When the prospective real return from a traditional 60/40 equities-and-bonds portfolio is less than half the level it has been for the past several decades, investors had better start to think about new ways to generate better performance.
Cliff Asness, founding and managing partner of the US-based fund manager AQR Research, said the return from a 60/40 portfolio has averaged about 5 per cent per year above inflation over the long term. But AQR’s research, using measures that have proven to explain well the portfolio’s past performance, suggests that the return for the foreseeable future will be about 2.3 per cent a year.
AQR’s analysis is based on US markets, because it has significantly more data than it has on the Australian markets. But the data it does has suggests that Australian markets are in exactly the same boat.
“The message… is that the expectation, going forward in the next decade, of making 2.3 per cent is approximately the lowest ever,” Asness told the AQR University last week.
The AQR University is an annual event, which this year attracted 70 of the best and brightest financial planners to Melbourne, several from as far afield as Perth. Asness told the event that what makes the current situation particularly ugly is that the prospective returns from bonds and equities are both low at the same time. Or, in other words, prices are high in both markets at the same time.
From here, one of three things can happen, Asness said. There can be a permanent change in the fundamentals of the markets. He says this scenario is unlikely, and “I don’t think this is the way to plan”.
Alternatively, Asness said, real yields will remain at current levels, which suggest a protracted period of relatively poor returns. Or yields could revert to their long-term averages.
“This is the scariest [scenario],” Asness said. “Expected returns going back to ‘normal’ is the same as saying prices will fall.”
Investors need to decide how to respond, and Asness said there are four broad choices:
- stay the course,
- add alpha to a portfolio,
- take bigger portfolio risks or
- cast a wider net and seek alternative sources of return.
Of these, taking bigger risks is the least palatable, he said, and casting a wider net is likely to produce better long-term results.
Moderate risk, diversified portfolio
A typical portfolio has an over-reliance on equities and as a result is exposed to a disproportionate amount of risk. Risk in the traditional 60/40 portfolio is massively concentrated in equities.
“If you think that risk is justified, you have to believe the risk-adjusted return from equities will be eight or nine times that of bonds,” Asness said.
AQR’s response is to construct portfolios with equal exposures to risk in three broad asset classes: equities, fixed interest and commodities. This approach has been dubbed “risk parity”. Testing of this approach shows a portfolio to have a superior Sharpe ratio over most time periods.
In fact, Asness said, an equal-risk-weighted portfolio looks very much like the optimal portfolio on the efficient frontier curve, generating the best return for the amount of risk taken.
Such a portfolio also generates a reasonably modest level of return, Asness said, and so leverage is needed to lift returns to an acceptable level – say, back to 5 per cent above inflation.
Building an optimal portfolio and gearing it increases risk as well as increasing return, but introduces risk in a more controllable way than, for example, concentrating the portfolio in risk assets.
“I find moderate leverage risk to a well-diversified portfolio to be better than concentration risk,” Asness said.