The reality of lower return expectations

fixed income fixed interest low interest rates poor returns financial planing financial advice industry

18 November 2016
| By Mike |
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Financial planners need to be frank with their clients and persuade them to accept the inevitability of a lower return environment, a Money Management roundtable found.


Mike Taylor (MT)  

Managing editor, Money Management  

Christopher Joye (CJ)  

Founder, Coolabah Capital  

Libby Newman (LN)  

General manager, income and multi asset, Lonsec  

Damien Wood (DW)  

Principal, Spectrum Asset Management  

Brad Bugg (BB)  

Head of multi asset income, Morningstar  

Andrew McKee (AM)  

Financial planner, Australian Unity 

MT: What should advisers be telling their clients with respect to their weightings to fixed?   

AM: Yeah, I think I've already said keep the defensive side defensive and for us the ultimate risk free at the moment for clients is term deposits.  And if you can get term deposit rates at 3% versus a 10-year bond yield of 2%, term deposits look pretty good value.  Retirees don't necessarily see it that way obviously, 3% is not what they're used to but it is a matter of trying to give clients a risk outcome that they're comfortable with.  And, together with managed funds that are focused on the shorter duration credit side makes up the defensive side of client's portfolios and that helps manage that duration risk that's out there.  Yeah, in terms of - for retiree clients at the moment part of the message is the returns that we're getting on your defensive portfolios are quite low and will be quite low for the foreseeable future.  If you're taking out 5% from your account-based pension and you're a reasonably defensive investor, chances are the portfolios not going to be generating 5% returns and we're going to be drawing down on your capital.  But there isn't much of a choice because either you ramp up the risk or you eat into capital and ramping up risk can come and - it can bite your back so you don't necessarily want to do that if you're not comfortable with volatility. 

BB: I think it's the first thing you've got to do with investors in this day and age is reset their return expectations. We think we're now in a much lower returning environment whether it be bonds, equities or cash and people need to understand that because, as you suggest they've got used to these very high return rates.  People always talk about the five-year deal Westpac offered in the crisis of five years -  

DW: Eight per cent 

BB: Eight per cent. 

DW: Yeah. 

BB: I don't think that's coming back any time soon.  And even equities over the last five, seven years, average double-digit returns.  They're probably not going to do that because of where fundamentals have got to and so we're really worried that people are going to benchmark returns they're going to return in the years to come against returns on what they've had previously.  So resetting that expectation is the first thing to do and then you can start talking how you're going to maybe generate these higher returns going forward. 

MT: Lib? 

LN: Yeah, I'd agree with that but I think there's still people out there who are going, well, where can I get my eight per cent.  And I go, 'Well, you can get your eight per cent but be aware that there's risk that comes along with that'.  

AM: It comes with risk. 

CJ: Yeah. 

LN: – be it liquidity risk or there's bridge funds and construction and development risk embedded in those and, yeah, there's - if someone's showing you that sort of return, you need to have a look under the hood and see what's driving it because the return expectations from all other asset classes are nowhere near that so - yeah.  But there's still -- I still get advisers ringing me up going, "So what can I get that's going to give me eight per cent?" 

DW: I wish I knew. 

AM: It probably goes to the heart of that.  Again, if something looks too good to be true, it is.  You're not going to get eight per cent yield without some risk -- 

LN: That's right. 

AM: – and some significant risk, I would say. So, yeah, be cautious. 

MT: Damien, do you – 

DW: Nothing to add in this area. 

MT: Chris? 

CJ: Can you just tell me the question again? 

MT: Well, basically, what we were talking about was if you were an advisor, and clearly Andrew is, then you're looking to advise your client on allocations that were fixed.  At what level should it be? 

CJ: Yep. Okay, I mean, I don't know whether this is covered in other questions or whether this is completely on topic but I guess the one thing I have to add - the first point is, if we look at a macro asset allocation level, my view is that you should think about your cash and credit and duration allocations based on whatever your risk preferences are and therefore your return targets are. 

And I think aggreåssive is CPI plus five per cent which would be seven per cent in today's world but most people are targeting CPI plus three to four per cent.  And if you run a portfolio optimisation with a CPI plus three per cent to four per cent target over the last 30 years and you look at global equities, Australian equities, Aussie government bonds, Aussie credit and Aussie cash, what you'll see is, to hit CPI plus three per cent to four per cent you're basically almost 100 per cent invested in the fixed income side of the ledger, so cash which is done well, credit and duration. 

So you can actually get those sorts of returns.  Historically, you could have got those sorts of returns with very, very low risk.  You didn't need to chase the high volatility perhaps in Aussie equities or global equities.  Now, whether that's a good basis for the next 30 years, [is an] open question, probably not. 

The second point I make is I think what is really the elephant in the room that nobody, I think, in fixed income really gets is the lacuna or the paucity around active asset selection, so actually generating alpha.  If you've got a fixed income fund in Australia, they're going to give you three betas.  They're going to give you a duration beta, so lots of rates, duration; they've give you a credit beta, so we can take on more credit risk so we get higher yield mortgage funds or they'll give you an illiquidity beta, which is direct loans and mortgage funds and a high yield in sub-investment grade. 

None of that is anything to do with active asset selection that's driving alpha and, personally, I believe and I think we've demonstrated, that you can generate higher returns, so high absolute returns to which there is actually no theoretical limit through identifying mis-pricings in safe liquid investments so whether we're talking about cover bonds, senior bonds, subordinated bonds, to a lesser extent RMBS but within those markets, there are lots of mis-pricings because there are many inefficiencies. 

The Aussie fixed income market is incredibly dark, it's probably the most opaque asset class that exists. There is no publicly-mandated price or volume reporting.  Amazing that there's more than a trillion dollars of turnover each year.  People have a talk - people like to talk about the illiquidity in secondary market but nobody has the data because Austraclear doesn't report it.  The RBA's actually recently released some information on this and the turnover's actually much higher than you think. 

But the real question for me is S&P reported today on the performance of active managers across all asset classes.  I think something like 56 per cent of Aussie equity funds failed to beat the index or circa 50 per cent to 60 per cent over the last one to five years. But 90 per cent of Aussie active fixed income funds had failed to beat the composite bond index over the last one, three and five years. And I think there's an issue.

Click here to read part one of this roundtable: Positioning the key amid continuing fixed income uncertainty
Click here to read part two of this roundtable: Making sure defensive portfolios are truly defensive

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