Research Affiliates: Starting Yields Matter To Future Returns

October 02, 2017

Key Points

  • Using historical returns to forecast the future is one of the most common shortcuts in financial planning.
  • Investment advisors who use only past returns to forecast future returns may well be creating unrealistic expectations and poor investment outcomes for their clients. 
  • Our online Asset Allocation Interactive, which uses starting yields to forecast future long-term returns, gives advisors a rich toolkit with which to construct portfolios most likely to achieve their clients’ financial goals.

 

Starting conditions matter. Today’s investment yields impact future realized returns. But many still rely on past returns to estimate future returns. Our online Asset Allocation Interactive tool gives you the information you need to look ahead, not just back. 

 

Introduction
The sizable assets financial advisors oversee are more than just market positions to be managed, and sources of fees to be earned, but exist to meet clients’ future spending needs linked to a personal hope or dream, such as a secure retirement, college education, second home on the lake, or difference-making philanthropic endeavor. The investment advisor’s job is to help clients understand the feasibility of their financial goals and maximize their clients’ probability of achieving them. Of course, the activities associated with such a seemingly straightforward mission are countless. There are only so many hours in the day. Where do advisors get the best advisory bang for the client buck? Conversely, where are advisors missing the mark, spending time and effort with little incremental net benefit to client outcomes?

This is the first article in a series designed to address specific investment advisor activities most likely to lead to successful investment outcomes for clients, which also happen to be the most productive outcomes for advisors—a win–win situation. Research Affiliates has built, and can offer to advisors, a suite of tools powered by our research insights and which are publicly available on our website. This article, which references the practical application of our online tools, emphasizes how to set reasonable expectations for capital market returns. In other words, what’s the likely long-term return for an individual investor’s normal portfolio? Thanks for reading!

 

Poor long-horizon investment outcomes invariably can be blamed on a handful of “usual suspects”: high fees and expenses; ignoring rebalancing opportunities; performance chasing; lack of diversification; and improper expectations. Rarely do these usual suspects operate as lone wolves. They typically travel together. 

The optimist in us believes that—slowly but surely—times are getting tougher for these culprits. Expense ratios are coming down; no doubt helped substantially by more wide-scale adoption of passive equity investing. Similarly, smart beta is on the march, a more effective means of capturing long-term excess returns than traditional active equity management. Investors are also becoming more aware of the softer, hidden costs of trading and market impact expenses (Chow et al., 2017). Automated rebalancing is now commonplace. Kinnel (2017) and others have shown how fund investors can be on the wrong side of mean reversion by chasing performance. And accessing diversifying assets has never been easier than it is today with the growth of reasonably priced mutual funds and exchange-traded funds (ETFs) offering investment opportunities ranging from emerging-market currencies to commodities to bank loans.

But what about the last suspect: setting improper return expectations? This culprit hasn’t received as much attention as the others, reminding us of a favorite all-time film, 1995’s The Usual Suspects. In the movie, a customs agent, Dave Kujan, tries to figure out which of five criminals is responsible for a drug deal gone bad on a ship docked in San Pedro Bay. Agent Cujan interviews the sole survivor of the crime, Verbal Kint (played by Kevin Spacey), who is intent on pinning the blame on one of the other suspects. Nobody at the police station suspects Verbal Kint, who has a palsied arm and foot—in their view, an unlikely suspect—was responsible. But the ending (spoiler alert!) reveals that not only is Verbal responsible, he is actually Keyser Söze, the “world’s most notorious” criminal. Of course by then, Kint, er, Söze, had walked out of the interrogation uncharged, never to be seen again. The movie ends with a quote from Söze: “The greatest trick the devil ever pulled was convincing the world he didn’t exist.”

As we survey the range of long-term return forecasts in the industry, we are shocked to see so many—including some (deservingly) well-respected asset managers—seemingly ignoring today’s low yields (and their downward pressure on future returns). Instead, many continue to use historical returns to forecast the future, one of the most common shortcuts in financial planning, and one we believe will not serve investors or advisors well.

How can advisors avoid this dangerous and common practice? Research Affiliates’ Asset Allocation Interactive tool illustrates the likely sources of future returns and provides an easily accessible way for proactive, client-oriented advisors to educate clients on probable future financial outcomes. In a subsequent article, we will show how the allocations in today’s normal portfolio can be shifted to offer more attractive long-term risk-adjusted returns.

 

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