Expected returns - November 2017
The expected rate of return on a portfolio of assets is an important, but difficult, input in the investment planning process. Important, because the investor’s current contribution level with which he/she aims to achieve a specific investment objective in the future will vary dramatically based on the discount rate (or expected rate of return) selected. If you are too optimistic, the investor will end up with less purchasing power than required, but if you are too conservative, the investor will unnecessarily defer consumption, thereby reducing quality of life in his/her younger years. Difficult, because the future is by its very nature uncertain and we have at best partial information to inform our forecasts.
Note that the long-term saver is primarily interested in the real, or after-inflation, rate of return. Inflation measures the general increase in prices over time. If the rate of return selected equals the inflation rate, the investor is merely protecting the purchasing power of what has been saved. It is only the real return that can be viewed as a ‘reward’ for delaying gratification, as earning a positive real return will enhance an investor’s eventual purchasing power.
A good starting point in setting prudent return expectations is to look at the very long-run asset class returns (Figure 6): growth assets (property and equity) produced a real rate of return in the 7% – 8% range, while income assets (cash and bonds) earned 1% – 2%. This implies an expected long-run real rate of return of around 5% p.a. for a typical balanced fund (assuming exposure of between 70% – 75% to growth assets and between 25% – 30% to income assets). Actual real returns achieved over the past decade were, with the exception of SA equity, in line with the long-term average, explaining why the typical balanced fund achieved a real return of 2.5% p.a. Coronation Balanced Plus, due to a positive active return contribution, achieved a real return of around 4.7% p.a. over the same period.
FIGURE 6 ANNUALISED REAL RETURNS PER ASSET CLASS (PAST 10 YEARS AND 5 YEARS VS 117* YEARS TO 30 SEPTEMBER 2017)
After a sustained period of below-average returns, our 10-year forecast for local equity is now slightly above the experience of the last decade as a result of more attractive valuations. The strong performance from global markets have contributed to global equities outperforming local equities over the past decade and warrant caution in future expectations. Current market conditions, influenced by extraordinary monetary policy accommodation and relatively full valuation levels lead us to a lower return forecast range for both global equity and global bonds (as set out in Figure 7). However, it is reasonable to expect better returns from the average balanced fund over the next decade based on a more favourable outlook for local growth assets. Based on the mid-point of our 10-year return expectations and asset allocation based on the composite index we use as benchmark for Coronation Balanced Plus, it is prudent to assume a weighted real rate of return of around 4% p.a. for the typical balanced fund.
FIGURE 7 EXPECTED ASSET CLASS RETURNS
IMPLICATIONS FOR INVESTORS
Figure 8 shows the increase in purchasing power at different real rates of return over time. If we use the 2.5% real rate of return produced by the average balanced fund over the last decade as a basis, we see an increase in purchasing power of 1.28 times over 10 years, and 2.69 times over 40 years - a reasonable reward for delaying consumption. However, if we increase the real rate of return to 5%, as has been achieved by Coronation Balanced Plus over the last decade, your purchasing power increases to 1.63 times over 10 years and to 7.04 times over 40 years. Being able to add that additional alpha of 2.5% p.a., improves purchasing power by 25% - 30% after a decade, and more than doubles purchasing power over 40 years.
FIGURE 8 INCREASE IN PURCHASING POWER
THE VALUE OF ACTIVE RETURNS
Coronation, like all active managers, pursues the outperformance of market indices or benchmarks (net of the fees we charge and costs that our portfolios incur). Since the launch of Coronation Balanced Plus in 1996, we have added 1.6% p.a. to the returns produced by its benchmark (comprising a combination of indices representing local and global equities, bonds and cash), and 2.4% p.a. more than the fund’s average competitor. Both measures of outperformance are shown after the deduction of all our management fees and portfolio costs. If we are able to achieve a similar rate of outperformance in future, it could mean the difference between achieving a 2.5% and 5% real rate of return (as discussed above).