. No one wants to go back to clients and tell them the solution they are using will return less than in the past. No one wants to say that 6% portfolio return we plugged into the cashflow plan was “wrong”! But this conversation isn’t about what’s wanted, but about what’s needed. And honestly, we need to talk about guideline returns.

Long-term return forecasts

One of the things we do, as a multi-asset investment house, is research long-term return forecasts. We do this for all the different asset classes that would appear in a typical portfolio. These are very long-term estimates, and so don’t necessarily drive investment decisions in the near term. However, they can be used to set sensible expectations for what portfolios may deliver through time.

We take the weights of all the asset classes in our portfolios and multiply them by the return for each asset class to get a guideline return for portfolios. We have been doing this since we started running money and over the last decade these numbers have been coming down. For example, back in 2004, some 17 years ago, our guideline return number for a balanced portfolio was close to 6.5%. Today that number is more like 4.5%*. Despite a drop of a third, it is important to consider the underlying drivers of this.

Whenever people bring up guideline returns for investments, particularly in equities, it can be very tempting to get caught up in short-term arguments about valuations, bubbles and “SKY HIGH PRICES FOR TECH STOCK ABC”. However, the forces that are driving returns are more fundamental than this, less market-led and easier for end clients to understand. Recent decades have been characterised by slowing economic growth, falling inflation, and low interest rates. These forces lead to lower guideline returns.

Picking one, a key reason global growth is slower is (simply) because it has been higher in the past. Emerging markets have “emerged” and caught up with their developed peers. Some of the easier technological gains have been made; the iPhone 1 was a huge leap forward, but the iPhone 12 is not that different to the iPhone 11 (despite what the marketing would have you believe).

Finally, people globally are getting older, about 10 years older on average over the last 50 years¹. All these factors combined mean slower economic growth, which means less earnings growth for companies, and less to be paid back to shareholders. Lower guideline returns.

What are the solutions?

When thinking about lower returns for investment portfolios though, it’s important to ask what the alternative is. The real alternative, of sticking money in the bank, doesn’t cut it given the negative returns on offer after adjusting for inflation. It was much easier when cash in the bank beat the impact of inflation – but that’s no longer on offer! We think multi-asset investors face a couple of choices:

• Tweak the model away from the traditional approach, sometimes dubbed 60-40
• Accept lower returns for multi-asset portfolios going forward

The best answer is something of a combination of the two. We think it’s right to try and do better than the most simplistic passive investments, especially given the meagre returns on government bonds. This means a “better than 60-40” long run, internally produced benchmark (the proprietary 7IM Strategic Asset Allocation). This spreads the equity risk amongst credit investments and includes emerging market equity and bond investments as a default.

It also means seeking out shorter-term, “tactical” opportunities in specialist areas like US mortgages and financial debt, where we think investors take on relatively little extra risk but for potentially meaningful extra return.

For us at 7IM, alternatives are a big part of the solution but it is important to be clear on what we mean by alternatives! We favour using some market neutral investments to replace part of the traditional government bond allocation. We combine a range of different strategies, with a focus on liquidity and genuinely different returns to some of the equity-like commodity and real estate investments people usually gravitate towards when talking about “alternatives”.

It’s not an easy world in which to be building multi-asset portfolios, but with a focus on a variety of different areas, such as alternatives and credit, we think we can do a better job of delivering higher returns.

At the same time though, clients need to be aware that their expectations may be too high. The difficult conversations need to be had now, to prevent a far more painful one in ten or twenty years’ time.

Walk the walk and talk the talk

It’s right to be talking about lower guideline returns and we think investment products should be trying to do something about it. Clients with money in the bank are losing in real terms faster than ever before. For those with long-term savings goals, the impact of even a small uptick in long run returns can lead to a big difference in outcomes when we consider compounding! These are the messages advisers are best placed to deliver. We need to talk about guideline returns.

If you want to hear more on this subject, register now for our upcoming webinar.

¹ UN World Population Prospects 2019*

* The Average Annual Guideline Return (AAGR) is based on investments being held for a period of 5 years or longer. This data is based on long-term forecast asset class data. Forecast returns are not a reliable indicator of future performance. The AAGR is quoted gross of fees. If the AAGR is achieved, the return you actually receive will be lower, due to the effect of the fees and charges, as well as any other fees payable to a financial adviser.

For professional advisers only. Past performance is not a guide to returns and the value of investments could go down as well as up. Any reference to specific instruments within this article does not constitute an investment recommendation.