Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 21

Managing for real returns

I have previously made the case that real return outcomes are crucial for those saving for retirement and living off their retirement savings. Yet institutional super funds do not explicitly manage the risk of real return outcomes. The typical mix of assets in a default super fund results in the risk to real outcomes (that is, the returns adjusted for inflation and the more important outcome) being greater than the risk to nominal outcomes (that is, returns before adjusting for inflation, a less important outcome). This article explores the concept of managing for real returns.

In a nominal return portfolio construction framework, investors think of the major asset classes as follows: cash is our risk-free asset, bonds are a defensive asset class which should perform well in a difficult economic environment, and equities are a growth asset which participates (less consistently than you may think) in the strength of the broader economy.

As a result we see higher levels of risk, as displayed in the rolling nominal return volatility table below. Table 1 below looks at the volatility of annualised returns for both nominal and real outcomes over a period from 1900 to 2012.

Table 1: Volatility of annualised returns for different asset classes (1 January 1900 to 31 January 2012).

Asset Class Volatility (Nominal) Volatility (Real)
Cash 3.9% 5.4%
Domestic Bonds 10.7% 12.1%
Australian Equities 17.7% 17.7%
Global Equities (unhedged) 18.7% 17.6%

Source: Schroders; “Why SAA is Flawed?” March 2012, Schroder Investment Management.

The nominal results are in accordance with the expectations described above. However, the returns from bonds and cash have, over the very long term, been more volatile than one may expect, since the last 20 years has been a period of low volatility for these asset classes. Once we switch our mindsets to focusing on the risk to real return outcomes, the risk profile changes:

  • The historical real return from cash is more volatile than the nominal return, which may surprise, given the current setting we have become accustomed to whereby the Reserve Bank adjusts the cash rate to control medium term inflation.
  • The return profile of nominal bonds becomes more volatile when viewed from a real return perspective rather than a nominal return perspective. The reason why is that in high inflation environments it is common to see nominal bond yields rise (based on inflation expectations). Rising bond yields results in falling bond prices so investors in bonds may take two hits in an inflationary environment: the purchasing power of their capital falls (due to rising inflation), and the value of their nominal portfolio falls.
  • The return profile of equities remains volatile when outcomes are viewed in real terms. There is no clear pattern whether companies are able to pass on input cost increases (including labour). Indeed there are many other factors at play such as government policy and macroeconomic effects such as changes to exchange rates and interest rates. So we see the volatility of real outcomes remain high.

Overall, when we are focused on managing the risk to real return outcomes we are considering outcomes relative to inflation. In this sense inflation becomes what we call the numèraire (the basis for comparison). Observing and hence managing nominal return risk assessment is easier because risk is measured as variability in the nominal outcomes. When considering real return risk assessment, we need to consider the nominal return against the inflation outcome. That is why nominal bonds appear more risky in a real return context: they often experience negative returns at the same time that inflation is high (so a double whammy), as illustrated previously.

In terms of other assets and investment strategies:

  • Inflation-linked bonds are often viewed as a low risk investment when we are focusing on real return outcomes. However this is only true over a long term holding period. Over shorter periods of time indexed bonds often have very long maturities and carry significant duration risk, so the short term variability in the bond price may be quite large even though the risk to inflation outcomes is offset by the indexation of the coupons payments. This is an important consideration if you have a range of investors in a fund all retiring at different times (we call this sequencing risk, as discussed in Cuffelinks on 6 March 2013).
  • Real assets are often regarded as good inflation hedges. Examples include property and infrastructure where the income stream may be linked to inflation. However the real outcomes could still be volatile due to other factors. For example, if interest rates rise significantly in response to inflation, the asset price may fall if based on a discounted cash flow technique.
  • Investments in commodities are also viewed as inflation hedges. There is logic to this argument but there will still be large variability as there are many supply and demand factors (besides inflation) which affect commodity prices.

Overall the challenge of managing real outcome risk is significant. Managing real outcome risk is more complex than managing for nominal outcomes (because the numèraire, inflation, is itself a variable quantity). It creates the challenge to think more strategically about inflation itself and the role of each potential investment in different inflationary environments. The starting point of a real return focussed asset allocation framework would be:

  • Create expectations of real returns for each asset class. For each asset consider the underlying ability for its return stream to change with inflation.
  • Consider the risk to real return outcomes for each asset class. How could each asset class perform in different inflationary environments?
  • Consider the likelihood for the inflationary setting to change.

I’m yet to see any super funds that explicitly manage for real outcomes. There is also an opportunity for asset consultants to frame their asset allocation advice in this manner as well. There are some managed funds in the real return or target return space that are heading down this path. There is a significant leadership opportunity for super funds to manage real return risk and ultimately improve the outcomes of those in Australia’s retirement income system, where the inflation risk represents a potential erosion of their retirement outcomes.

This is the third of three articles which makes the case that we need to have a greater focus on real return outcomes. Simply stated, real return outcomes are more volatile than nominal outcomes, and of course have been lower. However there is a dangerous tail risk element evident as well, due to periods of higher inflation. By explicitly targeting real return risk we are better positioned to manage the risk that most directly relates to retirement outcomes.

 

RELATED ARTICLES

Hold the champagne, that’s not a recovery yet

The utmost importance of real returns - but does the industry care?

The role of financial markets when earnings are falling

banner

Most viewed in recent weeks

An important Foxtel announcement...

News Corp's plans to sell Foxtel are surprising in that streaming assets Kayo, Binge and Hubbl look likely to go with it. This and recent events in the US show the bind that legacy TV businesses find themselves in.

Warren Buffett changes his mind at age 93

This month, Buffett made waves by revealing he’d sold almost 50% of his shares in Apple in the second quarter. The sale not only shows that Buffett has changed his mind on the stock but remains at the peak of his powers.

Wealth transfer isn't just about 'saving it up and passing it on'

We’ve seen how the transfer of wealth can work well, with inherited wealth helping families grow and thrive for generations, as well as how things can go horribly wrong. Here are tips on how to get it right.

Welcome to Firstlinks Edition 575 with weekend update

A new study has found Australians far outlive people in other English-speaking countries. We live four years longer than the average American and two years more than the average Briton, and some of the reasons why may surprise you.

  • 29 August 2024

The challenges of building a portfolio from scratch

It surprises me how often individual investors and even seasoned financial professionals don’t know the basics of building an investment portfolio. Here is a guide to do just that, as well as the challenges involved.

Welcome to Firstlinks Edition 573 with weekend update

Steve Eisman, best known for his ‘Big Short’ bet against US subprime mortgages before the 2008 financial crisis, is now long and betting on what he thinks are the two biggest stories of our time: AI and infrastructure.

  • 15 August 2024

Latest Updates

Investing

Legendary investor: markets are less efficient and social media is the big culprit

Despite an explosion in data, investment titan, Cliff Asness, believes the market has become less efficient, not more, over his 34-year career. He explains why, and how you can take advantage of it.

Property

A housing market that I'd like to see

Our housing system isn't working, with prices and rents growing faster than wages, longer public housing waiting lists and more people are experiencing homelessness. Here are five ways to ease the crisis.

Retirement

It isn’t just the rich who will pay more for aged care

The Government has introduced the biggest changes to aged care in almost 30 years. While the message has been that “wealthy Australians will pay more for aged care”, it seems that most people will pay more, some a lot more.

SMSF strategies

Meg on SMSFs: At last, movement on legacy pensions

Draft regulations released this week finally provide the framework for unwinding legacy pensions cleanly and simply for members who choose to do so. There are some caveats though, including a time limit.

Investment strategies

A megatrend hiding in plain sight: defence

Global defence spending has inflected higher, bringing huge opportunity to a group of companies that have already outperformed broader market indices over the long-term.

Investment strategies

The butterfly effect, index funds, and the rise of mega caps

Index fund inflows to the US market are relatively tiny. Yet a new research paper suggests that they have distorted the size of the market's largest stocks to a surprising degree.

Investment strategies

Options for investors who don't want to sell overpriced banks

The run-up in Australian bank stocks has some investors confounded: do they continue to hold them in expectation of further gains - or sell and take profits now? There are alternative options to consider.

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.