Investors should consider four options when facing the prospect of a prolonged period of low returns, according to a just-released paper by asset consultant Towers Watson Australia.
The ‘Investing in a low return environment’ paper argues that with most risky assets “fully priced” and cash rates at historic lows, investors need to revisit previous return assumptions.
“[Based on current pricing] expected asset class returns are likely to remain significantly lower (by around 2% pa) than the assumptions that are typically used by investors for the purposes of setting the strategic asset allocation,” the Towers Wastson report says.
The paper suggests investors have four possible courses of action to manage through a potential low-return era:
- Do nothing;
- Increase portfolio risk;
- Reduce return objectives; and/or
- Change risk allocation within the portfolio – for example, by increasing active strategies.
“At a high level there are no ‘wrong’ answers and what is most important is that each investor responds to the low return environment in a way that is appropriate given its specific circumstances and beliefs,” Towers Watson says.
The paper says the ‘do nothing’ option “will be an entirely appropriate response”, especially for low-scale investors.
“We would however stress that ‘doing nothing’ needs to be a decision that is actively taken by an investor,” the report says.
However, Towers Watson says increasing portfolio risk may not be the preferred approach of many investors given the current market-pricing paradigm.
“We believe there will be times in the future when it will be appropriate to take more risk,” the paper says. “We do not currently know when that time will be, but in our view the low level of realised and implied volatility in major asset markets is unlikely to last into the medium term.”
Reducing annual return objectives by 2 per cent is also likely to be “unpalatable” for the majority, Towers Watson says, while the final option – changing risk allocation with the portfolio – could suit only a “relatively small proportion of investors”
“This said, for investors who are able to do so successfully, we believe that a combination of a dynamic asset allocation overlay, improvements to active mandates and replacement of some or all passive exposures with smart betas can add around 0.5% pa additional return,” the paper concludes.