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

Is it better to rent or own a home under the age pension?

With 62% of Australians aged 65 and over relying at least partially on the age pension, are they better off owning their home or renting? There is an extra pension asset allowance for those not owning a home.

Too many retirees miss out on this valuable super fund benefit

With 700 Australians retiring every day, retirement income solutions are more important than ever. Why do millions of retirees eligible for a more tax-efficient pension account hold money in accumulation?

Is the fossil fuel narrative simply too convenient?

A fund manager argues it is immoral to deny poor countries access to relatively cheap energy from fossil fuels. Wealthy countries must recognise the transition is a multi-decade challenge and continue to invest.

Reece Birtles on selecting stocks for income in retirement

Equity investing comes with volatility that makes many retirees uncomfortable. A focus on income which is less volatile than share prices, and quality companies delivering robust earnings, offers more reassurance.

Superannuation: a 30+ year journey but now stop fiddling

Few people have been closer to superannuation policy over the years than Noel Whittaker, especially when he established his eponymous financial planning business. He takes us on a quick guided tour.

Comparing generations and the nine dimensions of our well-being

Using the nine dimensions of well-being used by the OECD, and dividing Australians into Baby Boomers, Generation Xers or Millennials, it is surprisingly easy to identify the winners and losers for most dimensions.

Latest Updates

Superannuation

Superannuation: a 30+ year journey but now stop fiddling

Few people have been closer to superannuation policy over the years than Noel Whittaker, especially when he established his eponymous financial planning business. He takes us on a quick guided tour.

Survey: share your retirement experiences

All Baby Boomers are now over 55 and many are either in retirement or thinking about a transition from work. But what is retirement like? Is it the golden years or a drag? Do you have tips for making the most of it?

Interviews

Time for value as ‘promise generators’ fail to deliver

A $28 billion global manager still sees far more potential in value than growth stocks, believes energy stocks are undervalued including an Australian company, and describes the need for resilience in investing.

Superannuation

Paul Keating's long-term plans for super and imputation

Paul Keating not only designed compulsory superannuation but in the 30 years since its introduction, he has maintained the rage. Here are highlights of three articles on SG's origins and two more recent interviews.

Fixed interest

On interest rates and credit, do you feel the need for speed?

Central bank support for credit and equity markets is reversing, which has led to wider spreads and higher rates. But what does that mean and is it time to jump at higher rates or do they have some way to go?

Investment strategies

Death notices for the 60/40 portfolio are premature

Pundits have once again declared the death of the 60% stock/40% bond portfolio amid sharp declines in both stock and bond prices. Based on history, balanced portfolios are apt to prove the naysayers wrong, again.

Exchange traded products

ETFs and the eight biggest worries in index investing

Both passive investing and ETFs have withstood criticism as their popularity has grown. They have been blamed for causing bubbles, distorting the market, and concentrating share ownership. Are any of these criticisms valid?

Sponsors

Alliances

© 2022 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. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). 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.

Website Development by Master Publisher.