By Julian Howard, lead investment director, multi asset solutions, Gam Investments
Equity investors are promised long-term potential returns by professional managers. While there can be reasonable grounds for cynicism about such promises, there is the hard evidence of history and the logical potential for listed corporations to grow over time.
The National Bureau of Economic Research’s (NBER) The Rate of Return on Everything 1870-2015, which explores long-term returns across equities, fixed income and real estate, and Jeremy Siegel’s regularly updated Stocks for the Long Run, an Old Testament of buy-and-hold investing, both show real return on equities has historically been around 6.5-7% over a multi-decade period.
The recent Covid-19 pandemic, Russia’s invasion of Ukraine, the ensuing inflation spike and rising interest rates, as well as a new banking crisis, make a robust 7% annual real return seem unimaginable. Yet these factors and worse have been seen before and are priced into the 6.5-7% historical figure.
Structural allocation to stocks
From the mass manufacture of the Model-T Ford in the 20th century to the introduction of artificial intelligence into search engines, listed companies can boost human progress. A structural allocation to stocks in nearly all long-term portfolio solutions remains undimmed.
The challenge is when a time horizon is introduced that demands at some definite point in the future that funds be made available. For individuals, this may be a retirement date. For institutions, perhaps a funding requirement for a planned project. Such a specifically-defined ‘landing zone’ is at odds with the concept of indefinite buy-and-hold, simply because there can be entire years or longer in which markets underperform.
The 2001-2003 dot-com phase, the 2007-2009 Global Financial Crisis, and the more recent post-pandemic inflation shock of 2022, are notable examples. Such times are clearly not ideal for selling. However, both planned and unplanned liabilities can often fall at inconvenient moments.
How do we balance a stock-dominant portfolio without excessively sacrificing returns? Such perfect asymmetry is hard to achieve. A diversified portfolio focused on capital preservation can, however, help ‘smoothing’ of volatility so investors can meet future liabilities. How?
Fixed income and alternative assets
Fixed income and credit, or bonds, can accrue a steady income with varying degrees of capital stability. Alternative investments can potentially generate returns independent of the stock market. Both have practical difficulties. Wringing out a good yield from bonds usually demands some combination of risk-taking in the form of time, default potential or esoteric complexity.
In alternative investments, the HFRX Hedge Fund and Macro CTA peer group indices have delivered lacklustre compound annual returns of 1.5% and 0.7% respectively over the last decade, despite premium fees and some of the brightest investment talent.
One cannot ignore the significant role fundamental research plays in identifying effective instruments and funds within both asset classes. But a glance at the performance of the Lipper Flexible Global peer group suggests consistency in multi-asset portfolios holding more than just equities remains a challenge.
Short-dated fixed-income instruments issued by treasuries of the US, UK and Eurozone are a solution. Cash and near-cash instruments have directly benefited from rising interest rates in those respective economies.
The six-month US T-Bill now offers a 4.7% nominal yield, far in excess of the 10-year annualised return from the HFR Hedge Fund index, with near-instant liquidity. This return is essentially risk-free, unless one feels the US government is about to default on its obligations. It is however still below the 5% rate of US headline inflation, and thus represents a negative real return.
Beating inflation is arguably best covered by long-term investment in stocks that can exert pricing power over time. The US T-Bill, and to a lesser degree its UK and European equivalents, are almost unbeatable capital preservation assets designed to protect nominal capital and smooth out delivery of returns.
Markets are underpricing further Fed rate rises
At some point, monetary policy in major economies will peak and start to ease off again. This will reduce the risk-free yields of short-dated fixed-income instruments on offer. Although investors can be somewhat reassured that, in the US at least, market participants have consistently underestimated the Federal Reserve’s (Fed) resolve to tackle inflation.
Eventually, inflation will drop down to the Fed’s target and it will be able to pause rates. But for now, short-dated fixed-interest instruments are still an effective nominal capital preservation tool for US investors.
Equities are best unlocked over a multi-year period. Smoothing out their characteristic volatility to better meet future funding requirements demands consistency from capital preservation that has proven elusive in recorded outcomes.
Cash can be unpopular in some dogmatic investment circles. But short-dated fixed income can periodically offer a near-total solution to the capital preservation issue, even if only temporary. Now is the time for investors to be flexible and pragmatic.