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Targets and Tactics: Overcoming Lower Return Expectations

As consensus grows on the prospect of lower asset class returns, investors are taking a fresh look at the potential consequences and solutions.

As consensus grows on the prospect of lower asset class returns, investors are taking a fresh look at the potential consequences and solutions.

The potential consequences are stark:

  • Public pension funds may not achieve their return targets, making it difficult to meet obligations without future budget sacrifices.
  • Corporate defined benefit pension plans relying on excess returns over the liability growth rate to shore up deficits could be on the hook for additional contributions.
  • Individual investors facing a steeper challenge in accumulating sufficient assets to live comfortably in retirement may have to lower living standards and save more.

As to potential solutions, investors could raise their expected returns by increasing allocations to riskier asset classes – but this would come with significantly higher risk and shortfall probability.

We believe a better and more efficient approach would be to replace current traditional physical equity exposures with synthetic equity exposure backed by long-duration bonds. This may enable investors to achieve increased long-term expected returns with lower incremental volatility.

TIMES ARE CHANGING

According to research by Callan Associates, lower returns expected across a variety of asset classes would require investors to take significantly higher risk today to reach the same expected returns as in the past (see Figure 1).

Figure 1 features three pie charts to show how targeting a 7.5% expected investment return has gotten riskier over time. The first pie chart, on the left, indicates that an allocation in 1995 could be all in bonds to get the 7.5% return, with risk at a standard deviation of 6%. The next chart, representing 2005, shows that 48% of a portfolio must be allocated to other riskier asset classes of equity, real estate and private equity, resulting in a risk of 8.9%. By 2015, shown in a pie chart on the right, has just 12% of holdings allocated to bonds, and the rest to other asset classes, resulting in a risk of 17.2%.

Most investors would find such an increase in risk undesirable, and many have already responded by trimming return expectations to some extent.

However, we believe investors should also consider non-traditional approaches and strategies with the potential to enhance returns with lower incremental risk. Among these, strategies that combine returns from two different asset classes for the same invested dollar can potentially offer a better risk/return trade-off than a blunt shift toward riskier assets – provided that the asset classes combined have a relatively low correlation. This approach – variously known as portable alpha, double value or overlays – is simpler than it sounds.

DOLLARS WORKING OVERTIME: AN ILLUSTRATION

Consider an investor with a traditional 60/40 equity-bond portfolio. In The New Neutral environment, this portfolio is expected to return about 4.0% annualized over the next 10 years, based on PIMCO’s capital market assumptions. If our investor seeks to compensate for lower return expectations with a riskier asset allocation, she could boost her return expectation by 50 basis points (bps), to 4.5%, by drastically shifting the portfolio to 90% equity/10% fixed income. However, as shown in Figure 2, this would increase her risk exposure by a whopping 50% (with return volatility jumping from 10.1% to 15%). As such, simple asset allocation shifts toward riskier asset classes are unlikely to be an attractive solution.

Figure 2 is a table showing two different portfolio allocations: a 60/40 equity/fixed income setup, and 90/10 configuration. Data as of 30 June 2016 for estimated return, volatility and estimated return per unit of risk are included within. Bottom line, by going to a 90/10 portfolio, potential return only rises 50 basis points, yet volatility increases by 4.9 percentage points, resulting in a lower expected return per unit of risk of 0.1.

Let’s now postulate that our investor maintains her equity exposure at 60% of assets. The equity exposure, though, is achieved through the use of an overlay (equity index futures or swaps), which requires only a small capital commitment. The assets that had formerly been deployed in the traditional equity portfolio made up of physical stocks now become available for investment in a portfolio that will serve as collateral for a synthetic equity exposure. Under the right conditions, these assets could be put to work in an effort to enhance the equity overlay returns.

The collateral portfolio should have these attributes:

  1. Relatively low correlation to equities
  2. High probability of outperforming the equity overlay financing rate (i.e., earning a return meaningfully above Libor)

If these conditions are met, the risk/return trade-off could be significantly better than the traditional re-risking approach shown in Figure 2.

Given their historically low correlation to equities and outperformance potential relative to the financing rate, long-duration bonds could represent a good choice for the collateral portfolio investment (see Figure 3).

Figure 3 is a line graph showing the five-year rolling correlation of long bonds versus global equities over the time period 2000 to mid-2016. In 2016, the correlation is about negative 0.2, and has been negative since mid-2012. In 2000, the correlation is 0.2, then declines to about negative 0.1 by mid-2001. Over most of the 2000s it’s close to zero or slightly negative. In 2007, it shoots upward to a high of 0.4, and then starts a gradual downward trend until plummeting from about 0.175 in 2012, then falls further to its lows of more than negative 0.2 in 2013 and 2014. A table beneath the graph shows that rolling returns for long bonds outperformed Libor over the last 20 years through June 2016: 73.9% for one-year returns, 88.3% for three-year, and 99.6% for five-year. Asset class proxy indices are listed below the table.

In fact, with the equity overlay approach, our hypothetical investor could maintain her equity exposure at 60% while achieving a significantly higher expected return and lower incremental risk (Enhanced Scenario #1) when compared with the traditional re-risking approach. Alternatively, if she sought less return enhancement, she could match the return target of the traditional re-risking approach with 38% lower risk as in Enhanced Scenario #2. (See Figure 4.)

Figure 4 is a table that shows four different portfolio allocations, and the estimated return, volatility and estimated return per unit of risk (ratio). The four allocations include a 60/40 initial position, a traditional re-risking to 90/10, and two enhanced scenarios. Data and asset class proxy indices as of 30 June 2016 are detailed within.

BUT WHAT ABOUT …

Rising interest rates: While the long bond collateral could be negatively affected by rising rates in the short run, over the medium to long term long-duration bonds are likely to achieve a return consistent with their yield at the time of purchase (absent defaults) – and therefore may provide the expected return enhancement even in a rising-rate environment. In addition, rising interest rates are often accompanied by corporate spread tightening; this could potentially provide a partial offset to the impact of rising rates if a portion of the underlying long bond portfolio is invested in the corporate sector (see Figure 5).

Figure 5a and 5b feature two line graphs. Figure 5a shows hypothetical 1-year rolling return of the enhanced strategy (described below the charts) over the time period 2000 through mid-2016. Its peaks show 25% returns or greater at various periods, while its lows are just around negative 10%. The one-year rolling returns show wild fluctuations, from one year to the next. By contrast, Figure 5b graphs the 3-year and 5-year rolling returns over the same time period. Most of the time each is above zero, with the five-year rolling the least volatile over time. Asset class proxy indices are detailed below the charts.

The financing rate: The financing rate on the equity derivatives position will reduce the amount of return enhancement provided by the long bond portfolio. And as the yield curve flattens, return enhancement may be less significant.

However, we would suggest investors employing this strategy consider active management of the underlying long bond portfolio, as well as incorporating a certain amount of credit exposure to further enhance return potential and offset the possible impact of flatter yield curves. With long-dated corporate spreads (as measured by Barclays Capital Long Credit option-adjusted spread) currently yielding about 215 bps (compared with a historical average of about 150 bps) and the potential for alpha from active management, we believe return enhancement is possible even in a flatter yield curve environment. PIMCO CIO for Global Credit Mark Kiesel explores the potential of higher-quality credit in his latest Global Credit Perspectives.

CONCLUSION

In an era of lower expected returns, traditional approaches may fail to deliver the returns targeted or desired by pensions, other institutions and individuals in tax-deferred accounts (e.g., 401(k)s and IRAs). Investors could raise their expected return potential by increasing allocations to riskier asset classes, although doing so would come with higher volatility and risk.

In our view, a better and more efficient approach would be to replace current traditional physical equity exposure with synthetic equity exposure backed by long-duration bonds. This may enable investors to achieve an increased expected return over traditional equity exposure, with lower incremental volatility.

The Author

Mike Cudzil

Portfolio Manager

Rene Martel

Head of Retirement

Mohit Mittal

Portfolio Manager, Multi-Sector

Disclosures

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Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Swaps are a type of derivative; swaps are increasingly subject to central clearing and exchange-trading. Swaps that are not centrally cleared and exchange-traded may be less liquid than exchange-traded instruments. Derivatives may involve certain costs and risks, such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Management risk is the risk that the investment techniques and risk analyses applied by PIMCO will not produce the desired results, and that certain policies or developments may affect the investment techniques available to PIMCO in connection with managing the strategy. Investing in derivatives could lose more than the amount invested. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.

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