Investment consultants face challenges as bearers of bad news in assisting asset-owner clients grappling with lower capital market expectations that are pushing them to extend risk exposures to reach assumed returns.
“Unfortunately, there is a conflict between what can be expected from the capital markets and what is desired by many” asset owners, said Jay V. Kloepfer, executive vice president and director of capital markets and alternatives research, Callan Associates Inc., San Francisco.
“Hope isn't a strategy.”
The primary “thing we are helping our clients do is set realistic expectations,” Mr. Kloepfer said. “You can have a rate of return and really want it. ... We need to help our clients understand what is actually achievable given the amount of risk they would like to take on.”
Steven Carlson, Chicago-based head of investment consulting for the Americas, Willis Towers Watson PLC, said pension plan sponsors and other asset owners will be challenged in meeting their return assumptions.
“It really depends on what their assumed return is,” Mr. Carlson said. “If it's in the 7% to 8% range, that's probably going to be much more difficult to achieve. If they are bringing it down to the 5% or 6% range, there is a much greater probability of achieving it. So a lot of it is dependent on the plan sponsor bringing the rate of return down to a level that is more in sync with how they are allocating their assets.”
David Druley, chairman and CEO, Cambridge Associates LLC, Boston, said, “We do think we will continue to be in a low-return environment where global equities and are likely to return no more than 5% or 6% (annualized) over the next 10 years (and) bonds 2%” annualized over the same period.
“We would expect a simple 60% global equities/40% bond portfolio to compound roughly 2-3% real, 4-6% nominal, over the next decade driven by low bond yields and elevated equity valuations,” Mr. Druley said in a follow-up e-mail. “These data suggest that investors are highly unlikely to get returns they need from the market alone in the next 10 years and underscores the continued importance of delivering alpha through active management.”
Mr. Kloepfer said, “The irony is as you lower capital market expectations, it pushes investors to take on more risk. So there is less reward for taking on more risk. Yet they often feel forced into taking on more risk to try to reach for return.''
Addressing plan sponsors, Mr. Kloepfer said, using Callan's capital market expectations, ”If you want a 7.5% return, we suggest you would have to drive your fixed income (allocation) all the way down to 12%” and increase exposure to a diverse set of alternatives and strategies to capture more expected return.
“The response back (from clients) is that is sure a risky portfolio.”
Ten years ago, an asset owner could have a 50/50 allocation to fixed income and risky assets to reach a 7.5% return expectation, Mr. Kloepfer said. “And 20 years ago, when bonds were yielding 7.5%, you (could have been) ... all in bonds” and meet that return assumption.
“So the risk of portfolios to reach for 7.5% (expected return) has tripled over 20 years,” he said.
Long-term capital market assumptions of major consulting firms and money managers point to lower annualized returns in major asset classes over the next 10 years, compared to historical averages.
Willis Towers Watson projects expected returns in U.S. equities of 5.6% for the broad market equities, 5.5% for large cap and 5.2% for small cap. For U.S. bonds, it projects 1.6% for aggregate investment grade, 1.7% for intermediate government and 3.9% for high yield and 2.1% for cash. It projects 5.6% for developed market international equities, 4.7% for emerging markets equities, 2.8% for emerging markets debt, 4.5% for real estate, 4.9% for infrastructure, 4.4% for “medium-skilled” private equity funds of funds, and 4% for “medium-skilled” hedge funds.
Callan projects higher returns generally, although still below historical averages. In U.S. equities, it projects returns of 7.4% overall with 7.3% for large cap and 7.6% for small- and midcap. For U.S. fixed income generally, it projects 3% and for high yield, 5%. It projects 7.3% for developed market international equities, 7.6% for emerging markets equities, and 4.6% for emerging markets debt. It projects 6% for real estate, 8.2% for private equity, 5.3% for hedge funds and 2.3% for cash.
Callan projected annualized 10-year returns and risk for a portfolio under different asset allocation scenarios. For a conservative portfolio, it projects a 5.2% return and 7.4% standard deviation, while for an aggressive portfolio, it projects a 6.9% return but requiring twice the risk level at a 14.8% standard deviation.
Asset owners will be challenged in the next few years, especially if interest rates rise as expected, to reach their assumed rates of return, Mr. Kloepfer said.
“We are the ones charged with delivering realistic expectations,” Mr. Kloepfer said. “So that means we are the bearers of bad news. So there is a temptation in our industry from some of our colleagues to sell the dream if you will. To say, 'Yes, we can get your higher return. We will just load up your portfolio with more risks than you can probably tolerate or understand. Just trust us.'”
“You may want a 7.5% return, but if it means driving your portfolio to only 10% fixed income and it's too risky for you, maybe that's not a good choice.” Mr. Kloepfer said.
Consulting firms face challenges as a business to assist clients.
“One is just the increasing complexity and the risk that is now embedded in the capital markets and the portfolios that many of our clients and prospects have,” Mr. Kloepfer said. “So we have to stay abreast of developments and opportunities that are far more complex, far more challenging to understand and implement and monitor. And they require resources.”
Smaller firms that don't have resources face challenges competing.
Mr. Carlson said. “The smaller consulting firms are going to struggle, given the need to have the breadth and depth of their people to be able to explore … various asset classes.”
Among other challenges, “this low-return environment … puts pressure on fees for all service providers, active managers, passive managers, custodial banks, consultants,” Mr. Kloepfer said.
Mr. Carlson said consultants are helping not only manage the return side of assets but also the funded side in reducing or stabilizing risk of liabilities.
Willis Towers Watson has been working with clients more to “understand how their assets are moving through time relative to liabilities” to help manage funded-level risk, Mr. Carlson said.
“One key is to continue to diversify away from a straight stock/bond portfolio, using alternative investments or illiquid investments that help keep your assumed rate of return a bit higher,” while seeking to manage funded risk through liability-driven investing, using fixed income to match a set of liabilities and assets, he said.
More complicated classes
Mr. Druley said, “The way people are going to achieve their return (is) to look at things that have the ability to add significant value. We think that is manager selection but also investing in more complicated and at times illiquid asset classes, such as private equity and venture capital and private credit.
“You saw a rush into hedge funds after the great financial crisis,” Mr. Druley said. “Maybe people who didn't have the skill or resources to actually find the few hundred managers that really could generate returns ended up disappointed.”
Asset owners “now clearly understand you need experienced, skilled resources to generate extra return or alpha in what looks the most to be a low-return environment.”
Asset owners “we work with are either building up more staff internally, or if they have staff and don't want to build more … are using us selectively in special parts of their portfolios (such as) private equity, hedge funds, private credit,” Mr. Druley said. “Or if they don't have staff, they are outsourcing,” delegating fiduciary risk and responsibility.
With low-return market expectations, Mr. Kloepfer asked, “how do you guide people through those waters? If you are going to have a lot more risk in your portfolio, you want to diversify it and hence the strong interest in alternatives assets that will be different from your public market equity. That includes real estate, private equity, hedge funds, liquid alternatives, multiasset class strategies, and then on the debt side, looking into market that aren't publicly traded” such as private debt strategies.
“Another irony embedded in this (low-return market) is many investors have lost faith in active management and are moving to passive at the very time they are also seeking strategies to protect them on the down side,” Mr. Kloepfer said.
They “want to hire somebody who is going to protect (them) on the downside because (they) have so much equity risk. It's conundrum that has to be resolved.”
To reconcile the issue, Mr. Kloepfer recommends allocating to asset classes where “you think you can get the best bang for the buck spending your active management budget. Typically it is focused on the less researched, less liquid parts of the liquid market (such as) small caps, international, emerging markets, international small cap. That's one source of alpha. A second is perhaps looking at multiasset class strategies … to try to generate a total portfolio return that is a better risk-adjusted ride.”
This article originally appeared in the November 28, 2016 print issue as, "Firms try to keep clients grounded in reality".