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Aug 26

Real Return funds…lacking real-ity?

What a fascinating investment world its been over the past few months. We’ve had concerns about Greece exiting the Euro, commodity price crashes, a Chinese sharemarket crash and now some of the biggest developed economy sharemarket declines since the dark days of the GFC. Volatility has been somewhat benign for a long time thanks to QE3 and the money printing out of Japan and Europe but its come back with a vengeance.

One of the more recent trends in the product landscape resulting from the GFC has been objective based investing…most notably Real Return funds. The story goes that investors are looking for a decent return above inflation and don’t really want exposure to the nasty volatility of sharemarkets as this market exposure didn’t appear too aligned with their true investment goals….so these objective-based investments appeared (or at least most of them did) following the GFC and have been quite popular.

Today (and pretty much most of recent times), these products have a bit of a problem…unfortunately these products have dug a hole for themselves and will probably struggle to get out. The problem is they are real return plus “too much”….and it has turned them into investments that not only will struggle to meet their objectives, but have landed their investors back where they came from…that is, exposures that carried too much risk.

The most popular objective (at least that I’ve noticed) of Real Return funds is CPI + 5%. A few years ago, this wasn’t perceived as too big a problem….Cash rates during 2011 and 2012 were in the mid 4%s, term deposits were paying attractive premiums (150bps+) over government bond yields, as too were investment grade bonds (BBB rated bonds were 200-300 bps of government bonds) so with an expected CPI at the RBA target mid-point of 2.5%…scrambling for a few extra basis points didn’t require massive risk taking and a diversified portfolio of defensive and risky investments could do the trick.

Fast forward to today and its a completely different story…

  • RBA Cash rates are at 2%…below expected inflation…and priced to go lower
  • Government bond yields are yielding between 1.8% (for short term) and 3.2% (if you want 15+ year terms)
  • BBB rated bonds have premiums at less than 2% over government bonds with total yields for 3-5 securities at less than 4%

…meaning these traditional defensive securities are quite debilitating to any portfolio looking to achieve CPI + 5%. This can only mean that in order to achieve the desired objective requires loading up on risk and a fair bit of it. Risk from sharemarkets, junk bonds, and almost by default…illiquidity.

None of this should have come as too big a surprise when you consider the last 50 years…equity returns in Australia and Globally have produced real returns of only a little more than 5%…pretty much equaling these Real Return objectives, whilst bonds and cash have understandably fallen well short. So portfolios containing not much other than equities (& other risky assets) should have been expected.

So today, we are clearly in a position where these Real Return funds (or at least those with +5% real targets) require significant levels of risky assets to achieve objectives, and waddayaknow…we have badly behaving sharemarkets. Hopefully this bad behaviour is short-lived but either way, I have to wonder how these objective-focused or real-return investors will react when they discover, once again, their objectives are struggling to be met and/or they are carrying uncomfortable levels of risky assets. Unfortunately the main problem real return investors have failed to grasp is that there aren’t too many asset classes that actually provide real returns of a +5% magnitude…sure they might outperform inflation by 5% over long periods of time, but the returns are typically not highly correlated to inflation so real returns is quite the misnomer. Oh yeah…and inflation linked bonds don’t provide anything like CPI + 5%.

So the bottom line… real return investing isn’t too real at all with big targets like CPI + 5%…it is an objective that is not strongly linked to the reality of investment markets so prepare for another investment approach aligned with disappointment.

Fire away!

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1 comment

  1. Matt Ritchie

    Not sure that just because the targets are ambitious we should throw the baby out with the bath water. The biggest issue is that we live in a sales environment, and if a Manager came out with a product that targeted CPI plus 2%, no one would sell any of it!

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