Tour d’Expected returns

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Edit: updated for stats from Credit Suisse yearbook

Tl:dr Prediction is difficult … especially about the future. Take them seriously not literally.

I do love a well put-together set of expected returns, and it’s been great to see asset managers getting more comfortable sharing their own in recent years (in a previous post I said that expected returns ought to be the new macro outlook – far more likely to be useful than “market go up/down type commentary”, as much as we all love that stuff).

Although, there is a push back: do expected returns carry too much weight in allocating capital. Wherein effectively made up numbers in spreadsheets (let’s be honest) can spawn entire industries of asset manager products (hello: private equity).

Why expected returns?

Well, couple reasons. We need future returns for all sorts of planning purposes, where part of the planning is often the amount of contributions that need to get made over the short/medium term to deliver an outcome over the longer term. Yes, expected returns are far from certain, but you need a number. A good example of this was a paper I co-wrote back in 2021 arguing that in the then lower expected return world, an annual 8% annual savings rate needed to be more like 12% to deliver a reasonable retirement outcome. (the world changed since then, but more of that later).

Another interesting takeaway from expected returns relates more to asset allocation. Relative differences in expectations also matter, for example emerging market vs developed and US vs rest of world are two key ones for asset owners of all types. Alternatives, private markets. Allocations to all of these things typically depend on the attractiveness of their expected returns relative to conventional public assets.

Yes, but. Is there any evidence that expected returns forecasters are actually any good? That’s the tricky bit. In an excellent paper Mike Sebastian and others looked at the decade ending in 2022 and the short answer was … no. Here’s the key chart (and I discussed this in my newsletter)

Notable there are two things: the large deviation of actuals from average expected: several percentage points per annum in a world where decimals are often sweated over, and also the false confidence coming from the range as most of the time the actual is outside the range. In just one example famously persistent bearish real return forecasts from renowned investment house GMO were spectacularly wide of the mark in the years running up to 2022.

That being said …. we do need something and expected returns are something. Things have objectively changed a lot in the last year and I think it is important to make our best effort at getting a handle on that and what it means for long term investors.

Here’s the best comparison I could put together of a half dozen different forecasters. The comparison is harder than it first seems as there’s not consistency between real, nominal, USD vs GBP US vs world etc. I’ve done the best I could.

I’ve tried to pick a variety of different types of forecaster too (asset managers, asset owners, academic).

Sorry, lot of numbers here but trying to tease out the best comparisons

31 Dec 2022 p.a. in USD, nominal returns, 20 years where possible or nearest
(31 Dec 2021 in brackets where available)
US EquityDM EquityEM EquityEuro EquityGlobal 60/40 Portfolio
Vanguard 4.7-6.7%
Research Affiliates6.7%8.1%12.7%11.1%6.4%
AQR6.2%* (5.8%)6.3%* (5.9%)6% (real)5% (4%)*
JP Morgan7.9% (4.1%)8.4% (4.8%)10.1% (6.0%)10.5% (7.1%)7%
Aswath Damodaran9.8% (5.75%)
Norges Bank IMc6.5%5.3%
Credit Suisse Yearbook6% *5% *

* based on real return assuming 2% p.a. average inflation long term

The takeaways

  • For the global developed market estimate the range of central estimates is 6.3-8.4% with Professor Damodaran a potential outlier at 9.8% (although he just forecasts the US)
  • For most forecasters this is a significant increase on the prior year although the amount of the increase varies quite a lot:
    • JP Morgan and Professor Damodaran see an increase of almost 4%, whereas AQR and Norges Bank something much smaller around 0.5%
    • This seems to have to do with the methodology. A forecaster who starts with an equity risk premium and adds this to a risk free rate will almost certainly see a big increase purely from higher risk frees. But some forecasters do not do this and estimate equity returns in isolation from risk free rates by using an intrinsic IRR model on equities where earnings growth is the key input. These folks have slightly higher returns now but nowhere near as big an increase
    • The growth rate there is the key assumption – AQR and Prof. Damodaran both use this method but seem to arrive at very different expectations. AQR assume 1.5% real growth, whereas Prof Damodaran use 5.9% (nominal) for the next 5 years from current analyst estimates and the risk free rate thereafter. This seems to give a more generous return assumption than AQR
  • Inflation matters! Philosophically you need to get clear on whether you really care about real returns or nominal returns (answer: probably real is what matters, but nominal is easier to deal with). If your nominal returns are high because of higher assumed inflation then this definitely matters! For example Research Affiliate’s nominal returns look high, but the difference with say, AQR more than disappears when you look at their real returns, as they are assuming higher than usual inflation in the US and UK
  • Emerging markets. A premium to emerging markets over developed is a pretty universal feature of all forecasters
    • Is this just another lazy behavioural received wisdom that isn’t questioned enough, or a no-brainer universal truth?
    • Not surprising given what a bad last decade EM has had, any kind of valuation driven forecast will give it a higher expected return. This has been a fairly consistent feature of the last decade though and allocators who followed this direction have not done well
    • I’ve written before about emerging markets. Addressing the question of EM strategically I think is one key question facing long term asset owners, but the persistent return premium across forecasters shows you why you should address it
  • Some forecasters but not all see a premium in European equity (and often in UK as well). Again these tend to be the ones with a valuation driven component to the model as again, non-US equities have not done so well over the last decade. So your views on whether that valuation matters for the future will impact your forecast and probably your allocation
    • UK and european equities tend to have higher dividend yields and lower dividend growth (past and future), of course total returns matters
    • The issue here is that it may make sense for valuation to feed into expected returns, but if you’re not careful you end up embedding a significant value tilt structurally into your portfolio (rather than intentionally). As investors know from the last 10 years, this can hurt returns quite a lot, so better do it knowingly and in a limited way
  • A final point is the attractiveness (or otherwise) of various alternatives from private equity to liquid alts vs equity. Haven’t shown these above.
    • A general trend over the last decade as expected returns fell was the increasing search for alternatives that could fulfill higher returns
    • A key question is, how do these stack up in a new expected returns world?
    • One part of this is private markets. These tend to be slow moving so it may be that we are not yet in a position to fully appraise future expected returns, but there’s a few interesting data points:
    • AQR, JP Morgan and Research Affiliates all have estimates for alternatives. AQR see the expected returns of private equity and private real estate (importantly net of fees) falling substantially, below that of public equity – mainly due to a higher cost of debt finance. Research Affiliates expected returns are generally dominated by liquid classes at the higher end.
    • JP Morgan see an increase in exepcted returns for things like private debt and infrastructure vs last year, but a far smaller increase than for public equities, decreasing their attractiveness. In their world private debt at 6.0% and infra at 6.1 when the expected return on equities was just above 4% looked great, but it’s a different story now with stock expected returns up at 8% as they see it and the private markets only nudging up a little.

So what! Where does this all leave asset owners / savers

The work I did back in 2021 showed that a fall in real returns from 4.2% to 2.4% for a balanced portfolio (a 1.8% fall) resulted in a third less pension savings at age 65 and required 12% rather than 8% annual contributions/savings rates to get back to the same level.

Has that fall in expected returns now been reversed?

Probably partly, at least half, but it does depend who you listen to and what is your favourite methodology for expected returns. Back then we were looking at expected real returns on stocks of 3-4%, now it looks like 4-6% is a decent bet. So that’s about 1% higher, maybe a touch more for a balanced portfolio as bond expected returns have shot up across the board. So somewhere between half and three quarters of the fall in expected returns over the prior decade has been reversed.

Do everyday people have a good handle on expected returns? The work I did before with interactive investor unearthed an interesting result on this front – back then (2020) their survey suggested that people in the UK weren’t actually too far wrong in their thinking on this (see below) – maybe erring slightly on the conservative side which I wouldn’t have expected.

This neat little chart from the Credit Suisse yearbook packs a lot of Insight:

  • Almost no equity premium to bonds last 30 years, minimal last 50 years (even worse ex-USA), 60/40 has been king
  • Bonds future real returns now above zero
  • Prospective stock returns now in line with experience over last 50 years, balanced portfolio bit lower

To wrap up there are really five key takeaways around expected returns and investment planning I’d say:

  1. Inflation. It really matters over the long term, you probably should be thinking in real terms returns. If expected returns are high simply because of higher inflation this is important to know
  2. Slightly less bad. Return expectations were awful, they are now slightly less bad than they were before so it should be slightly easier to make sensible savings plans “work”.
  3. What’s under the hood matters. Whether your investments are all in stock markets, or a mix of stocks and bonds really matters for the returns you’ll get
  4. Charges matter As expected returns have fallen, charges eat up a larger and larger part. We got to a point a few years ago where charges could potentially eat up nearly all the returns of a lower risk portfolio. The good news is that at the competitive end of the market, fund charges and access have massively fallen, but there are still plenty of lazy legacy funds out there gouging you on charges and not telling you about it. Just because returns have now gone up doesn’t mean you shouldn’t take a microscope to all the charges you are paying.
  5. Time. As always, time in the market is what matters. Compounding is an absolute wonder over 20-30 years. don’t try and time the market, stay invested and just keep buying.

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