Institutions with allocations to outcome-oriented strategies are often underwhelmed by relative performance evaluated by using blended benchmarks comprising government bonds and large-cap equities. Measured over three-, five- and 10-year periods, such benchmarks lack context. So, before reducing allocations, we urge further dissection of asset returns to create context, fully understand results and build realistic risk and return forecasts.
At Standard Life Investments, we use two dimensions of evaluation: we consider economic eras; and we incorporate start-versus-end valuations.
Economic eras matter to fixed income returns
Identifying specific economic eras with distinct, self-reinforcing characteristics throws new light on fixed income returns.
Over the past 50 years, for example, the U.S. witnessed a distinct era when inflation repeatedly overshot forecasts, followed by an era of persistent disinflation. Consequently, U.S. fixed income delivered an average three-year real return of -2.3 percent from 1966 to 1981, compared with 5.7 percent from 1982 to 2016 — markedly different outcomes.
Our study of real annualized returns since 1871 revealed that the variance of returns is just as great for fixed income as for equity, despite far lower volatility for fixed income over shorter timeframes. So, investors have been as likely to experience a large loss from fixed income as from equities, challenging the perceived “safe-haven” status of bonds.
Start-versus-end valuations matter to equity returns
Economist Peter Bernstein critically observed that changes in valuation between start and end dates obscure the basic return earned by an asset class. From over 200 years of data, Bernstein organized real returns around widely separated dates and identical valuations to uncover what he termed the “basic return” of the U.S. equity market, which he and others estimate to be 5–7 percent.
Our own analysis sought to confirm that a particularly strong equity market and higher valuations go hand-in-hand. We compared start and end valuations for all 10-year periods where
equity markets achieved a real return of 5 percent or greater. We found the basic equity return outcome was met or exceeded in virtually all cases (95 percent based on data since 1871) where valuations looked relatively “cheap” at the starting point. Thus, expanding valuations are a key driver of equity returns.
For fixed income, each era will be different, making it all the more critical to focus on fundamental changes. Interest rates may now be bound at lower levels, with incidents of zero and negative rates more frequent and enduring. Or, this may be the onset of a new era, with its own unique characteristics.
For equity allocations, clean, convenient time periods will rarely share the same start and end valuation. Just as valuations determine boundaries and probabilities of potential returns, so the expected outcome fluctuates.
The 30-year bond bull market will end, and equity market valuations are likely to remain volatile. So, delivering the required risk and return will require different tools. The more tools in the box, the better the outcome — provided the manager has the expertise to pick the right tools and use them to advantage.
Join us on March 29 when Institutional Investor hosts: Is 60/40 the Right Tool for the Job? Rethinking Performance Evaluations of Outcome-Oriented Strategies. To register, visit institutionalinvestor.com/SLIwebcast.
IMPORTANT INFORMATION: Past performance is no guarantee of future results. This material is for informational purposes only and is not meant to be legal or tax advice for any particular investor, which can only be provided by qualified tax and legal counsel. This document may not be used for the purpose of an offer or solicitation in any jurisdiction or in any circumstance in which such an offer or solicitation is unlawful or not authorized. Parties should independently investigate any investment strategy or manager, and should consult with qualified investment, legal, and tax professionals before making any investments. Standard Life Investments (USA) Limited and Standard Life Investments (Corporate Funds) Limited are both registered as an Investment Adviser with the US Securities and Exchange Commission. Standard Life Investments (USA) Limited is also registered as an Exempt Market Dealer in Canada.
Standard Life Investments Limited is incorporated in Scotland (SC123321) at 1 George Street, Edinburgh EH2 2LL. Standard Life Investments Limited and Standard Life Investments (Corporate Funds) Limited are authorized and regulated in the UK by the Financial Conduct Authority. Standard Life Investments Limited is exempt from registration in Canada through reliance on the International Adviser exemption under subsection 8.26(3) of National Instrument 31-103 (the “Instrument”). These advisory services are provided only to permitted clients as defined in the Instrument.
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