Really Nominal

Real returns – returns adjusted for inflation – have been very poor, and based on today’s factors are expected to remain poor. The previous decade was one of the worst – the third worst to be exact – for blended investment returns. And that return was bouyed by bond returns that were just slightly below long-term historical average. Given the absolute level of bond yields today, it will be immensely difficult for large instiututional investment plans (pensions, endowments, other retirement plans including ones run by individuals) to reach benchmarks anywhere near their targets.

We are emerging from the lowest equity nominal return decade, and the second lowest nominal blend since 1871. Over the last 140 years, the annualized return of the U.S. equity market has been approximately 9%. Excluding the 1890-1910 period, the average returns in equity are closer to 9.5%. However, nominal equity returns during the “lost decade” of 2001-2010 were a mere 1.2%. Inflation ran at a rate slightly above 2%. COnsequently, real rates of return on equities is running negative – meaning, equity returns over that decade actually lost holders money in terms of purchasing power. Equity holders have only lost purchasing power over a decade once before since 1871. Between 1911 and 1920, equity returns were nonimally 3.2%; however, runaway inflation ate into real returns, leaving equity holders with a real rate of negative 4.2%.

Meanwhile, declining interest rates has left the bond market with its strongest 30 year run. The 2000s were hardly a lost decade for bonds. The 6.7% returns in bonds would have been the highest 10-year return in bonds since at least the 1860s, but for the fact that bond returns in the previous two decades dwarfed it. Despite the solid returns from bonds, an allocated portfolio generated an average return of only 3.8% – far short of many defined benefit plan obligations and asset allocators expectations. Moderate inflation during the last 30 years have left bond well above historical average, well outpacing the CPI.

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A simple measure over the years for asset allocation for many of those plans is a 60/40 mix – 60% equity and 40% fixed income. Institutional plans commonly target 7-9% nominal to meet their financial obligations. That meets most historical standards. The average blend since 1871 has been approximately 7.5%, and has been closer to 9.0% since 1961. Add addititonal allocations to alternative investments, and certain plans can acheive slightly better than average historical returns.

As of December 31, 2007 (roughly a year prior to the economic collapse), most major benefit plans were targeting 8-8.5% for expected plan asset returns, down almost 1.5% from the 9.4% average seen in 2000. The following is the laregst pension benefit obligations among public companies including their expected rate of return on plan assets.

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However, according to Milliman 2012 Pension Funding Study results of decade were not performing in-line when considering the large losses in three of the ten years.

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As such, funding status for the largest 100 plans by 2011 was less than 80% compared to 105% in 2007, and expected rates of return remain at approximately 8%. An attempt to make up ground of is one of the reasons we saw institutions significantly increase their allocations to alternative investments – particularly the large in-flow of cash into hedge funds.

Yet future returns are not looking any rosier. The major predictable drivers of long term returns on equities are dividend yield, earnings growth and inflation. The price to earnings multiple plays a role, but is an unpredictive measure. Expectations for fixed income is measured by the beginning yield on 10-year maturities.

AQR quant, Antti Ilmanen, who’s book Expected Returns I am currently reading and thoroughly enjoying, published the following chart in May 2012 (and recently displayed in the Economist) which looks at expected real returns on a portfolio comprised of 60% equities and 40% bonds. [side note, Ilmanen worked for Braven Howard when he wrote the book in 2011, and Cliff Asness founder of AQR, wrote the Forward. Now Ilmanen is an MD at AQR. hmmmmm...] At the time it was written, expectated real returns were 2.4%, the lowest in 112 years.

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Ilmamen’s rate is a forward looking measure utilitizing current parameters. He establishes that equities’ forward-looking real return is proxied by an average of two measures: (i) smoothed earnings yield, or the inverse of the Shiller P/E and (II) the sum of dividend yield and 1.5% (a proxy for long-run growth rate in EPS). Bonds’ real yield is the difference of the 10-year Treasury and a measure of expected inflation over the next decade.

From an equity perspective, the current Shiller P/E is 23.4x or 4.3% yield and the S&P500 dividend yield is 2.06%. Based on Ilmanen’s equation, the expected nominal return on equities in 7.86%. According to a survey by the Wall Street Journal, expected inflation (as measured by the CPI) is 2.1%, resulting in a expected real return in equities of 5.76%. The current 10-year constant maturity portfolio of bonds yields 2%, or roughly 0% on a real basis. Although off the low from last year, a 60/40 portfolio is still well below average returns. However, there is another rub.

Using the largest pension funds as a proxy, many institutional plans have changed their weighted allocation. Rather that being 60/40, today’s largest 100 pensions have actually significantly reduced their allocations to equity since 2005, and had increased allocation to fixed income as well as extended duration as a matter of de-risking. By the end of 2011, allocation to equity was running below 40%.

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The large allocation to fixed income is a concern for the short term. Arguments can be made for the equity market being over or under-valued – however, the long-term case for equities remains. The same can not be true for fixed income. Over the long term, rates will need to rise. The 30-year bull market in yield can not continue. At best, an erosion of return in fixed income returns can only be held at bay by the Federal Reserve. At these levels, it appears one’s best case is maintaining purchasing power. The draconian case will be a slaughterhouse of real returns.

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