Commentary: Safeguarding your portfolio in a low-return environment

For the past several years, a cocktail of subdued inflation, declining bond yields and expanding valuations have helped deliver heady returns to investors. However, political turmoil, potential confrontation with North Korea and catastrophic weather are just a few of the factors that have reduced capital market return expectations, and the strong returns investors have come to expect might fall short.

A low-return environment would pose a challenge to investors in the years to come, jeopardizing financial goals while forcing them to make tough choices on funding, spending, return targets, asset allocation, and portfolio risk and complexity.

Our research suggests many investors are unaware of the possibility of low returns. Half of the defined benefit plan sponsors we surveyed last year expect returns of at least 7%. However, our five-to-seven-year assumption for a portfolio consisting of 60% stocks and 40% bonds is just 4.8%. Many institutional investors have a long-term time horizon that allows portfolios to withstand shorter-term volatility, but we still recommend investors consider altering investment programs to ensure their potential returns can meet long-term financial objectives.

Investors should consider several approaches to potentially maximizing investment outcomes in a low-return environment and choose the one (or ones) that best fits their time horizon, goals and comfort with risk. Depending on specific financial situations, they may be able to take advantage of liability-driven investing opportunities, total return opportunities and incremental opportunities.

Investors with a relatively long time horizon for derisking their plans and a long-liability duration profile are trying to maintain a high expected return while hedging interest rate risk. These investors should consider implementing capital-efficient long-duration strategies, which allow them to achieve long duration with a relatively low amount of assets compared to a traditional long-bond approach. One example is Treasury Separate Trading of Registered Interest and Principal of Securities, or STRIPS, which adjusts a portfolio's allocation to long bonds and reallocates a portion of those assets to higher return-seeking assets.

Investors should also consider dual beta strategies, which allow investors to obtain two market exposures in a single fund – for example, U.S. large-cap equity and U.S. long duration. By combining two market exposures in a single fund, investors can preserve expected returns while introducing or adding to liability-hedging assets.

Lastly, we recommend using active management for traditional long bond allocations, which — for plans further along in the derisking process — may comprise 50% or more of the portfolio. Active managers can add value through yield curve positioning, sector allocation and issue selection, and the results can be very meaningful for an allocation of this size. Active managers can also customize portfolios to align with a plan's yield curve profile and prepare portfolios for derisking activities such as lump-sum payouts of annuities.

In a low-return environment, we recommend investors examine their use of fixed income and equities. Given that our return assumption for U.S. core bonds is below 3% in the upcoming market cycle, investors should consider a diversified approach to fixed-income investments, but they should weigh the potential return premium from diversifying against the additional risk.

Investors at the earlier stages of derisking may find direct-lending strategies in private markets appealing given their relatively shorter lives and attractive return potential. Emerging market debt may also offer opportunities for return enhancement relative to core bonds.

As with core bonds, U.S. large-cap equities are unlikely to help investors meet their return objectives. Most portfolios tend to be overweight in U.S. relative to international equities, and with emerging markets carrying high expected return assumptions, now could be an opportune time to diversify. However, investing outside of the United States is deemed riskier, and positions should be sized according to the investor's appetite for risk.

Lastly, many total-return investors are addressing the low-expected return environment by adding or increasing allocations to private equity. Increased capital flows into this space over the last several years have fueled questions on the return potential going forward, so investors should be disciplined and cautious if they employ this strategy.

When low returns are expected, every basis point counts. This is especially true for investors who need to maintain a strategic target allocation to cash in order to meet ongoing payments — which can come at a substantial opportunity cost over time. Investors can reduce this opportunity cost by securitizing cash via a futures overlay that seeks to replicate their policy target allocation as closely as possible. This allows investors to maintain liquidity while staying more fully invested, which can provide 10 to 20 basis points of incremental return.

Investors must also weigh the value added by active managers against the fees they charge. Broadly speaking, investors should pay reasonable fees where they anticipate the greatest benefit and pursue low-cost approaches where expected value-add is low. Many investment managers recognize the fee pressures facing their businesses and are increasingly reducing fees on a voluntary basis or introducing new products at lower fees than traditional approaches.

While many markets appear to be fully valued, we believe there are opportunities for investors to maintain or even enhance expected returns and meet financial objectives. In a low-return environment in particular, investors should embrace non-traditional diversification and pursue active management strategies where expected rewards are the greatest.

Mike Valchine is a principal and senior consultant with NEPC LLC, Detroit. This article represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.