19 November 2014

Times are challenging for anyone relying on their investments to provide a decent level of income. Before the financial crisis it was not unreasonable to achieve an annual return of around 5% by investing in the relative safety of cash and government bonds. Running at a higher yield than the pace of inflation, this approach provided an easy way to preserve the purchasing power of your assets (see figure 4).

Interest rates and bond yields have been falling steadily since the financial crisis. Today’s best cash savings rates are just 1.5% – and that is if you really hunt around. Yet the current rate of inflation reduces this to a real return of zero. The figure turns negative for both basic and higher rate taxpayers, which means holding cash erodes the real value of your wealth.

Conditions in fixed income markets are not much better with 10-year UK gilt yields hovering around 2.5%. But performance has been volatile this year and remains vulnerable to ongoing economic and political uncertainties. Inflation-linked bonds are relatively unattractive at the moment because the real return is negative (see figure 5). However, they can offer protection against any unexpected rise in inflation if interest rates do not rise at the same time. Meanwhile, the highest-quality investment grade corporate bonds are no longer delivering the yields they once were.

Figure 4

The savers’ dilemma.

As these two charts comparing interest rates and inflation show, it used to be easy to

preserve the real value of wealth without taking any risk. But those days are over.

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Source: Bloomberg and Rathbones

Figure 5

The real risk-free rate has disappeared.

This chart shows the real yield of UK inflation-linked bonds, which fell dramatically after the financial crisis and has not recovered.

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Source: Bloomberg and Rathbones

Pushed up the risk scale

This dramatic reduction in the risk-free rate is encouraging investors into other asset classes in order to boost their returns – and equity markets are a popular destination. Performance has been decent over the past few years but concerns are mounting in two key areas.

First, there are now some doubts about the direction and timing of the monetary policies that have buoyed share prices. The Us Federal Reserve has almost completed its third round of quantitative easing and the Bank of England has already stopped. Interest rates are expected to rise in both countries at some point next year.

Second, some believe that investors have been too optimistic about the profits outlook. The large gains over the past couple of years were caused in part by investors re-rating the equity markets (giving shares a higher valuation) rather than because of profit growth. With limited scope for further multiple expansion, company earnings will now have to grow in order to drive the markets higher. Yet profit margins are already at record levels.

Another reason behind the ongoing rally in equity markets has been the popularity of share buybacks and other types of financial engineering. Although these actions push up prices in the short term, it often means businesses are not investing, which is bad news for longer-term growth prospects. At the same time, there are some worrying global trends to suggest the recovery is slowing.

A change of view

Traditionally, a balanced portfolio targeting a real return of around 4% a year would have allocated around 60% of its assets to equities and 40% to bonds. But with bonds offering record low real returns, it is necessary to dial up the equity component in order to offer any chance of providing the same real return. Even this move is ambitious and optimistic given the current level of equity valuations. Some analysts suggest the real return from equities over the next seven years could be negative.

Importantly, shifting the strategy towards equities in this way increases the level of risk substantially. It is also likely to be inappropriate for many investors because it will be out of line with their appetite for risk, tolerance for loss, time horizon and financial situation. One of our investment principles is to avoid risking the long-term value of capital in the hope of chasing a higher return in the short term.

Away from the equity markets, there are a number of options to consider when looking for higher returns. They include high-yield bonds, property and infrastructure investments, renewable energy projects and various alternative strategies. Yet many of these investments can be illiquid and the risks are often unclear. If interest rates or inflation rise (or both) you could find yourself locked in to unattractive rates of return. Notably, the additional risks leaves investors exposed to deteriorating economic conditions.

Diversify the sources of return

In the new investment landscape of low bond yields and increasingly stretched equity valuations, our challenge is to help investors maintain their lifestyles through an adequate income from their assets without taking on too much additional risk. Within the investment framework we use to build portfolios, we consider investments in terms of three categories – liquidity assets including cash and government bonds; equities and other assets correlated to these markets; and diversifiers. We believe this third area is becoming increasingly important in the current environment.

Within diversifiers we seek to invest in securities, strategies and asset classes where performance has a low correlation to equity markets but that can still generate positive returns through the business cycle. There are several groups. The first includes commercial property and infrastructure. However, after enjoying a long period of strong returns, most of the funds offering exposure to these areas are trading at significant premiums to their net asset values (NAVs). Precious metals and agricultural commodities can also offer diversification but the returns tend to be volatile.

We believe some of the most interesting opportunities to diversify returns today are with actively managed alternative strategies. This varied group includes long–short equity managers with low net exposure to the equity markets, and macro funds that trade fixed income securities and interest rates. Managed futures is another interesting area, where funds use derivatives to profit from price trends they identify across any financial market. We also consider total return funds that seek to deliver consistently positive returns, as well as strategic bond funds which can take advantage of market conditions in a controlled way.

Investing successfully in more sophisticated strategies requires a thorough investment research and selection framework. Our rigorous approach to due diligence helps us to identify managers with the skills, resources and experience to find and exploit investment opportunities through all market conditions. Often they are smaller managers with a specific investment edge, and the ability to measure and monitor investment risk and performance in their specialist area.

The 2007–08 financial crisis has had a profound effect on the global economy and financial markets that is likely to last for many years. Central bank monetary policies have distorted asset prices and many of the traditional patterns of performance appear to have broken down. In the new world order of subdued growth, low rates and low inflation, the ongoing hunt for yield is likely to become an increasingly difficult challenge.