Looming Lower Returns Demand Creative Multi-Asset Response

Investors are often heard to say that “more jam today means less jam tomorrow.” In other words, an asset generating high returns in one period is likely to struggle to deliver continued elevated returns in following periods. Or, to put it another way, a higher price today means lower returns tomorrow. This is particularly the case at the asset class level, where it is difficult for investments to defy the gravitational pull of fundamental factors such as long‑term economic growth, inflation, productivity gains, and demographics indefinitely.

Despite the market turbulence that occurred at the beginning of the coronavirus pandemic, many investments have posted strong overall returns for the past decade. With valuations for key equity and fixed income metrics currently high or even stretched, though, the key question for many investors is: What would now be a reasonable long‑term expected return from a diversified multi‑asset portfolio?

Below, we examine our expectations for such portfolios based on our forward‑looking capital market assumptions and consider how these vary under different potential scenarios. We also consider the options available for investors where their return requirements might now be greater than these expectations.

Capital Markets Assumptions

T. Rowe Price’s capital markets assumptions are produced on an annual basis. The results blend quantitative models and qualitative oversight, leveraging the collective insights of our subject matter experts across the Fixed Income, Equity, and Multi‑Asset Divisions to produce five‑year forecasts in five major base currencies. While there will be significant variation around these assumptions, we believe they give an indication of the central tendency of likely returns to different asset classes.

We show our current five‑year forecasts¹ for a range of asset classes, as well as the realized investment returns for 5‑, 10‑, and 20‑year periods to the end of 2020, in Figure 1.

For most of the asset classes shown, we forecast five‑year returns that are lower than those seen in previous periods—in some cases considerably lower. In fixed income markets, this reflects levels of expected risk‑free rates that are close to historical lows in key markets such as the U.S., Japan, and Germany. We believe yields will likely rise in key government bond markets over the next five years, with higher yields overall, particularly at the long end of the curve. Low rates today and rising yields in the future are likely to result in relatively low positive or negative total returns for many types of bonds.

In equity markets, a positive outlook for earnings growth as economies put the impact of the pandemic behind them is offset by valuation measures that look elevated for many markets. We expect returns in many large markets such as the U.S. to be restrained relative to recent history as a result.

Figure 2 shows the percentile ranking valuation for a range of asset classes as of the end of July 2021 relative to their own history over the previous 15 years. For example, a percentile of 93% for U.S. Treasuries means that 10‑year U.S. Treasury bonds were more expensive as of July 31, 2021, than they were 93% of times over the last 15 years. While valuations across asset classes vary, and some assets are attractively valued, the valuations of most assets are elevated on these measures.

Prospective Multi‑Asset Portfolio Returns

Lower return expectations for equity and fixed income clearly also have a knock‑on impact at the multi‑asset portfolio level. In Figure 3, we consider the expected returns for different hypothetical globally diversified mixes of equities and bonds, compared with the actual returns using index data as a proxy that these would have produced over periods to the end of 2020.

The returns received from equity and fixed income market exposure in the periods shown historically are well in excess of what we expect over the next five years, based on our capital market assumptions. We do not anticipate the strong returns of the past five years in particular to be matched in the coming periods.

Point estimates of future returns are implicitly accompanied by high levels of uncertainty. For that reason, we construct four additional sets of capital market assumptions that represent bearish, moderately bearish, moderately bullish, and bullish outlooks. These scenarios allow for consideration of a wider range of economic and return conditions. Figure 4 shows estimates of future returns for our three illustrative multi‑asset portfolios under each of these scenarios.

Even in the two more optimistic bull market scenarios, the expected returns on the illustrative multi‑asset portfolios are well below those that investors have experienced in recent periods. For the hypothetical 50:50 multi‑asset portfolio, estimated returns in a strong bull market are calculated as more than 3% less than returns on the same portfolio over 10 years to the end of 2020 and almost 5% less than the returns over the last five years of that period.

What Does This Mean for Investors?

Given that investor expectations for future returns are often based on previous returns, these estimates highlight the likelihood of disappointment if expectations are not tempered by awareness of current market conditions. If a target level of nominal or real returns has been set based on what similar portfolios would have delivered in the recent past, the potential for disappointment is even more acute.

The implications for individual investors could be material. For example, long‑term savers can find themselves without sufficient savings at retirement when relying on overly optimistic expected returns on their investments. We believe such investors should act today, and potentially revise their financial planning, because when retired it may be too late. Without sufficient savings, full retirement at the desired retirement age may not be a viable option.

A simple example shows the impact in monetary terms. A hypothetical savings pot of GBP 100,000 invested in the 50:50 equity:bond portfolio at the end of 2015 would have been worth GBP 155,000 by the end of 2020. Based on our current expectations, a similar hypothetical portfolio would amount to just GBP 114,000 at the end of the next five years—over a quarter less.

What Portfolio Construction Options Are Available?

Possibly the simplest response is to accept that the investment environment has changed and that returns on multi‑asset portfolios are likely to be lower than they have been in the past. For investors, this may mean recalibrating their behavior—reducing spending as a percentage of their portfolio’s value, increasing savings, or pushing back an anticipated retirement date may be valid options for individuals, for example. However, such adjustments may have a significant impact on the individual’s quality of life.

If reducing spending or increasing contributions to a portfolio are not palatable options, it remains to be considered what can be achieved by varying the investment mix within the multi‑asset portfolio.

One way of boosting anticipated long‑term portfolio return is by increasing the level of market risk within the portfolio. Moving from the 50:50 equity:bond portfolio to the 75:25 equity:bond mix, for instance, increases expected return over the five‑year period by more than 1% p.a.

It is also possible to make adjustments within asset classes. For example, an investor might allocate a greater portion of their equity allocation to areas such as emerging market equities and small‑cap companies, which offer current lower relative valuations and potentially higher prospective returns at the cost of higher expected volatility. Such allocations could be on either a strategic or a tactical basis.

Similar adjustments could be made within a fixed income allocation. Our illustrative portfolios are allocated to global investment‑grade bonds, for example, but including exposure to riskier sectors of the fixed income universe, such as high yield or emerging market bonds, would increase expected return due to the higher perceived exposure to credit risk within such assets. It is also possible to extend the duration of fixed income holdings by focusing on longer‑maturity assets. Given that yields are generally higher for longer‑dated bonds, this also increases yield at the cost of higher interest rate risk.

Increasing portfolio risk, however, is not appropriate for every investor. The risk tolerance of some investors is not high enough to accommodate riskier investments—raising the possibility of sleepless nights. Other investors cannot take more risk because their investment horizon is too short. Nevertheless, some investors may consider taking investment risks that are expected to be compensated in a well‑managed and appropriately diversified portfolio.

What Role Could Active Management Play?

Our expected returns are based on returns to markets, meaning they do not account for the potential benefits of active management. In a lower‑return environment, investors may see an increased role for active risk in the pursuit of higher returns. In the current uncertain environment, new trends and creative disruption following the coronavirus pandemic have created a fertile environment for skilled active managers to add value. Active management can potentially enhance performance, through both dynamic asset allocation across asset classes and security selection within each asset class.

A greater focus on manager risk could come via the active management of existing asset holdings or looking to strategies such as alternatives, seeking to generate most or all of their return regardless of market direction and add independent sources of potential return. Active returns from active strategies—or alpha—typically have imperfect correlations with market returns and can therefore add to the diversification of multi‑asset portfolios.

Risk management overlays can mean sharing some of the upside if markets continue to do well and mitigating some of the downside risk if markets retreat. Even for globally diversified equity portfolios, periods of crisis are usually accompanied by a substantial increase in market moves.

Managed volatility risk overlays, for example, aim to maintain equity volatility within a prescribed range. When expected equity volatility rises in this way, the overlay automatically reduces portfolio risk—this should allow investors more confidence in maintaining equity market exposure even when the outlook is uncertain. Investors could also look to set defined triggers in place to “lock in” gains from riskier assets as they arise by reducing exposure in a systematic way when certain targets are hit.

Overall, then, we believe that lower expected market returns ahead mean that many investors will need to become more creative with their portfolios. Taking thoughtful risks, using skilled active management, and deploying less traditional sources of return and risk management techniques are all part of the available toolkit.