While traditional asset allocation has served investors well over the past three decades, those expecting a repeat might need to have another think, according to M&G Investments’ Tristan Hanson.
Hanson, lead manager of the £87.9m M&G Global Target Return fund, said it has been a “wonderful” decade or three for traditional 60/40 equities/bond portfolios.
“Equities and bonds have enjoyed stunning bull markets and, over the last 25 years, have provided negative correlation during equity bear markets,” he said.
“The result has been a staggering return for this ‘naïve’ strategy: the investor’s wealth is today nearly 4x what it was in March 1990, adjusted for inflation.
“In the last decade alone, such a strategy has delivered a 5 per cent per annum return after inflation, or a cumulative 63 per cent gain in real terms, with volatility around 4 per cent.”
However, Hanson noted that these figures refer to a hypothetical portfolio rebalanced quarterly that do not account for trading costs of management fees.
In addition, to achieve such returns investors would have had to remain invested throughout, which would have been extremely challenging over the past 30 years with significant market-impacting issues such as the global financial crisis, dotcom bubble, Brexit and US-China trade war.
“The same portfolio delivered four stomach-churning quarterly returns of -10 per cent or less since 1990, and -7.8 per cent as recently as Q4 2018,” Hanson added.
“It wasn’t easy, in other words. Staying invested was the hardest challenge. Those that have done so have been rewarded, deservedly so.”
As such, the fund manager said it’s more difficult to see how the traditional asset allocation model will continue to meet investor expectations.
“The returns investors experience are a function of changes in fundamentals – profits, dividends, defaults, inflation, interest rates – and valuations, which reflect the starting-point yield – or risk premia – [that] investors require to hold the asset at any point in time,” said Hanson.
“It is difficult to say too much with confidence about fundamentals in the decade ahead.”
Inflation has been stable at around 2 per cent on average for the past 30 years, he said, and this could continue. But it could just as easily fluctuate too. The low interest rate environment of the post-financial crisis period could also change, as was seen in recent years.
“This leaves us with an observation on starting point of valuations,” he said. “Real yields on bonds are very low by historic standards and where coupons are fixed, unless a very material deflation arises, real returns from bonds are likely to be very poor over the coming decade, probably negative.”
From an equity perspective, valuations have also moved much higher in recent years as the equity bull run has continued apace.
“The earnings yield on the MSCI World is below average, but not as measly as at the start of the century – from which point equity returns were very poor,” he said, highlighting the table below. “Equity returns have shown some correlation with starting point yields, but with considerably more variation than bonds.”
He added: “Altogether, this leaves us with the lowest prospective yield on a 60/40 equity/bond portfolio that we have seen in the past 40 years. That is a sobering thought for future returns.”
Should the 2020s be a decade of stellar profits growth and low inflation then returns from a traditional balanced portfolio should be satisfactory, said Hanson. But for that to happen, equity markets will have do the heavy lifting and generate returns far superior to bonds.
“At current levels of interest rates, along with flat yield curves and compressed credit spreads, bonds simply cannot generate returns anything like their historic average, unless inflation is much lower than expected, which wouldn’t intuitively seem very supportive of corporate profits and equities,” he explained.
As such, investors should have “very modest expectations” for future returns from a simple passive equity/bond split, the M&G Global Target Return manager said.
“Seeking anything better than low single-digit returns is therefore likely to involve taking on much more equity or liquidity risk, or will require a much more active approach,” he added.
While last year was a “profoundly surprising” year in which both bonds and equities performed well, investors shouldn’t extrapolate a long-term trend nor abandon active asset allocation completely.
“Such short-term deviations in trend are to be expected, but for anyone with a consideration of prevailing valuations and a reasonable time horizon, we would anticipate dynamism and selection to show their worth once again,” the manager concluded.
The M&G Global Target Return fund aims to achieve a total return of at least 4 per cent per annum above the 3-month GBP LIBOR rate investing across a range of asset classes.
Performance of fund vs benchmark since launch
Source: FE Analytics
Hanson has managed the fund since launch in December 2016, during which time it has made a total return of 3.29 per cent against a 1.99 per cent gain for the Libor GBP 3 Months benchmark. It has an ongoing charges figure (OCF) of 0.65 per cent.