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“I'm not in this world to live up to your expectations and you're not in this world to live up to mine.” - Bruce Lee
On a recent Monday morning, I arrived in the office thinking about the concept of happiness after an enjoyable weekend spent outdoors with family and friends. For many of us, Monday mornings tend to bring about the exact opposite emotion, as work related thoughts or tasks that we have put off frequently dominate our focus. But this time around, I only felt good vibes. I thought to myself, wouldn’t it be nice to start every workweek or even every workday this way? And so, instead of worrying unnecessarily on this day per usual, I chose to dig a little deeper into the concept of happiness and why things were different for me this time around.
People like to say that the worst day on vacation is still better than the best day at work. I’m not so sure this was ever true for me. Don’t get me wrong vacation is great and I hope to take much more of it in the future, but isn’t it true that our best days, the days in which we feel the most satisfied or happiest are distinctly related to our expectations? And this is really what I am driving at here. How we feel about ourselves, our relationships, our life accomplishments are firmly attached to the expectations we subscribe to or have set upon ourselves. Investing in the financial markets is no exception to this idea. An investor who is hoping to make a return of 6% and realizes 9% will likely be happier than the investor who is hoping for 12% returns and also realizes 9%. In the end, we are playing this game against ourselves.
With that in mind, I recently stumbled across a comprehensive report put out by the McKinsey Global Institute, “Diminishing Returns: Why Investors May Need To Lower Their Expectations.” The conclusion, which should not be a surprise to anyone paying attention, is that US and Western European market returns over the past thirty years ran at considerably higher levels over their long-term averages. With the favorable conditions that were in place during this past period either weakening or reversing, they conclude that market returns over the next twenty years will be much weaker. I have highlighted some of their key findings below.
Real (also known as inflation adjusted) total returns for equities between 1985 and 2014 averaged 7.9% in both the United States and Western Europe. This is 1.4 and 3.3 percentage points respectively above the 100-year average.
Real bond returns in the same period averaged 5.0% in the United States and 5.9% in Western Europe. This is 3.3 and 4.2 percentage points respectively above the 100-year average.
Drivers of these exceptional returns include sharp declines in inflation and interest rates; strong global GDP growth lifted by positive demographics, productivity gains and rapid growth in China; strong corporate profit growth due to revenue growth from new markets, declining corporate taxes and increased productivity related to technological advances.
As a result of many of these trends having run their course - total real returns for US equities could average between 4-5% which is more than 2.5 percentage points below the 1985-2014 average while fixed income real returns could be around 0-1% which is approximately 4% lower than the past average. Europe looks similar.
In light of our discussion on expectations and investment returns, I found Warren Buffett’s recent criticism of both expensive hedge fund management and consultant fees during Berkshire Hathaway’s annual meeting timely and appropriate. If it is likely that future returns over the next couple of decades will be lower than what has been realized in the past, investors should think long and hard before paying out 2 and 20 (2% management fee plus 20% of the profits) to the fund manager. In a world of high interest rates and high returns those investors who pay out big fees to their managers and consultants may think nothing of it, however in an environment of low returns those high fees can easily eat up half of the profits or more. According to aBloomberg article highlighting the criticism, Buffett went on to say that “Wall Street salesmanship has masked poor returns for years. Consultants have steered pension funds and others to high-fee managers who, as a group underperform what you could get sitting on your rear end in index funds. The arrangements eat up capital like crazy.”
My thoughts on the consultants and fund of funds managers who target the institutional market place is that they are probably more of a drag on returns regardless of the market environment. I can only speculate that their popularity with pensions, endowments and foundations stem from a legal position. Meaning that plan fiduciaries, those individuals who are responsible for operating and administering the program on behalf of the beneficiaries, believe they gain some sort of protection through hiring a consultant to assist in their due diligence process.
On markets overall I am cautiously optimistic. I believe zero to negative interest rates will fuel most asset prices higher. Bonds and gold should continue to appreciate in price while both developed and emerging market equities should also benefit. We are managing investment portfolios conservatively given that traditional valuations by most measures appear stretched, but also recognize that with long term interest rates very low in many markets, and in my opinion likely to stay that way much longer than anticipated, prices can run much higher than many people typically expect. The question I have been wrestling with lately is the
idea of zero or even negative interest rates used as an input to discount stock prices over a very long period of time, and what that means for today’s theoretical valuations. In most cases, I keep coming back to the same conclusion - and that is prices can move considerably higher from where they currently stand.
Justin Kobe, CFA Founder & Portfolio Manager
Advisory services through Cambridge Investment Research Advisors, Inc., a Registered Investment Adviser. Securities offered through Registered Representatives of Cambridge Investment Research, Inc., a broker-dealer, member FINRA/SIPC. Cambridge and Pacificus Capital Management are not affiliated.Material discussed is meant for general illustration and/or informational purposes only, and it is not to be construed as investment, tax, or legal advice. Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary. Therefore, the information should be relied upon when coordinated with individual professional advice. These are the opinions of Justin Kobe and not necessarily those of Cambridge Investment Research, are for informational purposes only, and should not be construed or acted upon as individualized investment advice. Investing in the bond marketis subject to risks, including market, interest rate, issuer credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies is impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Diversification and asset allocation strategies do not assure profit or protect against loss.