The expected returns from cash, near cash and income funds will be significantly lower for the foreseeable future.
Retired investors who rely on drawing an income from their investment portfolio, but also need protection against inflation, could be setting themselves up for further disappointment if they are over-exposed to cash-like investments.
Since the beginning of 2016, close to R75 billon has flowed out of multi-asset class funds with low- or medium exposure to equities. That equates to a withdrawal of about 25% of the assets invested in these more conservative balanced funds. And the pace of withdrawal has been accelerating, even during 2019 when these funds delivered good performance.
The Covid-19 lockdown shock added to risk-aversion, causing more investors to reduce the level of risk in their portfolios.
Meanwhile, about R130 billion of net new money was invested in managed income and bond funds over the same four-and-a-half-year period. Another R150 billion was invested even more conservatively in money market and cash plus funds.
The net outcome is that many retirees are more conservatively positioned than is justifiable when applying textbook theory. This is especially concerning given the collapse in cash yields since March this year.
Return gap prompts shift into cash-like investments
So why has there been a such a significant move out of more conservative multi-asset funds?
The shift to cash-like investments is simply an understandable response to disappointing historical performance delivered by these funds. Investors expect to be rewarded for taking on additional risk, with many of the more conservative funds targeting annual returns of inflation plus 3% to 4%. This translates to a return target of around 9% over the past five years. Given the weak state of the local economy, the local equity and property markets performed poorly over the past five years, with annual returns of less than 4% per year and minus 15% per year respectively.
While the more conservative multi-asset funds did better, by on average eking out positive returns of around 5% per year in the recent past, a return gap emerged. These funds also underperformed money market and managed income funds, that on average delivered a little more than 7% per year.
Many investors responded to this gap by switching to managed income and even more conservative cash-like funds.
What investors should remember, however, is that an extended period with no reward for risk is unusual. While managed income funds performed better or the same as the conservative multi-asset funds in three of the past five years, this outcome is not the norm. Looking at the previous five years (2010-2014), the multi-asset funds with larger risk budgets delivered better returns than the income funds in four of the five years. Over this period, these funds returned 10% to 11% per year, more than double the recent experience, while the managed income and cash funds returned a similar 7.2% per year.
Expected returns from cash, income funds to fall
You may rightly think that we can’t plan for the future by looking only in the rear-view-mirror. While we do not know whether the reward for taking additional risk over the next five years will be more like the past five years or the early 2010s, there is one datapoint that there can be no dispute on. This is where we think the biggest risk lies for many retirees, given how conservative their investment portfolios are positioned.
The Covid-19 crisis this year has resulted in a dramatic and unprecedented steepening in the yield curve. Longer-dated government bonds trade at historical highs, with for example the 15-year bond yielding around 11% compared with 9.6% a year ago. At the same time, cash yields have fallen from 6.5% a year ago to 3.5% today.
The net result is that the additional annual yield paid by longer-dated bonds compared with cash has increased to around 7% now from 3% a year ago. While the higher long bond yields are attractive, they are not without risk, as it reflects the market’s concerns about the sustainability of government’s finances. If these concerns were to grow, yields could rise further, resulting in capital losses for existing bondholders.
This argues strongly for the judicious introduction of riskier assets in retirement-funding portfolios.
Avoiding the next possible return disappointment
Our key concern is that the current conservative positioning of many retirees is setting them up for another possible return disappointment over the next five years. Cash yields are at historically low levels and could well remain low for a lengthy period. Long bond yields are high, but that doesn’t come without risk. And local equities are now so unloved that they are undemandingly valued.
We therefore encourage retirees to consider adjusting to the current financial market realities and prudently re-risk their investment exposure. They can do this by investing in a multi-asset class fund that is appropriately risk-conscious.
In so doing, they will be able to gain exposure to the more attractive return prospects available from both international and local asset classes that cannot be accessed through income and cash funds. In our view, these funds are better positioned to take advantage of the investment opportunity set that currently exists than managed income and cash funds.