The search for returns in a low-return environment

Editorial Note: This post on the search for returns originally appeared on our companion blog, Helping Advisors, on November 14, 2016.


We all know that successful investing is hard, but does it seem to be getting harder? For many investors the answer is “Yes” for two primary reasons:

  1. Many investors need fairly high nominal returns to achieve the investment outcomes they seek.
    According to a Goldman Sachs survey published in October 2015, the 50 largest U.S. defined benefit plans have assumed an average expected return of 7%. Many individual investors likely have similar return expectations built into their financial plans.
  2. Market returns have lagged long-term averages over the last decade.
    For example, a hypothetical balanced index portfolio composed of 60% MSCI World Index/40% Bloomberg Barclays Aggregate U.S. Bond Index had a 10-year annualized return of 5.50% as of 10/31/2016. That means that, over the past 10 years, a completely passive portfolio would have been hard pressed to achieve that 7% return so many investors expect.

What does the future look like?

No one can precisely predict the path markets will take. But, with major equity markets at, or near, all-time highs and interest rates around the world at historically low levels, the next 10 years are likely to be equally – and perhaps even more – challenging for many investors. As of June 30, 2016, Russell Investments’ forecasts suggest that a hypothetical 60% global equities/40% U.S. bonds portfolio may have an annualized return of 4.78% over the next 10-years. Even if that return was generously rounded up to 5% – for illustrative and simplicity purposes – 5% is not 7%.

So, how can investors potentially move from a 5% to a 7% expected return?

The three rules of the low-return imperative

Aside from attempting to win the lottery, investors generally can attempt to increase the value of their nest egg through a combination of saving more, spending less or finding higher return opportunities. Of course, these choices are not always easy: Saving more effectively means lowering the current standard of living; spending less means either having a shorter retirement or a lower standard of living in retirement; pursuing a higher return can mean contemplating investment strategies that may be beyond the investor’s risk comfort zone.

Many investors are currently focusing on reducing fees as a way to potentially increase the actual performance received. However, prioritizing fees can cause investors to rotate out of actively managed investments into passive ones – thereby decreasing the likelihood of achieving a greater than the estimated 5% index-based return. A passive portfolio may make that 5% expected market return more “certain” than an active portfolio – but 5% is not 7%.

In our view at Russell Investments, this challenging market environment creates a very simple low-return imperative for investors:

 

When expected future market returns are likely to be lower than the required rate of return, we believe an investor cannot afford to:

  1. Ignore any investment strategy that may offer incremental return.
  2. Take on risks they do not expect to get paid for.
  3. Disregard implementation inefficiency.

 

So how might an investor earn an incremental return to help close the gap between the expected 5% passive return and a 7% required return? A skilled investor could potentially generate net-of-fee performance above the passive index by:

  • Selecting above average active managers
  • Maintaining targeted exposures to investment factors (for instance value, momentum, quality, low volatility)
  • Dynamically adjusting the portfolio’s asset allocation
  • Judiciously applying leverage and illiquidity where appropriate.

Of course, these strategies add uncertainty and risks, but also offer the potential to get investors closer to their required return of 7%.

5% is not 7% – a hypothetical investor example

Bob is 45 years old, makes $100,000 a year and plans to retire in 20 years. His current nest egg is worth $155,000. Bob and his financial advisor have determined that Bob will need $40,000 per year in retirement – which, by their calculations, would require a $1,000,000 nest egg at retirement. If Bob saves 10% of his income for the next twenty years, and earns a 7% return on his portfolio, he will reach his $1,000,000 goal in twenty years. However, if his portfolio earns a 5% return, he will have only $741,000, which, at a 4% withdrawal rate, would generate an annual retirement income of only $29,640. In order to get the same expected retirement income, he would have to save $18,000 a year rather than $10,000.

The bottom line

The search for returns in today’s low-return environment is real and presents investors, and their advisors, with critical decisions. Russell Investments is dedicated to identifying investment strategies that help investors achieve the outcomes they seek. By taking a diversified and multi-asset approach, we offer our clients the tools they need to attempt to increase their probability of meeting return expectations.