How to Meet Clients’ Expectations in a Low Return Environment – Part 1
Posted on: 06/21/2016
By Chuck Self
The McKinsey Global Institute (MGI) recently released a study on . They cite the “exceptional economic and business conditions” during the past 30 years that led to above-trend equity and fixed income performance. They believe that over the next 20 years, the United States and Europe will see lower stock and bond market total returns.
In MGI’s slow-growth scenario (their base scenario), US equities will, on average, earn 4.0% to 5.0% on a real (inflation-adjusted) basis over the next 20 years compared to 7.9% over the past 30 years. US fixed income real total returns will drop from the historical 5.0% since 1985 to 0.0% to 1.0%, on average, through 2035.
Although there are some who have questioned the analysis of the data (most notably, Laurence Siegel in ; Larry is a very smart person and his response should be studied), few would question the direction and even the extent of the decline in returns suggested by MGI. If this is true, financial advisors and their clients are experiencing the following conundrums:
- For most working households, their greatest wealth is in human capital.
- Since the current employment milieu has increased the volatility of return on human capital, households would like to reduce the volatility in their savings.
- Yet, in order to earn historical rates of return needed to meet their financial goals, households will need to take on increased investment risk
- For retired households, their greatest wealth is asset-based capital.
- Since individuals are living longer, the path of investment returns received is more important than ever.
- Even though households would like to reduce the volatility of their investment return path, they cannot since they need to incur increased investment risk to meet their withdrawal requirements.
To illustrate the problem, let’s look at a typical client with a 60% US equities and 40% US fixed income allocation. If the client had invested a lump sum in 1985 with this target, she would have earned 6.7%, on an inflation-adjusted basis. Working households that stayed the course and contributed to their retirement plans had a significant chance of paying for educations and comfortably retiring. Retired households could take 4% to 5% out of their retirement accounts and see their balances grow on a real basis! It was a great time to be an investor.
Looking ahead, a client with the same asset allocation is expected to earn a real 2.9%. Although positive, the outcome compared to historical growth is massive. $100,000 invested at 6.7% will grow to $365,837 after 20 years (plus the growth from inflation.) At 2.9%, the $100,000 lump sum becomes $177,136. The 20 year growth in the account is 70% less at 2.9% return than 6.7%.
This is especially devastating for retired households. The generally accepted minimum withdrawal rate is 4%. At 2.9% growth and a 4% withdrawal rate, a $100,000 lump sum becomes $80,154 on an inflation adjusted basis at the end of 20 years. This assumes that 2.9% is received evenly throughout this timeframe. Clients that retire right before a strong bear market in stocks (think about those individuals that retired in 2007) could have devastating results.
The reality is that clients who need to depend on investment returns to meet their life goals will have to increase investment risk, but the adverse methods to do so include:
- Increasing allocations to equity risk. This includes raising asset allocations to stocks, credit-based fixed income classes, and private equity investments. By doing so, portfolios are becoming less diversified and more volatile. This is clearly against the client’s financial interest.
- Within equities, purchasing riskier sectors. This includes establishing or increasing allocations to small cap stocks, “high-growth” industries, or emerging foreign markets. Although these asset classes should outperform the broad market over time, the path along the way can be very curvy. For instance, the chart below presents the price of the leading emerging market exchange traded fund over the last nine years. 2007, 2009, and 2010 were great years. But would your clients stay with you after a 60% drop in 2008 or 35% drop in the year ending March 2016? Even biotechnology, the recent darling of sector investors, experienced a two month decline of 30% over 2015’s year-end.
- Allocating to leveraged real asset or hedged partnerships or funds – Of the three, we have some sympathy with this course of action. We believe that, for the most part, clients are under-diversified. Client with a 60% stocks/40% bonds allocation will be better served with a 50% stock/35% bond/15% alternatives allocation. But we become concerned when the alternative utilized are leveraged and increases portfolio volatility. Again, path risk is heightened when volatility is increased.
Recommendation: The best way to meet your client returns expectations in this market is to diversify the equity management process. Too many clients have stock allocations in static portfolios that are invested according to the nine-box capitalization-style matrix (large value, small growth, etc.) Unfortunately, an investor can have exposures to all of the style boxes and yet not have true diversification. As indicated in the graph below, all of the style boxes are highly correlated to each other. Therefore, little risk reduction will take place in equity portfolios utilizing this structure.
Advisors should choose an alternative scheme that provides true diversification. For example, the chart below represents a portfolio that uses, for the most part, low to moderate correlated sectors. In fact, the bond class is negatively correlated with many of the equity sectors. Portfolios comprised of these sectors can be created that have the potential return of the equity market and while reducing portfolio volatility due to the low correlated nature of the holdings.