Episode #79: Are your expectation of Market returns too high?

• INTRODUCTION

François Doyon La Rochelle:

You’re listening to Capital Topics, episode #79!

This is a monthly podcast about passive asset management and financial and tax planning ideas for the long-term investor.

Your hosts for this podcast are James Parkyn and me François Doyon La Rochelle, both portfolio managers with PWL Capital.

In this episode, we will discuss expected returns with Raymond Kerzerho, PWL’s Senior Researcher.

Enjoy!

• ARE YOUR EXPECTATION OF MARKET RETURNS TOO HIGH:

François Doyon La Rochelle:

As I mentioned in my introduction, to help us tackle today’s topic, we have invited Raymond Kerzhéro, PWL’s Senior Researcher.

So, good morning, Ray. It’s great to have you back on the podcast.

Raymond Kerzérho:

Good morning, guys. Glad to be here.

François Doyon La Rochelle:

Ray, you have recently published an updated version of your Financial Planning Assumptions for Market Capitalization Weighted Portfolio, but before we dig into the details of the report, can you give our listeners a brief introduction to this report and what its intended use is?

Raymond Kerzérho:

Sure. The report provides projections for a bunch of variables that are critical for investors, such as long-term projections for inflation, return, and volatility of asset classes. This is the data that our financial planners use to make their retirement projections. So this is quite essential material for our firm and for our clients. And so there are important nuances here. That’s why they’re called projections. They’re not predictions. Recognize that we have a substantial margin of error in our numbers.

François Doyon La Rochelle:

Ray, you update your numbers twice a year, and you’ve been producing this research for over 10 years. Can you now update us on your latest expected returns estimates, and are there any material changes compared to your more recent reports?

Raymond Kerzérho:

Yeah, sure. So to start up, the numbers are very similar to what we had last January, when we released the previous version of this paper. So jumping into that, our 1st projection is that we see long-term inflation at 2.5% in nominal returns. I’m providing you and our listeners with the nominal expected returns, which are easier to visualize. We see:

• Bonds with long term returns at 3.5%.
• Canadian stocks at 7%
• The US stock market, we see it at 6.5%
• And international stocks at 7.3%.

If we combine Canadian, US, and international global stocks into the global market, we have an overall expected return for this global asset class of 7%.

And if I look at all these numbers on a real term basis, it’s going to be at 1.5% expected return for bonds, net of inflation, and 4.5% for global stocks.

James Parkyn:

Ray, can you now please explain the methodology you used to calculate these expected returns estimates? I understand from the report that you use a blend of Market-Based Expected Returns and Equilibrium Cost of Capital, but can you please elaborate on this and how these two models complement each other?

Raymond Kerzérho:

Yeah. So, neither of these two methods is perfect.

So, to start with, market-based expected returns are essentially what they say. It’s that these are returns that are not returned but based on indicators that we can observe in the market, and the equilibrium cost of capital is just a fancy way of describing historical returns.

But you can’t make money out of trading based on these market-based expected returns.

James Parkyn:

Ray, you use a hybrid approach to estimate expected returns. You combine Market-based expected returns and Equilibrium Cost of Capital. You believe this is more robust than relying solely on long-term historical performances to estimate future expected returns. Can you explain further?

Raymond Kerzérho:

Yes. So, as I mentioned before, none of these of these two methods is perfect.

So, ideally, we would use only the market-based expected returns, because we want our assumption to be adapted to the market conditions. And so, how do they work?

If asset prices go up, generally expected returns go down, and, conversely, if prices drop, expected returns go up. However, we have done some statistical tests on these market-based estimates, and we found that these estimates work really well for bonds. They’re not perfect, but they work well, and for stocks, they have some predictive value, but they don’t work nearly as well as they do for bonds. So basically, we put a heavy weight on market-based for bonds, and the balance we put into the equilibrium cost of capital, and for stocks, we do exactly the reverse. We put the light weight on the market base expected returns, and we put the balance of the heavy weight towards the equilibrium cost of capital for stocks.

François Doyon La Rochelle:

That’s interesting, Raymond, but how did you calculate the Market-Based Expected Return and Equilibrium Cost of Capital?

Raymond Kerzérho:

So, market-based expected returns are calculated with the yield to maturity for bonds and the earnings-to-price ratio for stocks. So, the earnings to price ratio kind of provides us with a sort of interest rate, if you will, for stocks, a looking forward interest rate. Right?

Note that the expected return based on market fluctuates inversely to prices, like we’ve discussed before. So if stock and bonds price increases, expected returns decrease, and vice versa.

Equilibrium cost of capital, then, is based on inflation, adjusted historical returns since 1900. Like you on the podcast, you refer regularly to the Dimson, Marsh and Staunton publications.

And these authors publish historical returns dating back 125 years.

James Parkyn:

Ray, if I may add, that’s when we do our podcast about the UBS global asset returns, a report that they publish annually, which used to be published by Credit Suisse, so most of our listeners would know it.

Raymond Kerzérho:

So, a last note about our methodology. I should add that we adjust the Equilibrium cost of capital for stocks. We don’t take the historical return, as is, we subtract an element from the expected return to take account of the fact that stocks are much more expensive nowadays than they were at the beginning of their data history. Instead of having, if you look at the return data, you will have a 5.2% for global stocks. Historically, over the last 125 years, we subtract 0.7% of that to account for what we call the multiple expansion of the global stock market.

François Doyon La Rochelle:

For more details, you can consult the report that we will make available with this podcast.

James Parkyn:

Ray, now that you have provided us with your expected returns for each asset class, can you tell us what is your expected return for the classic balanced portfolio with an allocation of 60% Stocks and 40% Bonds? Also, can you tell us what’s the breakdown of your allocation to stocks?

Raymond Kerzérho:

Yeah, absolutely. So, for our expected return on a balanced portfolio, we’ve got like 5 and 3/4 percent. Once again, that’s nominal. And our global stock portfolio allocates about 1/3rd to Canadian stocks. And the balance is 44% US and 22% international stocks.

François Doyon La Rochelle:

How did you come up with this allocation to stocks?

Raymond Kerzérho:

Yeah, the stock portfolio may mix the weights of the Dimensional Global Equity Fund, and the way they manage the fund is 1/3rd Canadian stocks, and the balance is allocated based on market cap weights. So, it’s a large allocation to our stocks. It’s like the US; the stock market represents almost 2/3rds of the global markets currently.

François Doyon La Rochelle:

Yeah, that’s the way we view things also in our portfolios, except we’ve got lower weight in Canadian stocks instead of 1/3rd it’s 20%. And the rest is global market cap weights. So about 2/3rds to U.S. and 1/3rd to international equities.

Now Ray can you explain why the expected returns on Canadian and international equities are higher than for the U.S.? Also, since these expected returns are higher, should our listeners tilt their portfolio away from the U.S. or at least reduce their exposure to U.S. equities?

Raymond Kerzérho:

Yeah. Well, I’ll take the question in reverse. It’s the U.S. Stock market that is expensive. And that’s the reason why we put a slightly lower expected return on this asset class. It’s as simple as that. So, if you look at Canadian and international stock markets, the prices are much more reasonable than they are in the US. So that’s 1.

François Doyon La Rochelle:

Ray, may I say? Well, the U.S. could have done so well in the last 10 years. The expected returns for the future make sense because they’re lower.

Raymond Kerzérho:

Exactly when prices go up, expected returns go down, but we were never sure to what extent, and we never know how long it will take to correct in some ways.

To continue answering the second part of your previous question: “Should we tilt away from our stocks?”  I mentioned earlier that you shouldn’t use expected returns to trade. This is not a good trading strategy.

If I look at our history, like I’ve been measuring expected returns for PWL for over 20 years. The U.S. market has been more expensive than international markets since then, so we would have lost a lot of returns if we underweighted the US. Stock market during that whole period. So, as I mentioned, expected returns they’re not precise. The idea is to supply data for planning assumptions and for financial planning. And the other idea is you don’t need them. To be exact, you need to be in the right ballpark to provide good financial planning to clients.

James Parkyn:

Raymond, our most recent podcast #78 addressed this issue directly. I recommend our listeners go back to that podcast to get our view on U.S Equity allocation. Now, Ray I would like you to talk about your report on expected returns for factor-tilt portfolios. Can you explain what factor tilt portfolio means and how it’s different Vs. Market based?

Raymond Kerzérho:

So, yes, a factor tilt portfolio invests in a very diverse group of stocks, but it overweighs stocks with higher expected returns.

The variables associated with higher expected returns are small capitalization and value stocks.

PWL invests partly with dimensional funds, which are managed with a factor tilt strategy. Some of our portfolio managers invest exclusively with Dimensional funds, so they require a different set of assumptions to account for the higher expected returns and different risk characteristics associated with these funds.

François Doyon La Rochelle:

How much more return can investors expect when tilting their portfolios towards value and small cap stocks? And is it a worthwhile exercise given the added volatility and tracking error an investor may experience versus the main broad market indexes?

Raymond Kerzérho:

To answer the first part of your question, for an all-stock portfolio, factors account for about 0.45% of long-term expected return; for a 60/40 portfolio, the difference is about 0.20%.

James Parkyn:

If I may interrupt, Ray, that may not sound like a lot of return differential for our listeners. But when you compound that over long periods like 20 years, it adds up as an extra return.

François Doyon La Rochelle:

Yeah. And at least it covers most of the fees out of the ETF. And the tools you use to build the portfolios.

James Parkyn:

Correct.

Raymond Kerzérho:

To continue. Whether its worthwhile adding factors depends a lot on investors’ tolerance for periods of underperformance.

The advantage of factor-based portfolios is that they not only offer a higher expected return, but they also offer an effect of diversification, because the factors don’t correlate much with the market. So, in some cases you’ll have maybe lower stock market periods, and the factors are going to work well in these periods. It’s not guaranteed, but the low correlation adds an element of stabilizing the returns over the long run.

So, in my opinion, factor-based portfolios are better diversified. However, if investors tend to feel frustrated when their portfolio underperforms the indexes, I will instead recommend a passive market-weighted ETF portfolio, and they will just do fine with that portfolio.

James Parkyn:

So, Ray, I think your point is that you need to be able to tolerate underperformance. As we’ve discussed in our podcast, growth in the US market, specifically, outperformed value massively for 15 years, ending on December 31, 2024. So, tolerating underperformance can be quite a long time and can test investors.

Ray, in your report, you provide nominal return estimates, that is, before inflation. As we discussed often in our podcasts, it is important to look at real returns, that is, returns after inflation. Can you explain to our listeners the importance of measuring returns after inflation?

Raymond Kerzérho:

Yeah, of course, it’s quite simple. First, I would like to mention that I think we’ve discussed that earlier, but we do have an inflation assumption in addition to the nominal returns. We include it in the report so that the financial planners can do their calculation, which comes up with real returns. So, our assumption is once again 2.5% about the usefulness of real returns. That’s true, financial planning is centered around wealth creation if you obtain a 7% return on your portfolio. But it’s all offset by inflation. You’re not making any progress. So, it’s real returns that matters to financial planning, not nominal returns.

François Doyon La Rochelle:

Ray, your report also looks at the expected real return of owning a residence. I think that’s a very interesting aspect of your report since most people have a lot of money tied up in their primary residence. However, I think that our listeners will be surprised and find your estimated expected real return low given the big increases in house prices of the last decade. Can you please explain your findings?

Raymond Kerzérho:

Yes, so we assume a long-term real price appreciation of 1% on personal residence. And this assumption does not account for the cost related to homeownership, such as taxes, insurance, and maintenance.

When compared to stocks over the long-term housing does not compare well. In the last 20 years the data shows that Canadian housing real returns have performed much better than our 1% assumption. But that’s the exception rather than the rule.

Economists such as a Nobel laureate Robert Shiller, have done a ton of research on housing, and they mostly conclude that real returns are low.

So, it’s fine to own your own home, but my recommendation would be that it’s really a lifestyle choice rather than an investment strategy. People are impressed because when they sell their home after several years, they often pocket multiple times their original purchase. I have a personal story here. When my dad passed away, we sold our family home for 12 times the initial price, and I calculated the return net of inflation. Their return was not very high. It was 2.5%.

James Parkyn:

Yeah, the normal human being doesn’t understand compound interest mentally. Yeah. And that’s the compounding effect that creates that.

François Doyon La Rochelle:

And that’s just probably on the price. There were maintenance taxes, and all of that. During that period as well.

Raymond Kerzérho:

Yes, my parents managed their finance very tightly, so they didn’t do any big renovations and stuff like that. When we sold, we had the original kitchen that dated back to 1958. But they’ve redone the roof 2, 3 times, they changed all the windows, you know all that good stuff costs a lot. So yeah. It seems like a good investment. But when you start doing the math, it’s not all that great. I’m sure there are exceptions, but in general, it’s not an investment that is nearly as profitable as investing in the stock market.

James Parkyn:

Ray in August last year you published a blog entitled “What Should We Expect from Expected Returns” and in that blog you compare PWL’s expected returns with those produced by other sources such as BlackRock, AQR, and Vanguard. Can you tell us how PWL’s estimates compare to those of other firms?

Raymond Kerzérho:

Sure. So maybe your listeners when they heard my numbers earlier, they have thought to themselves “Oh, man, they’re so conservative. It’s not going to happen. The real returns are going to be higher…” And so, in this comparison, I’ll just take global stocks to minimize the number of numbers I’m going to cite here. But on global stocks, for most of these firms, the returns were 0.1 to 0.2% below us. So we were above the big firms, and for bonds, we were about half a percent above the big firms.

So overall, listeners may think that we were very conservative in our expected returns, but our assumptions were, a bit more optimistic than some of the major investment firms.

François Doyon La Rochelle:

Ray, I have a final question for you here. I have recently looked at the result of a survey from Natixis Investment Management, a French multinational financial services firm, which conducts a bi-annual survey of about 7,000 individual investors with at least $100,000 in investable assets. And from this survey, it looks like investor return expectations are much higher than the expected returns produced by PWL and the ones from the other firms we discussed a minute ago. To give some context to our listeners, Natixis survey highlights that investors globally are expecting an average return of 10.7% on their investments, in the U.S., investors are expecting an even higher return of 12.6%.

Now, how can you rationalize these high return expectations and what do you see as being the biggest risks for those investors who plan their retirement based on such high expectations?

James Parkyn:

Ray. I would like to, just before you answer. Like Francois, the Natixis report states that the expected return of 10.7% is after inflation. So, if you look at our nominal return for global equities, and you add in the inflation assumption, I mean the spread is huge.

Raymond Kerzérho:

Yeah, I had the same reaction as you, James. When I read the report, I was shocked, especially by the fact that 10.7% is a real expected return. It’s high. I think that’s nonsense.

However, we must understand that for non-professionals, it’s normal that they overestimate returns because estimating expected returns is a complicated task. I’ve put many, many years into doing that for our firm. So it’s normal that people don’t necessarily have the right expectations, and particularly, I’m sure that PWL clients are way better educated about return expectations, since we do the financial planning for most of them.

So this survey highlights the value of a podcast like this. I think it’s good information to start with the right assumptions, if possible. And for listeners, your advisor’s job is really to educate you. That’s part of his job to educate you about what kind of return you can expect from your portfolio. If your advisors don’t do that, I would consider a change.

Now, the second part of your question, Francois. There are many dangers of having unrealistically high expectations. So, I’ll cite just 3:

• First, you may save less than you need to do to prepare for your retirement or any other financial objective.
• The second risk is that you may get frustrated if your portfolio does not perform as well as you expected, and you may give up your strategy.
• And a 3rd risk that I see is that you may be blinded by your expectations and take too much risk.

François Doyon La Rochelle:

James, since you are constantly in front of client and have been for over 25 years, do you have any final comments in regard to the Natixis survey and the type of returns that investors think they will be getting from their investments?

James Parkyn:

Francois, I have read this year’s Report, and I am not surprised to see Investor Expectations be way higher than the Estimates in Raymond’s Report.  Our Regular Listeners know from our Podcasts where we review on the UBS Global Investment Returns Yearbook.  The long-term returns must factor in periods of negative returns. The UBS Report looks at 125 years of Capital Market History Data.  What also surprises me is that although the Institutional money managers have lower expectations their numbers are also higher than Raymond’s.  In both cases this could be explained by Recency Bias.

What Investors need to keep in mind is that negative returns in years like 2022 are hard to make up and you must factor that in.  For example, despite multiple years with double digit performances in the last 10 years the 10-year compound returns are in single digits.

The Final comment I would add is that Investors must stick to their Investment Plan with a long-term mindset regardless of if their short-term returns disappoint them and, especially if they have unrealistic expectations.

• CONCLUSION

François Doyon La Rochelle:

Thank you, Ray for our participation today, as usual this was very interesting, and I hope our listeners have found it interesting as well.

Raymond Kerzérho:

My pleasure, François.

François Doyon La Rochelle:

I remind our listeners that Raymond’s paper on expected returns can be found on PWL Capital’s website in the learn section. Also, thank you James for your contribution again today.

James Parkyn:

You are welcome, Francois.

François Doyon La Rochelle:

That’s it for episode #79 of Capital Topics!

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