Lately, there's been no shortage of commentators telling investors and advisors to expect stock market returns to be lower in the near future than they were during the long-running bull market of the 1980s and 1990s. Those raising the yellow flag include such notables as Stocks for the Long Run author Jeremy Siegel and Vanguard founder Jack Bogle.
More recently, a special symposium sponsored by the TIAA-CREF Institute and the Association for Investment Management and Research concluded that the future equity-risk premium (the amount that stocks return in excess of cash) will be in the range of 0% to 4%. That would be significantly lower than the historical premium of about 6% or 7%.
Let's assume that these forecasts are correct. What does that mean for advisors? After all, knowing that future stock returns most likely will be less generous is one thing; knowing how to apply that to portfolio construction is something else altogether. Nothing indicates that stocks will be less volatile in the future. Lower returns without lower volatility isn't a prescription for happier clients.
Harold Evensky, CFP, and principal of Evensky, Brown & Katz in Coral Gables, Fla., is at the forefront of thinking through what a lower equity premium might mean, not only for portfolio construction, but also for advisors' business plans.
More Stocks Or Annuities
Evensky and his partners have come up with their own estimates for future investment returns. "Our conclusion," he says, "is that returns in equities will be less, and returns in bonds will be slightly more."
Forecasted bond returns are high enough that "there's no longer that default historical comfort level that if you put more money in stocks you'll have more money 10 or 15 years down the road." But Evensky and company don't think bond returns will be at the level to justify a wholesale move away from stocks. In fact, clients may need to do the exact opposite.
"If a client requires a certain return," Evensky says, "then the client needs more stocks. To get the same return that you could've gotten in the past 50 years with a 50-50 stock/bond portfolio, now you'll need 90% in stocks."
A higher equity allocation combined with less confidence that a stock-heavy portfolio will outperform is a frightening proposition for most clients. Perhaps that's why Evensky and his partners aren't making wholesale changes in their asset allocation but rather are counseling clients to "revisit their expectations."
Not all clients have that luxury, though. While someone saving for retirement can plan on working a few years longer if the stock market becomes less generous, a client already in retirement may need every penny from a portfolio. That conundrum has Evensky considering what for him would be a nontraditional investment-a variable or fixed annuity.
"If returns are less and client needs remain the same, the only way to get extra returns is from a payout annuity," Evensky says.
Those extra returns only accrue to long-lived annuitants who, in effect, benefit from the early deaths of the other annuitants. A client who lived to be 85 or 90 might well get more income from an annuity than he or she would receive from a private portfolio, but a client who died at the age of 60 would get less. The best way to hedge this longevity risk is to annuitize only part of the portfolio rather than all of it.
Avoiding Multiple Managers
It's a truism that the more modest the return on an investment, the greater the impact of costs. A 1% fee takes 5% out of a 20% gross return, but a much larger chunk (17%) out of a 6% gross return. It stands to reason, then, that if advisors expect less-generous returns, they should be trying to lower their clients' costs. One obvious way to do so is by picking cheaper funds.
A less-obvious tactic is to move away from a multimanager strategy for taxable accounts. It's probably fair to say that most advisors employ a multimanager strategy, picking one fund to take care of the large-growth portion of the portfolio, another for large value, and so forth. But such an approach almost guarantees yearly taxable gains because of the need to rebalance.
For taxable portfolios, Evensky now advocates what he calls a core and satellite approach. The core would consist of roughly a 70% position in a tax-managed S&P 500 or total-market index fund or a comparable exchange-traded fund. The balance would go to managers who seem to have a good chance at hot shot returns, independent of the stock market. Hedge funds, convertibles, junk bonds-all would be candidates.
"I'm looking for a manager to add positive after-tax alpha and perform independently of the market," says Evensky. "I'm also looking for investments that are poorly correlated with each other and poorly correlated with the core."
Ideally, such a strategy will lower clients' overall costs-both from management fees and rebalancing-while also preserving the potential for above-average gains. And even if the satellite position underperforms, the large index-fund position should ensure that the overall portfolio doesn't deviate too far from the market.
Coming Home To Advisors
It's clear that lower stock market returns will affect clients' portfolios, but Evensky argues they also could impact the way most advisors run their businesses. It's fair to say that over the past few years, the fee-based or fee-only models have become the dominant ones within the advisor community, with the fees based upon a percentage of the assets under management. But a lower-return environment might put that model in jeopardy. "If it's harder to add value on portfolio management," says Evensky, "then it's harder to charge a fee for that service."
Besides potential client resistance to paying an asset-management fee, there's the hard fact that it's a happier proposition if a percentage of assets under management is paid when the market rises, rather than when it falls or remains roughly even. Many advisors have been grappling with sometimes sharply lower revenues over the past two years.
To get around this problem, Evensky and his partners already have moved away from being compensated in basis points to being paid an annual retainer, based upon the nature of services they do for a client and subject to a $10,000 floor. While such a model might work best for affluent clients, advisors successfully have implemented other compensation programs that don't link the money the advisor receives to the size of the client's portfolio. Examples include charging an hourly rate like an attorney, charging a flat fee for performing a particular task or charging a fee based upon a percentage of the client's overall net worth.
Evensky is still in the process of working through his ideas, and he says he welcomes other advisors' thoughts. If actual stock market returns live down to forecasts, more advisors might take him up on that offer.
Olivia Barbee is editor of MorningstarAdvisor.com.