In 1967 Albert King, a gifted guitarist who loved the blues, recorded a song written by William Bell and Booker T. Jones for the first time. Others followed, including the iconic British band The Cream a year later. That song was Born Under a Bad Sign with its signature chorus line written above.
Given I am generally a glass-half-full individual (especially when it comes to the future and identifying opportunities to invest) you may be wondering why I am writing like a latter-day Eeyore with a big grey cloud over my head.
Since the beginning of 2021, no fewer than six different major asset managers, two large institutional investors, and a plethora of economic and investment writers have reached the conclusion that future returns for both stocks and bonds will be well below historical outcomes. The most optimistic of this group is expecting, after-inflation, returns for balanced portfolios to be about 3% over the next decade while much of the rest of this grim group is calling for returns under 2% net-of-inflation and fees.
The name Cassandra is well known in Greek mythology. Cassandra (daughter of King Priam of Troy) warned her parents that Troy was in grave danger and would be destroyed. Her predictions went unheeded, and the Cassandra metaphor is now used to describe someone whose valid warnings or concerns about the future are disbelieved by others.
The projections for future returns have been well-publicized already and people are listening, reading, and aware. The question that matters is whether or not these relatively gloomy prophecies will turn out to be true. Connected to that question is how would/should one modify one’s investment strategy and asset allocation if the future environment for both stocks and bonds is bleak?
Let’s first review what has been written recently and then turn our attention to how this could impact your portfolio. (Spoiler alert! This newsletter gets more uplifting as it gets closer to the end).
Morningstar is considered one of the best investment research firms in the world. Each year they conduct a report based on their own analysis and combine it with the opinions of other major asset managers to look at future expected returns for stocks and bonds. This year, in addition to Morningstar, the following firms offered their opinions on US, developed and emerging market equities, as well as US bonds.
What we have done below is added to the summary they provided by adjusting returns for a combination of inflation and fees and then averaging the five groups into one result. The four other groups include Blackrock, Vanguard, Research Affiliates and JP Morgan.
The results show that if we followed a typical investor’s asset mix and invested 60% in equities (25% US, 25% Developed Markets, 10% Emerging Markets) and 40% in US Bonds the expected future return in 10 years time is just under 1.3% after inflation and fees (see disclaimers at end of this article).
Morningstar’s own analysis shows that since January 2000, returns have been disappointing for balanced portfolios using a traditional mix of 60-70% equities and 30-40% bonds. Results for their Morningstar Canadian Neutral Balanced Portfolio* has been 4.6% net of fees for the last 21 years. The Bank of Canada reports that inflation since 2000 has averaged 1.9% per year meaning that the real return for this portfolio has been 2.7%. Better than future predictions but well below historical results.
Our own results for our Nicola Core Composite (see disclaimers at the end of this article) are available on our website. Our net return before inflation was 6.9% and therefore 5% after inflation and fees.
Inflation and fees adjusted return projections combining Morningstar’s summary along with Blackrock, JP Morgan, Vanguard, and Research Affiliates. The highlighted is an average.
Needless to say, these numbers are not encouraging. Who else is on this bandwagon of doom? Jeremy Grantham is the founder of GMO, a US-based asset manager currently managing about $60 billion for families and institutions. He is a deep-value investor and GMO provides a 7-year forecast for a variety of asset classes each year. Below are GMO’s latest expectations for equities and fixed income. Out of ten different asset classes, they find only one that is expected to provide a positive real rate of return (Emerging Market Value). A rough estimate for a balanced portfolio made up of these asset classes is expected to earn about -3-4% annually for the next seven years according to GMO.
We can observe that the team at GMO makes our Morningstar group appear positively optimistic. What you might expect if Pollyanna became an asset manager suffering from a severe case of irrational exuberance.
One last point to note. As mentioned above, Jeremy Grantham is a deep value investor and has been forecasting negative returns for equities for well over a decade. It can be difficult for a value investor to make fundamental numbers such as private equity ratios and book-to-value resonate in a world where growth and technology have been so well rewarded.
Before we move on to how these prognostications might alter our investment strategies going forward, we should look at two institutional groups. The first is the Alberta Investment Management Company (AIMCO) that manages $120 billion dollars for a number of Alberta pension funds. The second is Credit Suisse who writes a report each year (a summary of which you can find here) about their projections for future returns tied into the context of historical returns on equities and bonds since 1900.
This chart from Credit Suisse best sums up their report:
You can see what World War II Boomers, Gen X and Millennials have fared historically in inflation adjusted terms with 70/30 balanced portfolios. However, Gen Z (and by inference all of the rest of us) will be doing well to earn 2% with the same strategy after inflation going forward. One problem I have with this chart is the 70/30 returns have been subdued since 2000. If the Millennial calculation had been done since 2000 only, the numbers would have been 3% real returns at best for a 70/30 Balanced portfolio.
So why are the analysts at Credit Suisse so glum? Their main argument is that a secular bull market in bonds, which started in the early 80’s, is over and COVID-19 likely delivered the final positive returns for a while because 10-year bond rates in both Canada and the US dropped to about 50 bps in August, 2020 (I was applying for a mortgage when they peaked at 14.9% in September of 1981). Since then, rates have slowly risen but are still about 1.6% in Canada and the US, and negative in countries such as Germany.
Credit Suisse believes yields will continue to rise which will result in negative returns for bonds for many years. Even if 10-year government bond rates rise to only 4% within the next five years a 10-year bond issued today would be trading at about 85 cents on the dollar while still only paying 1.5% interest for five more years; not promising as investments go. Since the beginning of 2021, 10-year bond yields have risen by about .7% (70 bps) and that has been enough to trigger a 5% loss in both US and Canadian 10-year government bonds.
I found one graph from this report particularly enlightening, see below. It shows the real rates of return for bonds in both the US and UK. While they did provide inflation-adjusted returns of 2.6% and 3.4% respectively, those returns were earned after 1981. For the period from 1900-1981, returns on bonds were effectively zero after inflation. If government bonds returned to their long-term real return of 3% then interest on those bonds would need to be about 5% in a 2% inflationary world. That is a long way from where we are now.
The argument for relatively poor stock prices is that massive government deficits globally, along with record low-interest rates, have made other assets expensive. One chart we have shared with our clients is the Cape Shiller Index. This measures price of the S&P 500 vs. 10-year trailing earnings as a ratio. As you can see the numbers today are higher than 1929 and the Great Financial crisis of 2007-2009. Only the irrational exuberance of the Dot Com Era (which peaked in the spring of 2000) has generated higher numbers. Future equity returns are likely to be considerably less than in the past when prices are at such lofty heights. By way of example, the ten-year total return (adjusted for inflation) including dividends for the S&P 500 from March 2000 (when the S&P 500 hit a record level as a percentage of earnings) to March 2010 was just over -3.5% annually.
We now turn to AIMCo and their recent analysis for future returns of a number of asset classes. A copy of that presentation can be found here on our website. Over the last ten years, AIMCo has managed a respectable 8% net rate of return on its assets. While it ran into some issues last year with a $2.1Billion trading loss, it has performed well over the longer term. In this year’s report, AIMCo believes that it will earn only a 4.9% return over the next decade on assets or about 3% after inflation. For AIMCo, which must manage assets to meet pension obligations, this a significant reduction in returns over a decade; and based on their current AUM of about $120 billion, would mean that AIMCo would be managing almost $70 billion less than would have been the case if they were able to match the prior ten years’ results.
The table below summarizes AIMCo’s return expectations. They feel that private equity, real estate, and infrastructure offer the best hopes for returns. With respect to public assets, they agree with GMO and Morningstar that Global/Emerging Market equities offer the best. As with other groups they expect that bonds will, at best, break-even after inflation.
Perhaps the first question should be this. Do we at Nicola Wealth agree with the projections and analysis of these disparate groups? And the corollary question would be, how would any of this change our recommendations for asset allocation and asset management?
The short answer to the first question is yes. Future returns for any asset class will always be less than ideal when one is starting from a high valuation. It can easily be argued that based on current prices, equity, bond, and real estate markets are all expensive. However, when it comes to public equity markets we do not invest in countries. We invest in companies and we do not limit ourselves to public markets only. Long-duration bonds are not the only way to effectively invest in fixed-income assets. Real estate can offer strong future returns if one can find ways to add real value.
Our clients are already aware that we do not support the traditional 60% equity/40% bond (or variations such as 50/50 or 80/20 which supposedly increase or decrease both risk and return). Some who support these models further postulate that as one ages, one should decrease one’s exposure to equities to avoid volatility and the inability to recover market losses during one’s retirement.
We consider this another fallacy and quite frankly poor financial advice. It is easier to argue that a younger person with less income, more debt, more obligations such as family, education, housing etc. as it is a far more vulnerable position financially than a retired couple who can comfortably live off the income of their assets and pensions in their mortgage-free home. That, however, is a discussion for another newsletter.
The investment/asset allocation model we support can best be described as institutional in that it combines public market assets such as stocks and bonds with private assets such as real estate, infrastructure, private debt, and private equity. This approach is far more representative of global wealth than a standard 60/40 is, and significantly more diversified, which helps reduce volatility and risk,
Individual investors have been able to invest in a simplified version of this through what has become known as the Talmudic Asset Allocation. Talmudic Asset Allocation is defined this way by Pinnacle Advisory:
Let every man divide his money into three parts, and invest a third in land, a third in business, and a third let him keep by him in reserve.
So it is written in the Talmud, a record of debates among rabbis about Jewish law dating as early as 220 C.E.
In today’s world of investment options this becomes 1/3rd in business (presumably both private and public),1/3rd in reserves (this can be seen to be gold but for us, it is fixed income so interest can be earned) and 1/3rd in land (income-producing real estate). So how would this portfolio have performed this century since January 2000? The results (net of fees) are below.
Talmudic Asset Allocation outperformed both stocks and bonds and beat a 60/40 equity/bond balanced portfolio by 1.5% per year net of fees or more than 30% annually and 35% cumulatively over the last 21 years. It accomplished this with half the volatility of the balanced portfolio. Even if you had invested 100% in equities over the last 21 years your net returns would have been just over 5.3%/year vs. 6.2% for the Talmudic Asset Allocation Model and with almost 3x the volatility.
** Talmudic Model Portfolio includes bonds, public equity and real estate.
The challenge for the Talmudic Asset Allocation model is finding the components at a reasonable price and with enough liquidity to use them. In the charts above we use the real estate database, Investment Property Databank (IPD), which measures total returns amongst institutions who invest in real estate in more than 20 countries for the last 40 years. The problem for investors is that they cannot buy this index.
Benefits of Private Assets
Initially, our solution was to form individual partnerships that allowed individuals to invest in separate real estate assets. In 2005, we moved to a pooled fund structure and now offer three Limited Partnership pools (LPs) in Canada, the US, and North American Development. All three LPs are open-ended and evergreen (which means that a new investor automatically is invested in the current portfolio and the funds do not have a specific wind-up date as most closed-end funds do). Details about their performance and assets held can be found here.
We also invest in private debt (initially mortgages) and private equity since 1995 and 2008 respectively. The results of that can also be found on our website in the chart below. Since 2000 our clients have averaged net returns of 6.92% /year. Or 70 bps more than the Talmudic approach and 2.25%/year more than a 60/40 portfolio (see disclaimers at the end of the article). See both comparisons below:
However, will this model continue to work so well in the future given the daunting challenges presented by many groups mentioned at the beginning of this newsletter? We believe it will and so do some of the prognosticators above. We believe there are a number of reasons for this which include:
• Added Value. Private asset managers are more actively involved in the management of the underlying assets within the pools they are responsible for. This is especially true for real estate where property management, leasing, proper use of capital expenditures, financing, and value-add development all contribute to the bottom-line returns. We could always choose to invest in REITs as a proxy for real estate for our clients, but it would be difficult for our expert real estate team to add the value they do by owning the real estate directly.
• Growth Outweighs Risk. While private equity markets are more expensive than they were 10 years ago they are still trading at much lower overall earnings ratios than most public markets. Private equity markets are less liquid and riskier than most public markets; however, they are, for the most part, made up of firms growing at a faster rate than both the economy and public companies overall.
• Direct access. Private debt markets allow the investor to be closer to the borrower and reduce transaction costs associated with lending in public markets.
• Rebalancing. Markets both public and private will not earn consistent results periods of growth. It will be followed by depressed markets and prices. This is where disciplined rebalancing can make a significant difference in returns over time. Our own research indicates that end returns could be as much as 1.2-1.5%/year higher than with no rebalancing at all.
This newsletter began with a quote about luck. The widely respected business author, Jim Collins speaks about return on luck, which is highly appropriate given the topic at hand.
Return on Luck is a concept developed in the book, Great by Choice. Our research showed that the great companies were not generally luckier than the comparisons – they did not get more good luck, less back luck, bigger spikes of luck, or better timing of luck. Instead, they got a higher return on luck, making more of their luck than others. The critical question is not, Will you get luck? But What will you do with the luck that you get? -Jim Collins, #1 Bestselling Author
Jim’s words are a good way to summarize the situation we find ourselves in and the approach we will take going forward (which is the same as the one we took to get here).
The critical question is not, will you get luck? but what will you do with the luck that you get?
* Morningstar Canadian Neutral Balanced is a proprietary index developed by Morningstar Canada based on the CIFSC Fund categories (www.cifsc.org). This index includes funds that meet the following criteria: Funds in the Canadian Neutral Balanced category must invest at least 70% of total assets in a combination of equity securities domiciled in Canada and Canadian dollar-denominated fixed income securities and between 40% and 60% of their total assets in equity securities.
**Talmudic Model Portfolio:
Bond (0.75% management fee):
Bloomberg Barclays US Aggregate Bond Total Return Index (50%)
ICE Bank of America Global Broad Market Total Return Index (50%)
Public Equity (0.75% management fee):
MSCI ACWI GR USD (50%)
S&P 500 TR USD (50%)
Real Estate (0.75% management fee):
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