Investments: Should you follow ‘smart money’ like the CPPIB?

Nominal returns of 3 to 4 per cent may become the new normal

For investors and savers, today’s financial environment must rank among the least rewarding in half a century, if not longer.

In the major advanced economies – the U.S., Canada, Japan, the UK, and most of continental Europe – the “policy” interest rates set by central banks are at or near all-time lows. This translates into almost non-existent returns for savers who squirrel away money in bank accounts, GICs and money market funds.

The same is true for the buyers of government bonds - 10-year yields in Canada and the U.S. now hover under 2 per cent. With inflation projected to be at or above 2 per cent, this means investors in government bonds who hold to maturity are on track for negative real (that is, after-inflation) returns. Despite this counterintuitive picture, there is no lack of demand for the sovereign debt of creditworthy issuers.

Far from being a positive sign, the peculiar behaviour of the bond market reflects gloom about prospects for the global economy. While 10-year government bonds may promise negative real returns, many investors judge them a better option than traditionally riskier asset classes, notably equities. And equities are indeed risky, as evidenced by a decade or more of negative cumulative returns across most developed country markets. Yet when interest rates rise – as eventually they must – bond-heavy portfolios will be hammered (interest rates and bond prices move in opposite directions.)

Today, the broad equity market indexes in many advanced countries are trading below their levels of 10, 12 or – in the case of Japan – 20 years ago. In Canada, the TSX index is approximately one-fifth below where it stood in the summer of 2008. How long before the benchmark Canadian index punches through the 15,000 level set a little more than four years ago? No one knows. In the meantime, stocks could easily fall another 10 to 15 per cent, amid a struggling global economy and faltering growth here in North America.

In part, the outperformance of bonds versus stocks can be explained by a long secular decline in interest rates (and inflation) over the 1980s and 1990s, which served to boost fixed-income returns. With interest rates currently plumbing the depths, it’s hard to conjure up a scenario of rising bond prices going forward. The end of the long bond bull market may cause investors to look more fondly on equities.

Yet consider what the “smart money” is doing. Many of Canada’s largest public pension funds – the Canadian Pension Plan Investment Board, the B.C. Investment Management Corporation, and the Ontario Teachers’ Pension Plan, to name just three – are shifting capital away from publicly traded securities (stocks as well as bonds) and toward “alternative” assets like real estate, infrastructure and private equity. To some extent this reflects prudent portfolio diversification. But it also speaks to a belief by these sophisticated money managers that the returns on public securities are apt to disappoint in the years to come.

In a slow-growth world where many advanced economies are burdened with both excessive debts and unfavourable demographics, it makes sense to scale back expectations for financial market returns. Instead of the 8-per-cent annual returns targeted by many fund managers prior to the 2008-09 financial crisis, something closer to 5 to 6 per cent seems reasonable. This assumes a portfolio mix of 30- to 40-per-cent fixed income, 50- to 60-per-cent equities, and 10-per-cent cash, gold and other alternative assets.

Some market-watchers judge even 5 to 6 per cent to be optimistic. Legendary U.S. money manager Bill Gross, for one, recently speculated that nominal returns of 3 to 4 per cent may become the new normal. Gross also has helpfully announced the “death” of what he calls “the cult of equities.”

Of interest, the Canadian Pension Plan Investment Board (CPPIB) has set a real return objective of 4 per cent per year, which after inflation amounts to roughly a 6-per-cent nominal return. Given its extensive resources, unrivalled access to investment opportunities, and ability to minimize costs and fees, the CPPIB is likely to outperform most other institutional money managers. If the CPPIB is correct in its assessment of economic and financial market prospects, even returns of 5 to 6 per cent may be out of reach for the rest of us.

Jock Finlayson is executive vice president of the Business Council of British Columbia.