Tom May: Could predictable returns be the key to setting expectations in low-return world?
Weather the Storm
Tom May: "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 multi-asset portfolios in this most uncertain of times."
As equities fall and forecasters cut the medium-term projected returns, building the predictable long-term return of shares into multi-asset portfolios can be a key tool to weather the storm, writes Tom May.
The first half of 2022 is one that most of the wealth management profession will be pleased to leave behind.
It is striking that as inflationary pressures mounted there were few shelters from the market storm it produced. Indeed, clients in some of the lowest-risk portfolios saw highly-similar losses on their portfolios to those in the highest-risk portfolios as bonds and shares fell in tandem.
Now as markets struggle to place the rising cost of money in its proper place and contend with the weaker growth it will produce, we are coming to terms with the weaker returns that are likely to be on offer 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. Firstly, the high valuations that had built in some assets such as bonds and growth shares. Secondly, the likelihood of a significant slowdown in economic growth and thirdly 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.
In this context, a great re-adjustment must occur in the expectations of underlying clients who have enjoyed a decade of strong returns. As much as good financial advisers and wealth managers have endeavoured to sell process and control 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 the predictable will be crucial.
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 has delivered as consistently.
With this in mind, equities must be a key part of the answer for investors in this high inflation and low-return environment. However, it is clearly vital to do what can be done in the short term to avoid the significant losses that could be seen throughout 2022 if Capital Economics' forecasts and those of the largest institutions prove true.
Who in this situation would say no to the option of receiving the long-term average nominal return of equities in the coming years? This return, around 7% a year, is still achievable in a wide range of market scenarios using derivative instruments that can build 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 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% return per year over the coming six years provided investors are willing to accept the risk that if the market, most typically the FTSE 100, falls by more than around 35% and fails 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 equities will be falling.
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 multi-asset portfolios in this most uncertain of times.
In a crisis such as this where correlations across asset classes have dramatically come together, we believe multi-asset investors should explore every tool in the box to meet the moment.
This article can also be read here: Professional Adviser