The last four years have been very disappointing for investors. The average low-, medium- and high equity multi-asset funds have hardly delivered returns in line with inflation – let alone reach the ‘inflation-plus’ targets they have set out to achieve. This frustration has led so many investors to ‘give up’ and take their money out of the market, locking in the weak growth of the last few years, to park it in cash products until the market starts performing again. “If ever?!” is at this stage what many investors are thinking.
But, what is reasonable to expect from the market over a 3-year period?
It is common practice for multi-asset funds to state an inflation-plus target with a minimum recommended time frame. It is important that one understands how these inflation-plus targets are derived and exactly what they mean.
Inflation – just like cash - is an absolute return target. This means it behaves very differently from the rest of the market, especially over the short-term. It displays very little volatility and is extremely unlikely to ever have a negative 1-year period. It is thus unreasonable to expect a fund that invests in the equity, property and bond markets – asset classes with the ability to deliver returns in excess of inflation - to achieve their inflation-plus target at all times under all market conditions.
A more realistic interpretation of the inflation-plus targets is expecting funds to achieve the relevant target over its stated minimum time frame at least two-thirds (67%) of the time. This likelihood is calculated on the typical asset allocation of each fund category, the expected long-term returns of the respective asset classes and more than 100 years of historic asset class returns data.
Why are so many fund managers lagging their inflation-plus targets at the moment?
Only the global equity and property markets managed to achieve a real return over 3% consistently. The ability for funds to benefit from this is, however, capped at the 30% limit on direct offshore exposure that regulators have set for funds who are managed in accordance with Regulation 28 under the Pension Funds Act.
What can we learn about the investment cycle from history?
The relationship between time, risk (largely driven by the level of growth versus income assets in your portfolio) and return hasn’t changed. The more time one has, the more risk one can take on - and the more risk once can take on, the higher the return one can expect to be rewarded with. Stated differently, the greater the rate of return one needs to achieve, the greater the level of risk one needs to accept. Along with a greater level of risk of an investment, the longer the time frame one may need to be able to achieve one’s investment goal.
Let’s look at the 3-year annualised real return of the domestic equity market since 2000 to understand the investment journey a bit better.
The simple answer is, because the market just hasn’t delivered. At the end of July, not a single domestic asset class had outperformed the SA inflation rate by more than 3% over the last 3 years. Only after a strong August did domestic equities hit the ‘+3%-target’ for the first time this year.
This illustration clearly shows us that:
- Growth assets can and will lag inflation and inflation-plus targets from time to time
- It is difficult, if not impossible, to predict the exact timing of a recovery
- Growth assets can recover significantly within only a few months (don’t get caught off-guard!)
- Outperformance enjoyed by growth assets is generally much greater than its underperformance
- Outperformance generally lasts much longer than periods of underperformance
Patiently sitting through this 3-year rollercoaster is the price you pay to enjoy the benefits of increased purchasing power over the long-term. Even though the stability and predictability that cash and income assets offer in the short term may seem very attractive, it is important to remember that these assets over the longer term do not deliver the same level of real returns over in inflation than what equities historically have.
The chart below illustrates the cumulative real return of cash versus SA equities over the past 20 years. To interpret this graph in a more real-life example, let’s look at it from the affordability to buy a new car perspective. If you kept the price of a VW Citi Golf 20 years ago in a cash product for 20 years, you’d be able to upgrade to a VW Polo today. However, if you invested the same amount in the SA Equity market, you’d be able to buy a Range Rover today at more than four times the price. The upgrade does come with its fair share of volatility and shorter terms capital drawdowns, like the -40% in less than a year through the Global Financial Credit Crisis in 2008. However, the reward for staying focused on the long-term plan paid off.
A fund containing growth assets will, at times, underperform money market and income funds. The reality is that the likelihood of your multi-asset or equity portfolio outperforming the average income and money market fund increases the longer you stay invested. The table below clearly shows that over the last 20 years, there hasn’t been a single rolling 7-year period over which the average income fund outperformed the average multi-asset or equity fund. Over a rolling 5-year period multi-asset and equity funds have outperformed 90% of the time – a pretty successful “hit rate”.
Where to from here?
Stick to the basic principles of investing, a few of which are listed below. Work closely with your chosen financial advisor, stick to the agreed investment plan and importantly, be patient.
- Your investment time frame is a key driver of the level of risk you can afford;
- Your risk tolerance drives the asset allocation suitable for your objectives and needs;
- Asset allocation is an important driver of expected return;
- Diversification has benefits as it enables you to reduce risk without compromising return;
- Emotions can erode value, so avoid knee-jerk reactions to short-term discomfort;
- Reasonable returns compounded over long periods can produce astonishing results.