Tuesday, September 3, 2019

Expected real returns are scarily low - What can an investor do when choices are limited?

What can we expect for real returns over the next few years? A simple examination of the GMO real return projections suggests that traditional assets will be give investors poor return choices. For pension funds, the chance of meeting their actuarial expected returns of around 7 percent seems nearly impossible. 

The only way to gain better returns is to get out of the slow growth developed worlds and hope that emerging markets will be a growth dynamo. It is possible that EM will be a help but this strategy will be risky. 

The simple combination of 60/40 stock/bonds in the US using large cap equities will generate a real return of approximately -2.9 percent. Even if the equity portion is diversified across international (DM and EM) stocks and the bond portion holds some international (EM) exposure (30/10), the real returns are not attractive at -.91 percent.  

A comparison can also be done with the expected real returns as generated by Research Affiliates. Their real expected return forecasts are for 10-years versus the 7-year used by GMO; however the story i very much the same. The real returns on both risky and safe assets are also very low, much lower than current expected return assumptions. RA has the expected real return at approximately 1 percent. Again, this is not going to reach any expected returns used by pension funds. 

Is there a solution to this problem? Certainly focusing on market beta will not provide good answers. Investors can look beyond classic equity and bond portfolios to include emerging markets, but perhaps a new paradigm is necessary. There are factor risks beyond market beta that can offer diversification and may not have the same level of overvalue. There is no easy solution but thinking beyond asset classes and dynamically looking at factor risks may offer some solutions.

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