How to achieve 5% returns in today's world

What was once as easy as abc has become quite challenging.

8 December 2016 | Investment

Ten years ago, generating returns above 5% was relatively simple. Today, with interest rates close to record lows, it is much more difficult, but still achievable.

Interest rates available on cash have been pushed to record lows, as central banks have attempted to revive weak economies. Investors have sought returns elsewhere, but the prices of investment grade bonds, high yield bonds, and equities have now all been pushed up. The search for yield could take on new impetus in 2017, with inflation rising even more quickly than interest rates.

We can’t reasonably expect more return without more risk. And aiming for any set return level if one cannot realistically cope with the associated risk is always a bad strategy.

But assuming risk tolerance is suitably high, we see three ways investors can consider to boost returns in 2017:

1. Investing in riskier assets

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Financial theory tells us that investors can’t expect more return without more risk. But equally, more risk is no guarantee of more return. Investors therefore need to be selective:

As we enter 2017, some of our preferred areas are:

US and emerging market equities. We believe that global equity markets are set to deliver positive returns in 2017, and prefer US and emerging market equities. Accelerating economic growth, improving earnings, and only gradual increases in interest rates should support appreciation in both markets.

US senior loans offer an attractive alternative to more “traditional," lower- yielding, fixed income investments. We expect the asset class to benefit from resilient US economic data and the global hunt for yield amid still low real interest rates. Senior loans are also “floating rate,” meaning that, unlike most fixed income assets, they will likely benefit as US interest rates rise. At the time of writing they offer a running yield of 5.9%.

Select emerging market currencies. After years of underperformance, emerging markets finally began to revive in 2016. Although Donald Trump’s electoral victory has added a layer of uncertainty, we believe some emerging market currencies look attractive for investors looking to boost returns. We have a positive view on a basket of EM currencies – including the Brazilian real, the Indian rupee, the Russian ruble, and the South African rand, equally weighted – versus a basket of equally weighted developed market (DM) currencies – the Australian dollar, Canadian dollar, and Swedish krona.

How to succeed: try hard enough. How to fail: try too hard.

Malcolm Forbes

2. Adding leverage

Investors could also consider leveraging a well-diversified portfolio to improve returns. Current market interest rates are low by historical standards, providing a conducive environment for leveraged strategies. For investors with a high risk tolerance, it may, in some cases, be more attractive to leverage a medium-risk portfolio than to invest directly in a high-risk portfolio.

That said, with interest rates expected to rise in the US in the coming years, investors will need to carefully consider their investment time horizon. With prospective returns also low by historical standards, small changes in borrowing costs can have a significant effect on risk-return ratios.

3. Seeking alternative risk premiums

Available returns from a traditional “buy-and- hold” strategy in stock and bond markets are lower than before. So we consider it important for investors to now look at a wider range of investment options.

This could include investment in alternatives, such as hedge funds and private markets. We currently forecast 7.2% annual returns over the next 10 years for a balanced portfolio with a 40% allocation to hedge funds and private markets. New approaches to portfolio construction could also help deliver risk-adjusted returns superior to more traditional methods. A diversified portfolio of partially illiquid global credit assets is expected to achieve 4.9%.

In short

We expect the US Federal Reserve to raise interest rates and the European Central Bank to taper quantitative easing in 2017. But policy will remain accommodative as the focus stays on stimulating economic growth and employment. Against this backdrop we overweight US equities, US senior loans, and Treasury Inflation Protected Securities.

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