Building a Portfolio for a Low-Return World

Note: This video is one of several interviews that Morningstar director of personal finance Christine Benz had with Vanguard officials at this year's Bogleheads event. See all of the interviews here.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. With not-cheap equity valuations and still-low bond yields, many market experts are suggesting that investors temper their expectations for market returns.

Joining me to discuss the potential implications for a portfolio construction is Fran Kinniry. He is a senior leader with Vanguard Investment Strategy Group where he is the global head of portfolio construction.

Fran, thank you so much for being here.

Fran Kinniry: Thanks, Christine.

Benz: Fran, let's start with market return expectations. Some people might say, well, you shouldn't even think about that. But we do actually need to be operating with some idea of what the market will return because that influences how much we save and so forth. Let's talk about that.

Kinniry: I think sometimes market forecasting gets a negative connotation, but there's really only a couple of ways you can do this. You can use history, and that would be agnostic to initial conditions. You would ignore what yields are, ignore what valuations are, and do a Monte Carlo off of that. That I would say is very problematic, especially if yields are at 3% when history shows 5%. No matter how many times you Monte Carlo that, you are going to get back to 5%.

What we do in the Vanguard Capital Markets Model is we take in the key initial conditions--on equities, they tend to be valuations, such as price to earnings valuations; on bonds, they tend to be yields--and then, we form a distribution to give people expectations of what that distribution may look like relative to history. So, to your point, it allows them to do financial planning. You can't really determine how much to save, what you may end up with, how you will allocate your assets without having some information of market outlook.

Benz: Let's talk about the current environment right now. For a while now, market watchers have been suggesting, investors temper your expectations, market returns might not be so good, yet, they've continued to be quite good. Let's talk about your and Vanguard's expectations for market returns. Is your view that investors should set expectations for lower returns going forward?

KiNniry: Yes. I think what differentiates us from what others may be forecasting is, we are really not into point estimates. We are not going to tell you that we think the market next year is going to give you 4.2%. We have a distribution of returns, and we really feel more confident in 10-year outlook, which again, is back to a financial planning horizon.

And so, clearly, there equities are elevated, and they have been, as you mentioned. That isn't a signal to do wholesale changes to your portfolio, meaning, sell all your stocks and go into bonds, because it still is a distribution. Low equity returns do not mean negative equity returns. And so, clearly, we have been in a low equity forecast. Same thing on bonds, because bonds' yields have been lower than history. So, low equities, low bond forecasts. You put that together for a balanced portfolio and balanced portfolios look low relative to history.

Benz: Can you give us a ballpark of where Vanguard would be in terms of a 10-year forecast for, say, a balanced portfolio?

Kinniry: For a balanced portfolio, depending on the asset allocation, somewhere like 4% to 6% would be the central tendency of a distribution. But we wouldn't be surprised if an investor got 8% or an investor got 2%, again, back to this distributional approach.

Benz: It seems like my time horizon should influence how much I should care about that. If I am in my 20s or 30s, probably don't have a reason to care a lot about what the next 10 years hold. But if I'm just about to embark on retirement, that matters more for me, right?

Kinniry: We have a 10-year outlook. I think the most important thing is, people have to update their outlook every year or quarter, because if we have a bear market--let's say, you get a 20% or 30% sell-off on stocks--that's going to have a negative headwind for the return. But then initial conditions of valuations become more reasonable. Your next time series is high. Same thing, if interest rates go from 3% to 4%, you may lose a little principal, but your forward returns now are 4% instead of 3%. You have to update this on a regular basis. Clearly, it matters closer to when you need the money. I wouldn't necessary, say if it's a 20-year-old versus a retiree, if I'm a 20-year-old saving for a car or a house in five years, then those returns may matter more than a 60-year-old who is retired who may not need those assets until they are 90.

Benz: Let's talk about portfolio construction in what might be a fairly low-returning next decade. Are there any things that people should think about when they are attempting to assemble a portfolio that will perform well, areas that they would underweight or overweight? How would you approach that?

Kinniry: I would say there's probably a lot more of what they shouldn't do than should do, and we are seeing a lot more of what they shouldn't do. What I mean by that is, reach for yield, reach for risk, believe in maybe high-alpha strategies such as a hedge fund or something like that. There's nothing wrong with alternatives, but I think sometimes the allure or the promise of them and the costs of them are quite high. We see a lot of investors not willing to accept low returns. They go toward, I call it, high-cost hope, higher-cost mandates and hope that they get the return.

Some things that they can do is really make sure that they have their asset allocation right in advance, make sure that they have really low-cost funds, broadly diversified; if you are in a taxable portfolio, highly tax-efficient. Those would be the things you can do.

Benz: One thing you alluded to, Fran, was the fact that starting yields tend to be a good predictor of what bonds will return over the next decade. Does the fact that yields have been picking up, does that make the picture a little more sanguine when you think about fixed income over the next decade?

Kinniry: We've always hoped that we would have a gradual rise in interest rates. At Vanguard, we've actually been one of the few who have said, as far back as 10 years ago, we didn't think hyperinflation was going to come out of the global financial crisis. You remember back to all the printing of money and QE, people thought inflation was going to run away. We were pretty early and alone in saying we thought interest rates were going to stay low. And now, recently, if they are going to rise, rise at a very gradual pace. That actually will help investors. A little bit of principal loss, I think if you look at bond returns this year, down 0.5% to 1.5%, but the forward returns, instead of it being 2% are now 3%, 3.25%. And so, if we have that general rise, and you have the long enough holding period, rising interest rates can somewhat be helpful in a nominal world; maybe not in inflation-adjusted world, but in a nominal world.

Benz: Well, that was my follow-up question, because a countervailing force is that we have seen inflation begin to tick up a little bit. Does that concern you with respect to cash and fixed-income investments?

Kinniry: It concerns us just a little bit, not a lot, because what we actually had a for a long time is negative yields. Meaning that the yields were so low that they are running below inflation. A conservative, a low-risk portfolio was actually giving up to inflation. What we have seen is interest rates have risen a little bit faster than inflation and that's good because you are actually returning to normal. This normalization of the interest-rate environment is quite helpful for investors.

Benz: Fran, always great to get your insights. Thank you so much for being here.

Kinniry: Thank you, Christine. I appreciate it.enz: Thanks for watching. I'm Christine Benz for Morningstar.com.