How to assess risk and return objectives in the low return environment

Introduction

It is widely acknowledged that the outlook for financial market returns over the medium to long term is lower (and quite possibly significantly lower) than the returns delivered in recent decades. This leads to the question as to what asset owners should do with their existing risk and return objectives.

Many institutional funds have lowered their return objectives, particularly where quantitative modelling using forward looking estimates of risk and return are used in the review process. But there is a trade-off between having objectives that are set for the long term (and which are stable) vs. objectives that are reasonably likely to be achieved over the medium term. The current dispersion between the medium-term outlook and what one might expect over the very long term (based on historical data) is extreme, exacerbating this tension.

We believe it is imperative, in the first instance, that asset owners take into account these extreme circumstances and communicate to members that returns are likely to be significantly lower than history would suggest. Asset owners should also consider their current investment strategies, and how their portfolios can best be managed to reflect the greater risks attached to the medium-term outlook.

Here, we set out how we believe asset owners should approach assessing their portfolios and their risk and return objectives. But first, it is helpful to look back at how objectives have typically been set.

Background and historical context

If we look back to 10 years ago, Willis Towers Watson had one set of asset assumptions which remained fairly stable from one quarter to the next. Effectively, these were longer term or “normative” asset assumptions and because they did not vary significantly, there was little difference in the projected risk and return statistics produced by re-running the model for a given asset allocation at the end of each quarter.

We used these assumptions to assess clients’ portfolios, to help determine appropriate risk and return objectives, and subsequently, to assess the likelihood of being able to meet these objectives. Our standard approach was to recommend that clients aim for a 60-70% chance of meeting their return objective, over the time horizon specified for their fund. As long as the longer term outlook for returns remained “normal”, our forward looking expected returns remained fairly stable, and whilst the likelihood of meeting the specified return objective did fluctuate, it generally remained within that desired range.

Following the Global Financial Crisis, the outlook for expected asset class risk and returns over the medium term appeared (to us) to be different to longer term, or normative levels. In our modelling framework we refined our process to make a distinction between projections over the short to medium term and over the longer term.

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Since then, we have continued to calibrate our model so that asset class assumptions in the early projection years reflect both starting levels/yields and also our expectation for the path and speed at which they will transition to more normal levels. An outworking of this process is that our expectations for asset class returns over the next 10 years are now more variable over time. We believe that this is entirely reasonable as the outlook for markets is constantly evolving – and in the absence of a change in market outlook, a material change in asset prices should imply a change in forward-looking returns.

About two years ago, the sustained decline in yields across all asset classes had led to a significant divergence between our expectations for asset class returns over the medium term (which we will specify as the next 10 years in our modelling framework) vs. the long term (10+ years), as reflected in our normative asset class assumptions. This divergence, plus the fact that we expected it to take many years before asset returns returned to more “normal” levels, led us to recommend that our clients reconsider their return objectives, which were still largely based on longer term, normative modelling assumptions.

As expected, modelling based on assumptions over the medium term (which reflected both starting levels and a transition path to normative levels) showed that the likelihood of meeting return objectives had indeed fallen, in many cases to below 50%. This resulted in many of our clients reducing their return objectives, generally by 50-100bps.

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More recently, we have introduced a new assumption set (labelled “Lower for Longer”) that not only reflects the current low level of yields, but also the headwinds that we believe financial markets will face over the next 10 years, so that the transition path to “normative” levels is both slower and the terminal values are lower. This assumption set reflects our current medium-term market views, and the implication is that clients now again find themselves with a likelihood of meeting their (reduced) return objective over the medium term that is lower than the desired probability of 60-70%. This begs the question – do return objectives need to be lowered even further?

We believe that the appropriate response depends on whether the return objective is intended to be used as an indicator or “proxy” for the risk profile of the fund, or if it is intended to be a realistic target that can be achieved over the medium term. We do not believe that there is a standard approach being used across the industry in Australia on this point and so the remainder of this paper describes the framework that we have adopted for working through these issues.

How should investment portfolios be assessed against their objectives?

An important part of the investment governance process for every institutional investor is a periodic (typically annual) review of the investment strategy and in particular the strategic asset allocation (SAA) for the investment funds offered to members/stakeholders. A key part of this review is the suitability of the SAA given the fund’s stated investment objectives.

If the objectives are not being achieved with a sufficient degree of confidence, then this will generally trigger a decision to either make changes to the SAA or to the objectives. It is therefore important that the process for assessing investment portfolios against their objectives is fit for purpose and leads to decision making that is accretive to, rather than potentially detracting from, the investor’s final outcomes.

In Australia, almost every institutional fund has both a return objective and a risk objective. Our observation is that, in practice, performance relative to, and the likelihood of

achieving, the return objective generally gets far greater prominence and scrutiny than the risk objective. As a result, in many instances, the return objective is effectively also used as a proxy or descriptor for the level of risk inherent in the fund. For example, superannuation investment options are usually described with a label (Stable, Balanced, etc.) and each has a clearly identified return objective (CPI + 2%, CPI + 3%, etc.) The risk objective is often not emphasised as much and so the return objective is effectively also being used as a proxy for the level of risk inherent in the fund.

While it could be argued that this is a totally acceptable situation, as risk and return are two sides of the same coin, in practice it is not so straight forward – there are problems with using the return objective as a proxy for risk.

The main issue is that the risk of a portfolio (measured by a statistic such as the standard deviation of returns) tends to be much more stable than the return. This is illustrated in the chart below which shows the rolling 10 year realised risk and return metrics for an indicative 70/30 equity/bond portfolio.

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Figure 1: Rolling 10 year risk and return for a 70/30 equity/bond portfolio

Source: Thomson, Willis Towers Watson

In Willis Towers Watson’s parlance, this implies that asset owners should assess their SAAs against their risk and return objectives using our longer term “normative” or equilibrium assumptions, based on our Yield Reversion model calibration. These statistics would be fairly stable over time (assuming the fund’s underlying asset allocation remains unchanged) and would not change in line with changes in the short to medium term outlook for markets. Because most asset owners have reduced their return objectives in the past year or two, it is likely that modelling results using these normative assumptions will show that the reduced return objective is likely to be achieved with a sufficient degree of confidence.

Reflecting the medium term outlook

This is not to suggest that the medium term outlook should not influence portfolio construction decisions – portfolios can and should reflect the environment that is most likely to be experienced over the medium term (i.e. the next five to 10 years). At the same time it is also necessary to consider the likelihood of achieving (the longer term) risk and return objectives over this medium term timeframe in order to manage the expectations of the underlying investors and other stakeholders.

In Willis Towers Watson’s parlance, this means portfolio construction decisions should be influenced by examining the risk and return outcomes under our Lower for Longer assumption set over the next 10 years. Modelling results, even over the next 10 years, will change over time, as markets move and as the medium term outlook for asset class returns adjusts to reflect this. This in turn means that the expected medium term return for portfolios will also be more variable than the (longer term) return objective, but we would point out that this is consistent with the variability in realised (ex-post) returns observed in practice.

The greater stability of risk makes it easier to forecast or predict than return, in our view, even when relatively long time periods are used. As a result, if the return objective is intended to be used as a proxy for the risk profile of the fund, it makes more sense to base the estimate of the return on longer term, or normative assumptions, as even best estimates of return over the medium term are subject to a high degree of forecast error.

Another reason why a further reduction in the return objective may not be helpful is that while asset owners typically specify their investment objectives over the medium to long term (for example, a 10 year time horizon), most funds have an intended life time that is significantly longer than 10 years. Therefore, investors in the fund will potentially experience many distinct 10 year periods throughout the timeframe over which the current asset allocation will (in broad terms) apply; unless a fairly dynamic approach to asset allocation is undertaken1.

It can be argued that the next 10 years should not have any greater or lesser significance than any other 10 year period, from the point of view of assessing the suitability of a fund’s investment strategy and/or risk and return objectives. This argument is strengthened if it is accepted that returns are very difficult to forecast, even over a 10 year timeframe.

If investment objectives are kept stable over time then there will be some periods when the objectives are less achievable and others where they are more achievable, but what matters is that on average across different market regimes, the chosen risk and return trade-off is sensible and the return target/risk profile is broadly “correct”, in the sense that it is broadly true to label and therefore aligned to the risk preferences and return targets intended by the end investor when they chose that particular fund/investment option.

Therefore, if the return objective continues to be the key point of focus for the monitoring and review of the investment strategy and is therefore effectively also used as a proxy for the risk profile of a fund, then we suggest that SAAs be assessed against these objectives using forward-looking assumptions that reflect longer term or “normative” expectations.

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1 Given that many asset owners (and certainly most superannuation funds) offer a range of investment options that broadly cover the risk-return spectrum, it is our observation that changes in the SAA and risk profile tend to be quite small over time.

What is an asset owner to do?

So what does an asset owner do now if the medium term modelling results suggests that the (longer term) return objective is unlikely to be achieved? This depends on whether the return objective is indeed being used as an indicator or proxy for risk, or if it is intended to be a realistic or achievable target over the medium term. Unfortunately, we do not believe that there is a standard approach currently being adopted across the industry in Australia on this point – whilst some asset owners have reduced their funds’ return objectives, others have not or they have not reduced their objectives by as much as others. The lack of a standard approach on this issue presents challenges for asset owners.

Our position is as follows:

�� At present, there is a sharp divide between modelling results based on our best estimates of asset class returns over the next 10 years and results based on longer term, normative assumptions. As a result, there is a tension between setting objectives that are more stable and those that are realistically achievable in the medium term. Inevitably therefore, a balancing act is required to determine how much weight to place on the two different sets of modelling results.

�� Where funds are effectively using their return targets as a label or proxy for the riskiness of their fund, it is appropriate to use longer term or “normative” assumptions to assess SAAs against the stated return (and risk) objectives.

�� However, if the return objective is intended to be a realistic target that is achievable over the medium term (say the next 10 years), then it should be assessed using results that are more reflective of current market conditions and the asset class returns over this timeframe – this involves using our Lower for Longer model calibration and may well result in a reduction in the return objective being recommended.

�� Whichever of these two approaches is adopted, it is important that the basis for determining the risk and return objectives is clearly communicated to all the stakeholders involved with the fund.

�� Irrespective of the assumptions used to determine the fund’s objectives, portfolio construction decisions (i.e. how the risk budget should be allocated across different investment strategies) should be based on modelling that reflects best estimates of risk and return over the medium term. This currently involves using our Lower for Longer model calibration.

�� While we do think it is very important that the lower return environment is acknowledged and communicated to stakeholders, many of our clients have already reduced their return objectives (generally by 50 to 100 basis points) and we do not see much merit in further reductions in these (unless as described above, there is a belief held that the return objective does need to be a realistic return target achievable over the medium term).

�� Given our view that, at the current time, risks are skewed to the downside, we would not encourage taking on greater risk in a portfolio in order to increase the likelihood of meeting the existing return objective. Instead, we would suggest leaving the existing return objectives as they are, as long as the likelihood of achieving them on long-term modelling results is reasonable (i.e. in the 60-70% range).

Summary

It is our view that the initial reduction in return objectives made by asset owners over the past few years was entirely appropriate, in that it highlighted the single most important issue facing investors – i.e. lower expected returns for a prolonged period of time. However, it is less clear to us that further reductions in return objectives are now needed, and we are more in favour of asset owners keeping their current (reduced) return objectives unchanged. At the same time, it is also important to acknowledge that the likelihood of achieving these objectives over the medium term may well be lower than is ideal.

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Copyright © 2017 Willis Towers Watson. All rights reserved.WTW-AP-17-WEB-7986 July 2017

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About Willis Towers WatsonWillis Towers Watson (NASDAQ: WLTW) is a leading global advisory, broking and solutions company that helps clients around the world turn risk into a path for growth. With roots dating to 1828, Willis Towers Watson has 40,000 employees serving more than 140 countries. We design and deliver solutions that manage risk, optimise benefits, cultivate talent, and expand the power of capital to protect and strengthen institutions and individuals. Our unique perspective allows us to see the critical intersections between talent, assets and ideas – the dynamic formula that drives business performance. Together, we unlock potential. Learn more at willistowerswatson.com

The information in this publication is general information only and doesnot take into account your particular objectives, financial circumstancesor needs. It is not personal advice. You should consider obtainingprofessional advice about your particular circumstances beforemaking any financial or investment decisions based on the informationcontained in this document.

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Further information

Please contact your Willis Towers Watson consultant: Melbourne 03 9655 5222 Sydney 02 9253 3333