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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.

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