An independent professional's take on the latest news and trends in global financial markets

Future Investment Returns In Perspective

Whatever your view on the next movement in security prices, which has been the subject of recent posts, it is important not to lose sight of the bigger picture. Bill Gross,  founder and head honcho at Pimco, the world’s largest bond fund manager, sees  nothing but mediocre  investment returns in the years ahead, a state of affairs which for some time he has been characterising as  the “new normal”.

He starts his latest monthly commentary by commenting on two recent items of news from the hedge fund world: (1) the decision by Ken Griffin’s Citadel Group, one of the giants of the hedge fund business,  to consider cutting fees on its  funds and (2) the decision by the  57-year-old hedge fund manager Stan Druckenmiller to pack in his investment career and retire to the golf course after a career that included many years working for George Soros as his right hand man.

His departure and Mr. Griffin’s price cutting are more than personal anecdotes. They are reflective of a broader trend in the capital markets, one which saw the availability of cheap financing drive asset prices to unsustainable heights during the dotcom and housing bubble of the past decade, and then suffered the slings and arrows of a liquidity crisis in 2008 to date. Similarly, liquidity at a discount drove lots of other successful business models over the past 25 years: housing, commercial real estate, investment banking, goodness – dare I say, investment management – but for them, its destination is more likely to be a semi-permanent rest stop than a freeway.

The New Normal has a new set of rules. What once pimped asset prices and favoured the production of paper, as opposed to thing, is now in retrograde. Leverage and deregulation are fading from the horizon and their polar opposites are in the ascendant. Some characterise it in biblical terms – seven fat years to be followed by seven year of lean. Others like Michael Moore and Oliver Stone describe it in terms of social justice – greed no longer is good. And the hedgies – well, after all, is the use of competing if you can’t play by the old rules?

Whoever’s slant or side you choose to take in this transition from the old to the new normal, the unmistakable fact is that future investments returns will be far lower than historical averages. If a levered Druckenmiller, Soros, or Griffin could deliver double-digit return in the past, then a less levered hedge fund community with a lower yielding menu will likely resign themselves to a high single-digit future. If a “stock for the long run” Jeremy Siegel grew used to historically “validated” 9 to 10% returns from stocks prior to writing his bestseller in the late 1990s, then the experience of the last decade should at least temper his confident that the “market” will deliver any sort of magical high single-digit return over the long-term future. And, if bond investors believe that the resplendent and abundant capital gains of the past 25 years will be duplicated from yield levels of 2 to 3% – well, they just haven’t been Japan, have they?

There are plenty of investors, Gross goes on, who have failed to adapt to this new world of lower investment returns. The New York Times recently pointed out that many pension funds are still reliant on an “illusion of savings” – the assumption that asset returns on their investment portfolios will average 8% over the long-term.  No matter that returns for the past 10 years have averaged 3%, and that with bond yields where they are today a typical 60/40 allocation of stocks and bonds now requires nearly a 12% return from stocks in order to reach the 8% overall target.

Investors will likely not know whether the house has grabbed for the cheese for several years forward. In the meantime, they are faced with 2.5% yielding bonds and stocks starting straight into new normal real growth rates of 2% or less. There is no 8% there for pension funds. There are no stocks for the long run at 12% returns. And the most likely consequence of stimulative government policies that strain to get us there will be a declining dollar and a lower standard of living. Stan Druckenmiller is leaving, and with good reason. A future of low investment returns, and a heap of trouble for those expecting more, is what lies ahead.

Just as significant, you may feel, is that Pimco, which for years has specialised in fixed interest, has recently decided to build up an equity fund division for the first time. Only time will tell whether Gross is right in his projections of lower than normal future investment returns – my suspicion is that it will be truer for the next five years than for the next decade – but his business is certainly putting its money where his mouth is.

Written by Jonathan Davis

October 4, 2010 at 4:22 PM