Building Better Portfolios In A Low Return World by Anwiti Bahuguna, Ph.D., ColumbiaManagement
- The near-zero interest rate environment has been a support for the financial markets, but as the economy normalizes so will interest rates.
- While we expect the bull market in equities to continue, returns will likely be far more modest over the next 10 years. For bonds we can expect returns in the range of 2%-3% going forward.
- For investors looking for higher returns, solutions require a non-traditional approach to portfolio construction and must emphasize flexibility.
Today’s low return world presents challenges to investors more than at any time in the last few decades. Financial markets have dramatically recovered since the lows seen in March 2009 with U.S. equities rising at the rate of about 20% annualized and bonds at 6%. Moreover, these returns have occurred while inflation has been low, making real returns even more attractive. We do not expect such spectacular returns going forward. So far, the near-zero interest rate environment has been a support for the financial markets. But as the economy normalizes, we expect interest rates to do so as well. Where can the markets go from here and what can investors expect from financial assets?
Let’s assume that growth continues to improve, bond yields rise but not violently and global growth is not derailed by the deflationary forces in play in Europe and parts of Asia. Under such a scenario, global growth recovers slowly but not enough to raise inflationary pressures. We can expect the equity bull market to continue in this environment until valuations become stretched or the underlying assumptions do not bear fruit. We use Shiller’s cyclically adjusted price-to-earnings ratio (CAPE) as a valuation measure for the S&P 500. This measure divides price by a 10-year moving average of earnings, adjusted for inflation. Like any other valuation tool this measure has its shortcomings, but we’ve found it to be a useful gauge of longer term returns. In the table below, we display annualized returns for the subsequent 10 years based on the starting positioning of the stock market in different quintiles.
Exhibit 1: Historical S&P 500 returns by quintile ranges of Shiller’s cyclically adjusted price-to-earnings ratio
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Sources: Columbia Management Investment Advisers, LLC and Bloomberg. Past performance does not guarantee future results. It is not possible to invest directly in an index.
In 2009, the Shiller P/E was about 13x, in the second lowest quintile, projecting returns of about 11-12% per year over the next ten years. Undeniably, we experienced spectacular returns of about 20% per year for the last five years. The Shiller measure for the S&P 500 now stands at 25x, in the highest quintile, projecting much lower returns of about 5.0%. While our current expectations are that the bull market in equities will continue, we believe that returns are likely to be far more modest over the next 10 years.
What about expected returns in bonds? Research has shown that the starting yield is a pretty good predictor of fixed income returns over a long-term horizon*. The correlation is high between the Barclays U.S. Government/Credit Index yield and its subsequent 10-year return (Exhibit 2). With the yield in the range of 2%-2.5% currently, we can expect returns in the range of 2%-3% going forward. Similar to equities, returns for bonds appear to have been front-loaded, with pretty respectable returns over the past five years.
Exhibit 2: Correlation between starting bond yields and subsequent returns
As bond yields have fallen and credit spreads collapsed, investors are struggling to meet their income needs. Adding equities only improves the return profile marginally. Based on these projections, for a simple balanced portfolio of 50/50 U.S. equities and bonds, returns going forward are likely to be quite modest. For investors looking for higher returns, solutions require a non-traditional approach to portfolio construction and must emphasize flexibility. We believe this can be done using three different approaches:
First, investors need to build portfolios using a multi-asset framework which recognizes diverging correlations and exploits valuation opportunities across global markets. As an example, stimulative central bank policy in Japan provides a tailwind to asset prices that will supplement portfolio returns when domestic returns are expected to be modest.
Second, we recommend incorporating alternative strategies that can provide needed diversification in an environment where bonds are less of a viable alternative. Portfolio construction now requires a regime change away from the traditional 60/40 stock/bond allocations, as fixed income is unlikely to provide downside protection. In addition, tail hedges also have a place in multi-asset portfolios to provide stability and downside protection.
Finally, we recommend that investors embrace the notion of investment flexibility and dynamically adapt portfolio allocations to changing market conditions. For example, if bond yields fall too far, the portfolio should reorient around a less bond-intensive starting point and re-allocate in a meaningful way based on the prevailing market state.
*Rolling Yields and Return Convergence, Martin Leibowitz, and Anthony Bova, March 2014.