Download Focusing on Long-Term Return Objectives in a Low Return World

Focusing on Long-Term
Return Objectives in a
Low Return World
January 2016
Unless otherwise noted, figures are based in USD.
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Historical Backdrop
Assumptions about future returns are made every day by
a wide variety of investors. Defined benefit pension plans
rely on return assumptions to calculate funding status and
necessary contributions while individual investors use
them as a guide to determine if they are properly saving
for retirement. Intuitively, higher return assumptions require
less savings than lower return assumptions as investment
gains are expected to be higher over time. Of course, the
assumption of high returns in no way guarantees that will
be the outcome. Rather, return assumptions should be
grounded firmly in reality to avoid an investment shortfall
in the future. Historical averages have been one popular
way to formulate long-term return expectations. However,
as we will see, these averages only tell part of the story.
Furthermore, stock and bond market valuations today
make it highly unlikely that a buy and hold approach will
deliver returns anywhere near historical norms over the
next 10 years. We believe that a flexible, active approach
to asset allocation is the best way to provide investors with
returns that allow them to achieve their financial objectives
over the coming decade.
S&P 5001 Company Pension Plans
Reported Long-Term Return Assumptions (as of Dec 2015)
90
80
Source: FactSet.
70
60
50
40
30
20
10
0
<5%
5% to
5.5%
5.5% to
6%
6% to
6.5%
6.5% to
7%
7% to
7.5%
7.5% to
8%
8% to
8.5%
8.5% to
9%
>9%
Public Pension Long-Term Return Assumptions
as reported in NASRA 2015 Public Fund Survey
2% 3%
12%
29%
<6.99%
7.00% to 7.49%
7.50% to 7.99%
8.00% to 8.49%
>8.50%
54%
Today many pension plans, both public and private, utilize
long-term return assumptions in the 6% to 8% range. The
chart above shows the distribution of return assumptions
as reported by companies in the S&P 500 as of their
last fiscal year end. The median return assumption of
this group of companies is 7%. Many public pension
plans have even higher assumptions. According to the
2015 survey of 126 public pension plans by the National
Association of State Retirement Administrators (NASRA),
the median return assumption among this group was
7.75%. A quick review of historical asset class returns
explains why these return assumptions are so prevalent
today. A simple blended portfolio consisting of 55% U.S.
Large Cap stocks1 and 45% Intermediate U.S. Treasury
bonds2 returned an annualized return of 8.5% since 1926.
Annualized Returns (1926 - 2014)
U.S. Large Cap Stocks
Intermediate Gov’t Bonds
55/45 Blend U.S. Large Caps/Int Bond
10.1%
5.3%
8.5%
Source: Morningstar.
However, these annualized returns are summary statistics
that mask tremendous amounts of performance variation
from year-to-year and even decade-to-decade. For
example, since the start of 1926, in 20% of rolling 10
year windows, a 55/45 blended portfolio failed to achieve
a return of even 6%. We believe that the next 10 years
may be one such period where returns to a passive buy
and hold balanced strategy are likely to come up short.
The reason is simple—starting valuations both in equity
and fixed income are not priced to deliver the returns that
history has led investors to expect.
Valuations are notoriously poor predictors of stock and
bond market performance over the short-term. Expensive
can always become more expensive and cheap can
always become cheaper, at least in the near-term.
Over longer periods, however, the predictive ability of
valuations becomes quite impressive. The table on the
next page looks at the ability of the Cyclically Adjusted
Price-to-Earnings ratio (CAPE) for the S&P 500 to predict
equity market returns and the yield on the Barclays U.S.
Aggregate Bond Index3 to predict bond market returns. In
each case, linear regression models are built to measure
the explanatory power (i.e., R-Squared) of valuations over
various time horizons. As the time horizon extends, so too
does the predictive power of valuation.
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R-Squared vs. Forward Returns
(January 1976 - November 2015)
Valuation vs. Asset Class
1 Year Forward
3 Years Forward
5 Years Forward
10 Years Forward
Starting CAPE vs. Stock Returns
4%
19%
35%
76%
Starting Yield vs. Bond Returns
35%
68%
86%
84%
Source: FactSet, Robert Shiller’s website: http://www.econ.yale.edu/~shiller/data.htm.
Looking out 10 years, starting valuations have explained over 75% of variation in stock returns and an incredible 84% of
the variation in bond market returns since 1976. Unfortunately for investors, this means that the message valuations are
sending today regarding long-term return prospects cannot be ignored. The scatter plots in the below charts show the
historical relationship between starting valuation and ten year returns for stocks and bonds. A shaded vertical box has
been added to highlight where we are today.
Yield to Worst vs. 10 Year Forward Return
Barclays U.S. Aggregate Bond Index3
CAPE vs. S&P 500 10 Year Forward Return
1
(January 1976 – September 2015)
R2 = 0.763
15%
10%
5%
0%
-5%
-10%
11/30/2015
CAPE = 26.36
0
10
20
30
(January 1976 – September 2015)
16%
10 Year Forward Total Return (Annualized)
10 Year Forward Price Return (Annualized)
20%
50
40
R2 = 0.8399
14%
12%
10%
8%
6%
4%
2%
0%
11/30/2015
Yield to Worst = 2.48%
0%
2%
Starting CAPE
4%
6%
8%
10%
12%
14%
16%
Starting Yield to Worst
Source of charts: FactSet, Robert Shiller’s website: http://www.econ.yale.edu/~shiller/data.htm.
The S&P 500’s CAPE ratio of 26.36 as of 11/30/2015 translates to roughly a 5.6% estimated 10-year annualized price
return for stocks. Factor in a dividend of 2% and this model suggests that a total return of 7.6% or so over the next 10
years is about as high as investors can reasonably expect. The story for bonds is even less compelling. The November
ending yield to worst on the Barclays U.S. Aggregate Bond Index (i.e., U.S. investment-grade rated bonds) of 2.48%
translates into an annualized total return based on our regression model of 3.3%. This number is exceedingly optimistic
in our opinion as the model was based largely on a 30+ year bull run in bonds where both yield and price appreciation
(i.e., falling yields) contributed to returns. At any rate, even if one uses the 3.3% estimate for bonds, a 55/45 stock/bond
portfolio is still only estimated to deliver a total return of about 5.7% over the next 10 years:
(7.6% *55%) + (3.3%*45%) = 5.7%
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The Case for Asset Allocation
Embrace a flexible, active asset allocation strategy
It should be apparent by now that the strong relationship
between valuation and long-term future returns spells
trouble for those relying on a static buy-and-hold
approach to achieve long-term returns anywhere near the
assumptions used by many today. Investors in a situation
like the one contemplated above have three options:
Long-term annualized returns can be very deceptive as
they mask tremendous amounts of volatility that occurs
over the course of a market cycle. For instance, consider
an investment made in the S&P 500 on 12/31/2004 and
held for 10 years. From start to finish, the annualized total
return on this investment would have been 7.7%. However,
the path to get there was anything but steady. In fact, in
eight of the 10 years the calendar year return varied from
the full period annualized return by 5% or more.
1. Lower long-term return assumptions
2. Raise target allocation to equities
S&P 5001 Annual Total Return
3. Embrace a flexible, active approach to asset allocation
(2006 - 2015)
40%
Let us consider each option in turn:
Lower long-term return assumptions
Return assumptions should represent good faith
estimates of the likely long-term return on investment.
These estimates can have a significant impact on the
estimated amount of savings required to reach an
investment objective. A lower return assumption in a
defined benefit plan increases the likelihood of greater
contributions mandated by law. In other cases, a lower
return assumption may require a foundation to reduce its
spending targets to ensure that it remains financially viable
well into the future. Participants in defined contribution
plans such as a 401(k) must also contemplate increasing
savings (if possible) in the face of lower expected returns
or accept the prospect of a smaller balance to fund their
retirement. While a lower return assumption may be
necessary for those with unrealistic expectations, others
should carefully evaluate their investment approach
to determine if there is a way to increase the odds of
successfully meeting their objectives.
Source: Bloomberg.
20%
0%
-20%
Calendar Year Return
10 Year Annualized Return
-40%
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
While timing the market perfectly is a fool’s errand, history
shows that it is possible to identify periods where the odds
of a particularly good or bad outcome are elevated. An
active strategy seeks to take advantage of these periods
by allocating capital away from areas that have an elevated
risk of sustained capital loss and toward those where
investors are being paid to take returns. To demonstrate the
feasibility of such an approach, consider a simple allocation
model driven by the shape of the yield curve.
The yield curve measures the spread between long and
short dated U.S. Treasuries. The yield curve tends to go
Raise target allocation to equities
negative (i.e., inverts) late in the business cycle as shortterm rates rise above those of longer dated maturities as
One seemingly logical solution to mitigate the impact
the Federal Reserve raises rates to rein in an overheating
of low expected fixed income returns is to reduce bond
economy. Conversely a very steep (i.e., upward sloping)
exposure and increase equity allocation. Depending on
yield curve tends to occur early in a business cycle as
an investor’s current equity allocation, an increase may
short rates are low due to central bank efforts to stimulate
indeed be justifiable but as always, there are no free
economic growth. Our yield curve model, as described
lunches. The greater expected return from stocks versus
below, presents an alternative to a 55% stock/45% bond
bonds is also accompanied by greater expected volatility.
portfolio (55/45 portfolio). Specifically, it takes a 30%
Greater volatility increases the likelihood that investment
weight (i.e., underweight position) in stocks when the yield
returns fall short of what was estimated over the long-term.
curve is inverted and maintains that position until the curve
In the shorter-term, it can also result in greater drawdowns
returns a positive reading of at least 150 bps, at which
that can adversely impact the ability of some investors to
point 80% is allocated to stocks (i.e., overweight position).
meet more near-term objectives.
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Starting in 1976, $100 invested in this simple active asset
allocation model grows to $6,750 by October 2015 while
that same $100 invested in a 55/45 portfolio only grows
to $4,265.
Growth of $100
(January 1976 - October 2015)
$10,000
Neutral Allocation
Yield Curve Model
$1,000
$100
1976
Source: FactSet.
For illustrative purposes.
1980
1985
1990
1995
2000
2005
2010
2015
In reality, one would never want to rely on a single factor
such as the yield curve to drive asset allocation. However,
the fact that a greater outcome would have been possible
using a simple model suggests that there is indeed merit
to an active approach to asset allocation. While we do
not know what the future holds, having the flexibility to
overweight and underweight particular asset classes can
provide investors with the tools necessary to potentially
outpace a static allocation approach.
valuations, wildly speculative sentiment, and economic
excesses, which all brought the great bull market to a
screeching halt in early 2000.
Those seeking a point estimate forecast for the U.S. equity
market in 2016 will have to search elsewhere. We believe
that such efforts are generally a fruitless exercise that
diverts attention from a true assessment of the risks and
opportunities present in the market. Rather, we prefer a
framework that seeks to identify regimes where the risk
of sustained capital loss (i.e., a bear market) is high,
or conversely market environments that strongly favor
owning stocks. Such a framework also acknowledges that
the market is likely to go through periods where neither
regime is overwhelmingly likely. This is precisely where
we find the U.S. stock market at the outset of 2016. While
valuations are somewhat elevated, the U.S. economy
remains far from overheating, and sentiment is anything
but speculative today. In an environment such as this,
investors can be rewarded by taking advantage of market
volatility to increase their exposure to attractively valued
and well positioned markets/sectors/companies. History
suggests that the volatility of the opening trading days of
2016 is hardly unprecedented. If this volatility continues,
investors may be presented with an opportunity sooner
rather than later this year.
Percentage of Time A Maximum Drawdown of a
Certain Size Is Experienced 6 Months Following
Active Asset Allocation Today
(November 1967 - December 2015)
The backdrop today for active asset allocation is
challenging both from a near-term and long-term
perspective. Having discussed the longer-term challenges
at length above, it is now time to shift our attention to the
outlook for 2016.
At any point in time, equity market returns are driven
by one or more of the following factors: fundamentals,
valuation, and sentiment. Our research finds that,
historically, unsustainable extremes among these factors
are often associated with market regimes that have a
heightened risk of sustained loss or high return potential,
depending on the nature of the extremes. For instance,
by the end of the 2008-09 bear market, stocks changed
hands at multi-decade lows in terms of valuation,
sentiment was so negative that it seemed the sun might
never come up again, and a global economic recession
wreaked havoc on corporate bottom lines. It was out of
these extremes that the strong bull market environment of
the past several years was born. The late 1990s provides
a great example of the other sort of extreme—sky high
70%
Source: FactSet.
61%
60%
50%
50%
40%
36%
34%
30%
20%
25%
27%
14%
13%
10%
0%
-15% or More
-20% or More
18%
7%
-10% or More
7%
3%
Max Drawdown
on Any Given
Day
1st Rate Hike
Economic Clock
Signaling Late
Expansion
Expensive
Valuations
Active investing, of course, is more than just seeking to
take advantage of market volatility. Valuations may be
far from compelling in the United States today, but there
are opportunities for those willing to invest globally. The
next page shows that the CAPE ratio (using next 12
month earnings-per-share estimates) for many countries
is significantly more attractive than for the United States.
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Valuation, of course, is just one piece to the overall asset
allocation puzzle, but it does suggest that there may be
opportunities outside of the United States today.
CAPE (NTM) Valuations for Select Countries
25
(as of 12/31/2015)
Source: FactSet.
20
15
10
United States
Turkey
United Kingdom
Taiwan
Thailand
Spain
Switzerland
South Africa
Russia
Singapore
Mexico
Korea
Malaysia
Italy
Japan
India
Indonesia
Germany
Hong Kong
China
France
Brazil
Canada
0
Australia
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Nevertheless, successful asset allocation is not just
about what an investor owns, it also is about what one
chooses not to own. Investors in passive strategies must
own whatever allocations make up the index, regardless
of the merit of those investments. This can prove
disastrous when an index becomes heavily skewed toward
overvalued segments of a market. Examples of such
distortions from recent decades include the allocation to
Japanese stocks in the MSCI EAFE4 in the late 1980s, the
allocation to technology stocks in the S&P 5001 in the late
1990s, and the allocation to financials in value indexes
such as the Russell 1000 Value5 heading into the global
financial crisis.
Today, we believe this phenomenon is occurring in
aggregate U.S. fixed income indices. Weights in these
indexes are usually based on the amount of debt
outstanding such that entities with the largest borrowing
needs receive the largest index weights. As a result, the
amount of U.S. Treasury debt in these indexes has steadily
moved higher in recent years. At the same time, the
duration (interest rate sensitivity) of these indexes has also
increased meaningfully. We believe that this dynamic will
be problematic for those pursuing a passive fixed income
strategy, as current yields do not compensate investors for
the duration risk they must take on to own these indexes.
However, investors pursuing an active strategy with
the flexibility to deviate from the benchmark can better
manage the risk of higher rates today, and may be better
positioned to take advantage of higher yields should they
rise in the future.
Valuations suggest that over the next 10 years a static
asset allocation approach is likely to fail to meet the
long-term return targets of many investors. In a low-return
world, investors can ill-afford to operate without what
we believe is the most effective tool for increasing the
likelihood of achieving their long-term return objectives:
an active approach to asset allocation. As 2016 unfolds,
there are likely to be many twists and turns in the financial
markets. Active asset allocation may provide investors the
opportunity to respond to these developments and shift the
odds of long-term success more in their favor.
Analysis: Manning & Napier Advisors, LLC (Manning & Napier). Sources: FactSet, NASRA 2015 Public Fund Survey, Robert Shiller, and Bloomberg.
Manning & Napier’s risk mitigation style, which is intended to provide protection in sustained bear markets, may cause underperformance during periods of strong appreciation in the equity markets.
Manning & Napier is governed under the Securities and Exchange Commission as an Investment Advisor under the Investment Advisers Act of 1940.
1
The S&P 500 Total Return (S&P 500) Index is an unmanaged, capitalization-weighted measure of 500 widely held common stocks listed on the New York Stock Exchange, American Stock Exchange, and the Over-the-Counter
market. The Index returns assume daily reinvestment of dividends and do not reflect any fees or expenses. S&P Dow Jones Indices LLC, a subsidiary of the McGraw Hill Financial, Inc., is the publisher of various index based
data products and services and has licensed certain of its products and services for use by Manning & Napier. All such content Copyright © 2016 by S&P Dow Jones Indices LLC and/or its affiliates. All rights reserved. Neither
S&P Dow Jones Indices LLC, Dow Jones Trademark Holdings LLC, their affiliates nor their third party licensors make any representation or warranty, express or implied, as to the ability of any index to accurately represent the
asset class or market sector that it purports to represent and none of these parties shall have any liability for any errors, omissions, or interruptions of any index or the data included therein.
2
Intermediate Gov’t Bonds are represented by the U.S. Intermediate Government Bond data is reflective of the Ibbotson Associates SBBI U.S. Intermediate-Term Government Bond Index, which is an unmanaged index
representing the U.S. intermediate-term government bond market. The index is constructed as a one bond portfolio consisting of the shortest-term non-callable government bond with no less than 5 years to maturity. The Index
returns do not reflect any fees or expenses.
3
The Barclays U.S. Aggregate Bond Index is an unmanaged, market-value weighted index of U.S. domestic investment-grade debt issues, including government, corporate, asset-backed, and mortgage-backed securities, with
maturities of one year or more. Index returns do not reflect any fees or expenses.
4
The MSCI EAFE Index (EAFE) is comprised of 21 MSCI country indices, representing the developed markets outside of North America: Europe, Australasia, and the Far East. The Index returns do not reflect any fees or
expenses. The Index is denominated in U.S. dollars.
5
The Russell 1000® Value Index (Russell 1000 Value) is an unmanaged, market capitalization-weighted index consisting of those Russell 1000® Index companies with lower price-to-book ratios and lower forecasted growth
values. The Index returns are based on a market capitalization-weighted average of relative price changes of the component stocks plus dividends whose reinvestments are compounded daily.
All investments contain risk and may lose value. This material contains the opinions of Manning & Napier, which are subject to change based on evolving market and economic conditions. This material has been
distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy, or investment product. Information contained herein has been
obtained from sources believed to be reliable, but not guaranteed.
This newsletter may contain factual business information concerning Manning & Napier, Inc. and is not intended for the use of investors or potential investors in Manning & Napier, Inc. It is not an offer to sell securities
and it is not soliciting an offer to buy any securities of Manning & Napier, Inc.
SMA-PUB002 USCDN (1/16)
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