INSTITUTIONAL INVESTORS ARE IN A QUANDRY. They commonly
target 5 percent real annual returns, or 7 to 8 percent nominal
returns. Starting from today’s prices for stocks and
bonds, the likelihood of actually achieving those returns is
low.
When economist John Maynard Keynes was criticized for his
shifting policy views, he is believed to have responded:
“When the facts change, I change my mind. What do you
do?” Unfortunately, institutional investors have been
reluctant to publicly accept the new fact of those
inconveniently low market yields. Instead of facing the grave
reality of past promises being unaffordable in a low-return
environment, these investors — or their sponsors —
use overly optimistic return expectations as a convenient way
to keep kicking the can further into the future.
In recent years some investors have gingerly lowered their
long-run return targets, but few institutions outwardly expect
less than a 4 percent real return or 6 to 7 percent nominal
return on their overall portfolios. Over the past decade and a
half, such expectations have generally not been fulfilled, and
most investors will likely be disappointed yet again over the
coming decade. In fact, those with simple, traditional
portfolios like 60-40 U.S. stocks and bonds are even more
likely to be disappointed going forward.
Sadly, we cannot change these facts. In the following pages
we document the challenge (record-low forward-looking yields),
review common institutional responses (highly equity-centric
portfolios) and give our recommendations (more effective
diversification). Specifically, we propose balanced risk
allocations across traditional market premia, truly
diversifying return sources from liquid alternative risk
premia, and improvements in portfolio construction and risk
control. Admittedly, some of these suggestions entail the use
of direct leverage, which is an obvious risk, although one that
needs to be compared with the near-complete concentration in
equity market risk found in most institutional portfolios. We
believe that prudent use of leverage is a manageable and
rewarding risk to take. We think the ideas presented above can
give the investors who adopt them their best chance of getting
close to 5 percent long-run real returns.
Current market yields and valuations make it very unlikely
that traditional allocations will achieve 5 percent real return
in the next five to ten years. These forward-looking measures
have been correctly sending the same message since the late
1990s. They are sending an even stronger message today.
As a proxy for expected long-term real returns, we compute
the prospective real yield of the traditional 60-40 U.S. stock
and bond portfolio. Our estimate of the real equity yield is a
simple average of (i) the smoothed earnings yield (the
so-called Shiller price-earnings ratio, inverted to become a
yield) and (ii) the sum of the current dividend yield and 1.5
percent, an assumed real rate of growth for dividends per
share. The real bond yield is the difference between the
long-term Treasury bond yield and a measure of long-term
expected inflation. The figure below (“Time to Get
Real”) presents the 60-40 weighted average of the two real
yields since 1900.
Until the 1990s it was relatively easy to achieve 5 percent
long-run real returns. The long-run average real yield since
1900 is 5 percent, and realized returns matched the promise of
this prospective return as the 60-40 portfolio delivered, on
average, close to a 5 percent real annual return. Indeed, this
historical experience may have contributed to the 5 percent
real return becoming such a widely used target for
institutional investors with 60-40-like portfolios. (Skeptics
might note that trading costs and fees, not included here, were
higher in the past and would have reduced realized returns in
past decades even more than now. Moreover, 60-40 only evolved
into an institutional standard over time; until the 1960s
stocks were considered speculative investments.)
Unfortunately, that favorable environment belongs to the
previous century. Since 1998 the ex-ante real yield of 60-40
has been below 3 percent most of the time, making the task of
investors that much harder. At first — say, during the
period of 1998 to 2000 — most investors took no notice
because stock markets boomed and return prospects were wrongly
judged on past performance, extrapolating the future long-run
equity premium from what it had been in the past, rather than
on prospective yields, which at the same time were falling as a
result of excessive valuations. In addition, while equities
were getting very expensive (low yields), bond yields were
relatively high. After the tech boom turned into a bust and
bond yields fell, investors began to pay attention to
forward-looking returns, but hardly enough.
Currently, the prospective real yield on the 60-40 portfolio
is 2.4 percent, its lowest level in 112 years. Roughly
speaking, the ex-ante real yield on stocks is 4 percent and
bonds is zero percent — both below their long-run average
levels, with bonds well below.
There are really only three possibilities going forward. First,
that there has been a permanent change in fundamentals, such
that real equity earnings growth will be sustainably stronger
than in the past, making expected real returns from here much
higher than the equity yields imply. In the second scenario
these yields will remain near their current levels, and the
expected real return of the 60-40 portfolio will be permanently
much lower than it was in the past. In the third scenario these
yields revert toward their historical averages, delivering
higher prospective returns after the reversion, but as this
occurs investors will experience a period of even worse
realized returns as rising asset yields cause capital losses.
Both the second and third scenarios strike us as plausible, but
we are skeptics of the first, while recognizing that dreams die
hard.
Of course, there will be market rallies, some quite
substantial, along any of these paths, but that does not change
the fact that these three are the only possible long-term
future scenarios.
It may surprise some that the prospective real return on
60-40 is now at a record low. After all, weren’t things
worse, for instance, near the peak of the tech bubble, when
equities were so expensive? Though equities are expensive
today, they were far more expensive in early 2000 (in the sense
of high prices versus fundamentals, yielding a low expected
real return). Yet in early 2000 bonds were quite cheap on a
historical basis. Today is relatively unique in that both
stocks and bonds are expensive at the same time.
Notice that throughout our history, while sometimes low and
sometimes high, the prospective real return on 60-40 has never
gotten seriously close to negative. However, there is another
asset whose near-term outlook is even worse and in fact
negative. The lower thin line in the figure above shows the
ex-ante expected real yield on cash (defined as Treasury bills
less a short-term measure of inflation). This cash yield is
currently near record lows, –2.1 percent, reflecting the
central bank’s attempts to stimulate the economy by
pushing investors into riskier assets or providing cheap
financing for direct investments. This effort sustains the low
prospective return environment for all kinds of assets, but it
can also offer direct benefits for those who can borrow
(finance their positions) at such low rates. A key distinction,
at least for the short term, is that one could borrow at a real
rate of –2.1 percent and buy a 60-40 portfolio with a real
yield of 2.4 percent, raising the prospective return on this
levered portfolio to 4.5 percent. This positive carry on risky
assets may balance some of the valuation concerns, for the time
being.
Investors have two broad choices in how to respond to the
stark news delivered above. They could take a very long-term
view and accept that the 5 percent real return target is
unlikely to be achieved in the next five to ten years but
perhaps is still a reasonable very long-term goal, making plans
according to these lower expectations. Or they could take
action. This article is about a set of actions, based
specifically on our recommendations, of course! In particular,
we recommend:
• Harvesting a broad set of return sources, far
broader than the typical set that relies heavily on the equity
risk premium;
• Implementing a series of portfolio management
methods we label “alpha in portfolio
construction”;
• Putting in place the risk control necessary to
see this, or any approach, through the tough times.
We freely admit that all our recommendations fall into a
strange category. They are all “alpha” in the sense
of a deviation from the market portfolio of wealth that we
expect will add to performance, stability or both. But one
should not pay alpha prices for the things we propose. Some are
strategic allocation recommendations, or bets on a broad set of
systematic strategies, while others are techniques for
combining these allocations and managing their risks. In
addition, as in all forms of alpha, they are zero-sum. We do
not claim, nor could anyone claim, to fix the problem of low
expected real returns for everyone. But on the other hand, we
are not just pointing to the magical, expensive alpha of
outperformance and saying, “Solve the problem by adding 2
to 3 percent a year.” That is not a recommendation;
it’s a hope, and typically a very elusive and expensive
one. We believe our recommendations are concrete — clearly
not doable for all investors at once but certainly doable for a
large subset and at low cost.
WE NOW DELVE DEEPER INTO OUR first recommendation:
identifying diverse return sources and harvesting them
cost-effectively. Later sections will discuss the value added
from portfolio construction and risk control. It is useful to
think of the return sources of any portfolio as a pyramid with
three layers, starting from the base, with the highest-capacity
and lowest-cost sources, and moving up to the top, with the
lowest capacity and highest costs.