Five Things Every Investor Targeting 7%+ Total Portfolio Returns Should Consider Today
Institutional investors around the world have benefited in recent years from a record-setting equity bull market. As equity markets draw closer to their inflection point, many investors are asking the question “How will we reach 7%+ total portfolio returns in coming years?” with increasing urgency.
With that in mind, we sat down with two experts from State Street Global Advisors – Rob Spencer, Global Head of Portfolio Strategy in the Investment Solutions Group (ISG), and Olivia Engel, Chief Investment Officer of Active Quantitative Equity (AQE) – to open a dialogue on this important question. Here are the five main points they think every investor should consider right now:
1. What worked in the past probably won’t work in the future. “Our long-term large-cap US equity forecasts are somewhere around 6%. Our long-term bond forecasts are somewhere around 3%. If you do the math on that, you’re not getting to 7% expected return,” Spencer says. Focusing on equity allocations, Engel notes that investors increasingly may need to look to less efficient markets outside the United States, including emerging markets. “Valuations outside the United States are comparatively favorable, and we think this trend will continue to take shape over time,” Engel says. “As they look outside the US for opportunities in equities, investors will encounter greater liquidity constraints, higher transaction costs, and, in general, less efficient – and therefore more volatile – markets.”
2. You’ll probably have to take on a lot more risk. Ten years ago, a relatively conservative total portfolio allocation could be expected to yield 7% returns. In 2006, for example, ISG analysis suggested that the following portfolio, with only a 20% total equity allocation, would yield an expected return of 7% and a portfolio standard deviation (a measure of risk) of only 6.7%:1
Ten years later, the picture had become much more complex – and more risky. In 2016, ISG analysis suggested that the following portfolio would yield a 7% expected portfolio return – this time with a much wider portfolio standard deviation of 13.2%:
“It’s important to note that the 2016 analysis anticipates the use of leverage to reach return targets, which is why the portfolio weights add up to more than 100%,” Spencer notes. “Using leverage in this way isn’t something we’d recommend, but it does help to illustrate how much more difficult it’s becoming to reach return objectives.”
The upshot for investors? Relatively conservative allocations that were once amply sufficient to fulfill total return assumptions may need to encompass greater risk exposure, in more asset classes and more geographies, to meet expectations.
3. Every corner of your portfolio likely will need to work harder – and smarter. “To work out how to get to 7%+ return, we would start with the lower-risk core of the portfolio. How can that work harder? We might considering adding in some longer-term factor exposures such as value, which may have a higher long-term return compared to traditional core allocations,” says Spencer, adding that a close look at cash management may offer additional avenues to add incremental returns. “Then we look to see where we can add in active, outperformance-seeking strategies. We believe these are generally most effective in inefficient areas of the market, including emerging and small-cap markets. And we would also propose on top of that some tactical asset allocation – an active strategy that dynamically shifts the proportion of assets across the broader, multi-asset portfolio to take advantage of pricing anomalies and other market conditions,” Spencer says.
As investors face increasing pressure to exploit the full potential of both core and satellite allocations in their quest to meet their objectives, careful consideration of risk will become paramount, says Engel. “Equity portfolios are going to have to work differently – not just harder, but also smarter, with an eye to risk as well as returns. Avoiding drawdowns can be as important to favorable outcomes as beating return targets to the upside.” With that in mind, she says, enhanced funds – which seek a small amount of outperformance by taking small positions away from their benchmarks, with tight active-risk control and comparatively low management fees – can be a valuable tool for investors. “Enhanced funds can help investors extract more from their core allocations in general, and they can offer some additional benefits,” she says. “In emerging markets, for example, where there’s more transaction friction, enhanced funds can help reduce the drag that can cause EM index funds to lag their benchmarks, because they have the flexibility to take positions away from the benchmark while factoring in transaction costs,” Engel says.
4. The search for unrelated alpha sources will pose its own challenges. As the pressure mounts to seek additional alpha sources, investors will also be challenged to diversify them effectively. “If your additions are the same types of managers and their performance is correlated, obviously that can lead to excessive risk exposure. But if you add too many active managers, you can start to overdiversify yourself – you can inadvertently reduce your active risk exposure to the point where it’s very difficult to achieve return objectives at a portfolio level, even as you’re paying active-management fees,” Spencer says. “Tactical asset allocation or ‘TAA’ can complement other, traditional sources of alpha, including security selection, because our research has shown that outperformance generated by TAA can be uncorrelated to those traditional alpha sources.”
AQE and ISG researchers recently teamed up to explore enhanced funds as a useful tool in the effort to combat overdiversification of active management. “For large institutional investors that are forced to allocate to dozens of concentrated active equity managers due to capacity constraints, enhanced funds offer some interesting avenues to explore,” Engel says. “Enhanced funds tend to have very high capacities, which may make them a practical avenue for greater consolidation of active exposures. And if you look at the return and risk profile of enhanced funds at an equity portfolio level – not just at an individual equity-fund level – and factor in lower fees, you start to get a feel for their potential.”
As they consider how to achieve substantial outperformance in their equity portfolios in light of the overdiversification issue, Engel continues, it makes sense that investors might begin to seek paths to more concentrated exposure to high-conviction active managers. “It’s important to bear in mind, though, that high conviction can introduce a lot of risk to an equity portfolio when you look at it from the perspective of total volatility,” she says. “Benchmark-unconstrained, defensive equity funds that have a dual return and risk-management mandate tend to have a low level of correlation to other active managers, which can help investors achieve their objectives for the active-equity sleeve of their portfolios without overdiversifying.”
5. You may need to free yourself from benchmarks. “Benchmarks weren’t created with your investment objectives in mind,” Engel says. “Achieving equity outcomes in an increasingly volatile, challenging environment means that risk has to be as important a consideration as return. And just as equity-market beta may well not be enough for investors to meet their return objectives, the need to avoid costly drawdowns means that investors will be under pressure to reduce their total risk exposure.”
Strong equity returns coupled with low market volatility through 2017 may have blunted the urgency of taking action through the all-too-human status-quo bias – that is, the tendency to do nothing or maintain previous positioning, when instead a change should be made, Engel notes. “We believe there’s life left in the US equity bull market and that emerging markets continue to offer a robust range of opportunities for skilled active managers,” she says. “As signs continue to accumulate that change may be on the horizon, this is the perfect time for investors to consider both the return potential and the total risk characteristics of their portfolios. We believe the best way to fully realize the return potential of the equity markets, while seeking to minimize total risk, is through benchmark-unconstrained equity strategies that embrace the vast breadth of return and risk characteristics that the global equity markets have to offer.”
Over the course of the coming year, we plan to explore how investors can reach their return and risk targets in a challenging investment landscape. Look out for more pieces in this “Getting to 7%” series on ssga.com.