Target rate of return and return expectations
In my last article, I discussed some of the key differences in how institutional investors tend to manage their assets relative to how retail investors manage theirs. This article addresses the target rate of return approach that institutional investors employ and how that target rate of return has been adjusted over the past number of years.
Most institutional investors (pension funds, endowments, and foundations are examples of institutional investors) have a target rate of return that they expect to achieve for their stakeholders over a stated period of time. The asset mix they employ to achieve that return is set accordingly; that is, their asset mix is set using the efficient frontier, so they take on the least amount of risk to achieve that given return objective. Retail investors should do the same. As part of their process, retail investors should determine their investment goals and the return objectives required to meet those goals. The asset mix that gives retail investors the most efficient means to achieve those goals should then be implemented so that they take on the least amount of risk to achieve a given expected return.
Expected rates of returns have declined over the past number of years. In fact, the average expected return of defined benefit pension plans of the S&P 500 Index companies has moved from 9.2% in 1999 to 6.6% in 2017. This reduction is a result of lower yields on fixed income and lower return expectations on equities.
Retail investors should have a clearly defined target rate of return for their wealth, and the asset mix they employ should be aligned with that target. Rebalancing back to the asset mix on a regular basis will give investors a built-in discipline of selling high and buying low, in that rebalancing back to a target asset mix means that investors will be trimming the weight of assets that have performed well relative to their other assets while adding to those assets classes that underperformed relative to others. Too often, retail investors get caught up in chasing returns; using a target rate of return will provide a discipline to their approach.
Institutional investors have a stated target rate of return set out within their investment policy statement. The asset mix is set according to the efficient frontier such that they take on the least amount of risk for that given level of expected return. The returns investors expect to achieve must be set in a reasonable manner and be consistent with those achieved over long periods of time. Institutions have reduced their return expectations over the past number of years; retail investors should have an investment policy statement that outlines the expected rates of return and the asset mix they intend to use to achieve those objectives.
Important disclosures
This commentary is provided for informational purposes only and is not an endorsement of any security or sector. The opinions expressed are those of Manulife Private Wealth as of the date of writing and are subject to change. The information in this document, including statements concerning financial market trends, are based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. This material does not constitute an offer or an invitation by or on behalf of Manulife Private Wealth to any person to buy or sell any security. The information and/or analysis contained in this material have been compiled or arrived at from sources believed to be reliable, but Manulife Investment Management does not make any representation as to their accuracy, correctness, usefulness, or completeness, and does not accept liability for any loss arising from the use of or the information and/or analysis contained here. Neither Manulife Private Wealth or its affiliates, nor any of their directors, officers, or employees, shall assume any liability or responsibility for any direct or indirect loss or damage or any other consequence of any person acting or not acting in reliance on the information contained here. Please note that this material must not be wholly or partially reproduced. Past performance does not ensure future results.
