Institutional investors should expect lower returns from bonds and equities and consider alternatives, warns report

By Daniel Lanyon on Tuesday 27 September 2016

Alternative Lending

Hermes Asset Management’s Saker Nusseibeh and Eoin Murray warn that markets are set for a tough longer term period thanks to a low growth world.

Large institutional investors such as pensions funds, insurance companies and sovereign wealth funds face an era of low returns caused by low long term interests rates, according to a new report from Hermes Asset Management.

Markets seem to agree that interest rates will be lower for longer in the past few weeks with increasing expectations that central banks, led by the Federal Reserve, are ever more reluctant to raise interest rates from their historic long term lows amid a panoply of risks to economic growth.

This is due to the extraordinary monetary policy measures during the financial crisis of 2008 have created severe distortions in capital markets with long-term implications for banks, insurers and pension funds, Hermes' chief executive officer Saker Nusseibeh and head of investments Eoin Murray conclude in their latest white paper 'Breaking with (un)convention: asset allocation for a future of lower market returns'.

“We now find ourselves at the beginning of an era of low natural interest rates, and investors should carefully consider their strategic asset allocations in response. The importance of getting these decisions right and the value of good active management have never been more important. An environment of lower rates will lead to lower returns from all assets in the future,” they said.

“The relationships between different asset classes, particularly equities and bonds, will likely change too. Therefore, meaningful return requirements will necessitate ambitious allocation decisions from institutional investors, and the importance of being able to deliver alpha consistently will grow too."

They say the coming decade will be one of the most difficult that pension funds have ever faced and that beneficiaries will depend on asset allocators and investment managers to make the right calls.

“In an unconventional world, with a lower natural rate suppressing expected returns from all asset classes, we believe that long-term investors need to make a radical response: go for growth. This means rejecting or at least substantially reducing exposures too low- or negative-yielding bonds in favour of listed and unlisted assets with strong prospects of generating positive real returns.”

They say investors’ method should be driven by the same resolution: "growth is the way forward.” They add illiquidity premia form unlisted assets such as private debt and other forms of alternative credit as well as infrastructure and private equity.

Why are long term interest rates important?

Nusseibeh and Murray say this stems from shifts in the long-term, natural rate of interest. This in turn can have a significant effect for any institutional investor that has a required rate of long-term return, such as an endowment or a pension fund, as they argue this is one of the principal underlying drivers of returns.

"It is essential in determining risk-free rate of return which is central to our understanding of how to price risky assets – their long-term fair value is derived from the real rate plus a premium above the risk-free rate.”

“Therefore a higher natural interest rate leads to greater return expectations for all asset classes. Hence the current low natural rate is expected to adversely impact pension schemes that need a required rate of return over the longer term to meet their liability commitments.”

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