Preparing clients to weather the storm of low returns
Tom May, CIO of Atlantic House and manager of the Atlantic House Defined Returns fund asks: could adding a more predictable long-term return to portfolios help clients weather the worst of any market storm?
There have been few shelters from the market storm as inflationary pressures mounted this year. Indeed, as bonds and shares fell in tandem, clients in some of the lowest-risk portfolios saw very similar portfolio losses to those in the highest risk portfolios.
Now, as markets struggle with inflationary pressures and contend with the weaker growth it will produce, we need to prepare clients for the prospect of lower returns in the years ahead.
After ten years in which the average return for a dollar investor in US shares has been 16.6%, Capital Economics is now* forecasting that 2022 will produce a return of -15.5% and even from this lower point will only return -1.5% by year end. Its forecast for US Treasuries over 2022 is a similarly gloomy -8.8%, compared to the long-run annualised return of 2.2% over the past ten years.
Atlantic House Investments’ own composite forecast - which is based on the average of several institutional forecasters - puts our forward-looking expected returns for a balanced investor with 55% in shares at 4.3% on an annual basis over the coming five years. This is based on a classically-optimised portfolio that would have earned 8.2% on an annual basis over the past ten years.
This reality is of course built on several factors:
the high valuations that had built in some assets such as bonds and growth shares.
likelihood of a significant slowdown in economic growth, and
larger secular factors such as de-globalisation and a structural rise in inflation compared to the ultra-low levels seen over the past ten years.
This will be a tricky time for many underlying clients who, having enjoyed a decade of strong returns, may now have to accept changing their expectations or a different approach to investing. Despite financial advisers and wealth managers talking to them about process and attempting to manage expectations, many clients will have struggled to grasp what the changing tide means for their returns.
In this context, moving from chasing the highest potential return, with a huge range of uncertainty around it, to instead pursuing greater predictability could prove to be key.
Swimming with the tide - pursing greater predictability
The long-term average return of shares over the last 122 years has been 5.3% in real terms with investors paid an average premium of 4.6% a year for the risk they have chosen to take, according to the Credit Suisse Investment Returns Yearbook 2022. The long-term analysis also reveals two key features of investing in shares during inflationary periods. Firstly, equities are negatively correlated with inflation in the short to medium-term. They are not a hedge. Yet, secondly over the long-term they are the only asset class that consistently beats that inflation. There have been many comers to challenge shares over the centuries from tulips to hedge funds, but none have delivered as consistently.
Equities, therefore, must be a key part of the answer for investors in this new low-return and high inflation environment. However, it is vital to do everything possible to help mitigate the significant losses that could be seen if the gloomy market predictions are correct.
Greatly increasing the probability of receiving the long-term average nominal return of equities seems to be a sensible option. This long-term return, around 7% a year, is still achievable in a wide-range of market scenarios using derivative instruments that can build greater predictability into portfolios.
Indeed, the pricing on offer for investors purchasing derivatives that seek to achieve a fixed return of 7-8% a year over the coming six years is better today than it has been for many years. There are no free lunches of course. An investor who seeks this return must accept much of the risk of investing in shares but is able to narrow the number of market scenarios in which they will not achieve this 7-8% long-term average return. This is achieved in exchange for forgoing the potential to outperform this number. In the current market forgoing that potential is a choice many wealth managers may be willing to make.
A portfolio of derivatives that behave like a classic ‘autocall’ can in the current environment offer investors this 7-8% annualised return over the coming six years provided investors are willing to accept the risk that if global markets, for example the FTSE 100 and S&P 500, fall by more than around 35% and fail to recover any of that loss, they will not receive this return but instead the return of the equity market itself minus dividends. Throughout the journey such an investment that was properly marked to market would rise and fall with markets – but intrinsic value can remain in place in a way that is not possible outside of the derivatives world.
It always remains possible that a depression-like scenario will bring a loss of more than 35% from which the market does not recover for six years. Whilst it is statistically unlikely, we know that black swans do float into view. However, in this scenario all types of equity investment will fall in value.
We believe that an investment that can deliver the long-run return of shares in a world of falling equity markets and structurally-weaker expected returns offers investors the possibility of building predictability into portfolios in times of economic and market uncertainty and can help your clients weather the storm.
* Capital Economics, Asset Allocation Outlook - 10 May 2022.
For Professional Investor use only
The value of investments and income from them can go down and you may get back less than originally invested. There is no guarantee that the Fund will achieve its objective.
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