Real yields on bonds have fallen, and
the prospects for capital gains are slim.
It is now clear, beyond the need even to present statistics, that investors, both institutional and individual, public and private, are turning increasingly to what are popularly called "alternatives"-hedge funds, other expressions of portable alpha, real estate, private equity, venture capital, managed futures and even more exotic investment options.
Most explain this phenomenon by pointing to the equity market crash between 2000 and 2002 and the widespread disenchantment it created about conventional investment vehicles. Doubtless those stock losses are a major factor, especially since the disappointment on equities developed a cottage industry in research to show that future equity returns could very well fall short of even the conservative longer-term average equity returns of the past.
Less commented on but probably more significant is the situation in fixed-income markets, especially the supposedly lower-risk Treasuries, agencies and high-grade corporates. After years in which investors were able to get adequate, even attractive real returns with effectively no credit risk, these areas of fixed-income markets now offer little yield or potential return, insufficient for institutional investors to meet their actuarial assumptions or for retail investors to meet their retirement goals. This change, more fundamental than anything that has happened in equities, explains a good part of the recent move toward alternatives and higher risk generally. It speaks to which investment disciplines will gain assets in the future and which will not.
Real Yields Shrink
Chart 1 tells a good part of the disappointing fixed-income story. It shows the level of real short interest rates and real longer-term yields going back for more than half a century. (The figures are calculated by subtracting the annualized rate of change in the consumer price index during that month from the prevailing interest rate each month.) Whether the calculation uses three-month Treasury bills or ten-year Treasury notes, the story is the same (and it is the same if the calculation uses agencies or high-grade corporate bonds). Between 1951 and 1979, real yields from fixed-income investments remained relatively low, below 2% on bills and between 2% and 4% on the notes. These real returns shot up in the early 1980s, and though they came down gradually over the following 20 years, they remained high by previous standards into the late 1990s. More recently, those real rates have actually averaged a little lower than in the early years.
It should be clear from the attached charts how
tempting it was after 1980 to rely on high real rates and yields to
deliver investment income and performance. Compounding this temptation,
falling yields created a bonus of impressive capital gains in these
seemingly risk-free investments. The returns were clearly unusual in
light of the longer history, but still, investors, institutional and
individual, grew accustomed to these safe, easy returns, and set their
investment policies as if they could go on indefinitely. Based on such
returns, people made promises, implicit and explicit, about what kind
of retirement benefit a given asset base can provide-pensions to their
beneficiaries, financial advisors to their clients and individual
private investors to themselves.
But efficient markets do not let risk-free assets pay high returns indefinitely. Now that game is over. Real yields have come back down, and the probabilities of capital gains are slim. Indeed, capital losses seem more likely. Investors, waking up to the change, have returned to an older, established market maxim: To get high returns, the investor must accept risk. It is hardly a surprise that investors had to return to this investment basic. The real surprise is how long the fixed-income "gravy train" lasted.
Surprised or not, it is now clear to individual and institutional investors alike that they must adjust to the new circumstance. Even those who vainly expect yields to return to the highs of the 1980s and 1990s know that they cannot go on as before, since such a rise in yields would necessarily involve capital losses on existing fixed-income holdings. With only disappointing or at best inadequate options available in these high-grade, fixed-income instruments, investor needs for returns have brought them naturally to a greater willingness to take on risk. It is the only way to make up for that lost yield. The drift toward junk, convertibles, foreign investing and alternatives is a natural outgrowth. Equities would probably have gained, too, had they not disappointed so between 2000 and 2002 and even some in more recent years.
Fewer Opportunities To Add Value
But there is an added consideration in high-grade, fixed-income investing that is also accelerating this trend. As Chart 2 shows, volatility in fixed-income markets has declined with the drop in real yields. The chart shows the standard deviation of the ten-year Treasury yield for rolling five-year periods since the mid-1950s. At first, it would seem that this drop in volatility would lure investors to the asset class. After all, lower volatility makes for more predictable returns. But volatility is also essential for active managers to find opportunities to add value, that is, provide alpha in a portfolio. Without it, there is little they can do with active management. The high volatility of the late 1970s and through most of the 1980s provided just such opportunities. On top of high real yields and the capital gains that accompanied the ongoing yield declines, active managers could use this volatility to enhance returns still further. They could trade along the yield curve, for example, or find the many anomalies between on-the-run and off-the-run Treasuries that developed in that environment. Those days could be described as a golden era for active bond management.
Now this potential, too, is gone. Volatility has not quite reverted back to levels of the 1950s and 1960s, but it has dropped precipitously. There is no reason to expect a reversion entirely to that earlier time, when active bond management scarcely even existed. Still, the decline in volatility has stolen much of the opportunity to add value. Along with the loss of real current yield, this lost opportunity for active management has also forced investors, at least those investors interested in robust returns, to move toward riskier investments. There are, after all, still many opportunities for bond managers to add value in more credit-sensitive areas of fixed-income markets, junk, convertibles, municipals and foreign debt. But this loss of opportunity in the Treasury, agency and high-grade corporate area also has encouraged the move toward even more exotic alternatives, which now attract funds that once sat comfortably in the relative safety of Treasuries and similar instruments.
A Look Forward
With little reason to expect a major change in such circumstances, it seems likely that investors of all stripes will continue to seek riskier bonds and alternatives just to equal the returns that were once easily procured in safer Treasuries and high-grade paper. In many ways, the trend is neither surprising nor distressing. It is, in fact, gratifying to see investment thinking return to the well-established historical relationship between risk and return. It was the anomalies of the 1980s and 1990s that distorted matters, not today's reality. But fundamentally healthy as much of this change is, there is one aspect of it that does give pause: Investors might not realize all the risks they are taking to get returns in many of today's less conventional alternatives-private equity, venture capital, real estate and hedge funds, especially this last category.
It seems pretty clear with real estate, venture capital and private equity that part of the trade-off for return is in the loss of liquidity. These instruments tie up funds, sometimes for extended periods, and do not have the developed secondary market available in conventional stocks and bonds. In a rational world, they should have to promise greater returns to attract funds. The balancing of return and liquidity is, of course, an old business concept, even if it is often neglected in the investment literature. Neither is this liquidity consideration difficult to quantify as part of a general assessment of portfolio risk. It is a reasonable trade-off if the investor has no need for liquidity, which is often the case, especially with younger pension funds and individuals.
There are, however, additional risks in real estate, venture capital and private equity that are much harder to quantify. Without a daily price quote, it is difficult to know their volatility or the probability of default. Worse, the absence of frequent valuation checks can tempt the investor-even the institutional investor-into a complaisant belief that such holdings are more stable than other, more conventional investments, when in fact it is simply harder to measure their volatility. It is, of course, up to consultants to rectify this problem for institutional investors and for financial advisors to do so for individual investors. Many are working diligently on the problem. But in the meantime, there is a risk that investors will assume considerable unknown risk when they substitute such alternatives for the lost risk-free return of earlier years.
Hedge funds present these problems in spades. Of course, it is ridiculous to speak of hedge funds as though they were an asset class. The only thing they have in common with each other is their compensation scheme. Otherwise, their investment approaches could not be more different one from the other. Some hedge funds fit nicely into portable alpha schemes and some do not. Some hedge funds simply build leverage on huge positions in risky investments. Especially because hedge funds do not have the same rules of disclosure as other sorts of managers, investors must press hard to know exactly where the investment risk lies, press harder than many investors, consultants and financial advisors do these days. Indeed, the enthusiasm for hedge funds has given added reason for fear, as it seems to have convinced many to exercise less due diligence than they would normally when, if anything, the novelty of some approaches, the use of leverage and the lack of reporting requirements demands more diligence.
No doubt against such a background, many who have turned to alternatives-institutional and individual investors alike-will suffer disappointments and outright losses. A disenchantment will follow that will likely drive investors back toward more conventional asset classes and techniques. If equities can improve on their rather uneven record to date, they might hold some of those assets. Much money will also stay, as it already has, in the more credit-sensitive areas of fixed-income markets, junk, convertibles, municipals and international. But if the quality parts of fixed-income markets continue to offer low real yields and low volatility, as is likely, some of those monies will inevitably flow back to that amorphous class referred to as alternatives. At that time, perhaps-hopefully-investors and their advisors will have a more complete, sober picture of the characteristics, potentials, and risks of these investments than they seem to have today.
Milton Ezrati is the senior economic strategist and a partner at Lord Abbett and an affiliate of the Center on Economic Growth at SUNY, Buffalo. This article is based on a talk delivered to the Fifth Annual Public Pension Funds Summit at the Hyatt Lake Las Vegas earlier this spring.