Forecast: Overcast With Low Returns

The year 2013 was a terrific one for investors. You’d do well to revisit your strategy or brace for losses.

Guy Rolnik
Guy Rolnik
Guy Rolnik
Guy Rolnik

What fun.

In a few days you should be getting your reports for 2013 from your pension fund and other fund holdings.

After your years of never-ending chatter in the press, the Knesset and on the street about haircuts and tycoons robbing your savings, you might be pleasantly surprised to learn that in 2013 your pension fund accrued real returns of 8% to 12%. How does that fit in with the unrest about haircuts, management fees, giant salaries and insider transactions?

Unless you follow the markets, you won’t understand the question. People suppose that double-digit returns are normal. Savvier market animals know they aren’t, and that the gains do not mean the capital markets don’t have the diseases we listed.

The government extracting itself from the markets and the transition of pension funds and investment savings to the free market began 30 years ago, but only reached critical mass five years ago, following the pension fund reform of 2003. And it was only when the 2008 crisis erupted in the financial markets that Israelis began to see how the state of the markets affected their short- and long-term savings.

The combination of the 2008 crisis with the haircuts, the social-justice protests in 2011 and the public’s growing awareness of economic concentration spurred people to study their pension portfolios for the first time. Yet most people have yet to realize that the factor most affecting their portfolios in recent years is this: the correlation between low interest and robust gains by pension fund investments in the past. What the future will bring is another matter.

The main reason investment portfolios have done so well in 2013, and in recent years in general, is the monetary policy instituted by central banks in the major economies, including the United States, Europe, Japan and Israel.

Out of wiggle room

A policy of keeping interest low and injecting trillions into the bond and financial markets by switching assets is unprecedented. It would have been thought science fiction until a few years ago. The only real reason for this policy is that the governments and central banks have exhausted all other policy tools. All they can do is pour money into the financial markets by buying bonds.

The main beneficiaries of the monetary easing are, of course, the bankers. For them, it is true relief: They get money practically for free from their depositors, they invest it, they lend − and keep the spread.

If you thought the financial crisis and unprecedented anger against the banks would change anything, think again. Since the crisis, the system has become even more concentrated and the subsidies it gets from the financial markets are bigger than ever before.

Steven Roach, an economist who left the banking system behind some years ago, claims that the main beneficiary of the U.S. monetary easing is the top 10%. A British central bank report estimated that about 40% of the financial market gains went to the uppermost 5% of the public. The only reason the public does not rise up against this tremendous transfer of wealth to the banks, to the financial industry and to their cronies is that the people are meanwhile ostensibly enjoying the upswing in the financial markets thanks to the low interest rates.

Naturally, not everybody wins. The poor don’t have investments and the middle class can’t and doesn’t tend to take risks.

Therefore, the main beneficiaries of the global financial upswing are the members of the ultra-high net worth crowd. The Wall Street Journal recently calculated that the fortunes of the 20 American managers with the biggest holdings in stocks increased by $80 billion in 2013. Other than Warren Buffett, who never sells shares, all the rest aren’t sitting around waiting for their pensions; they’re taking advantage of the boom to sell, to cash out, sometimes selling billions worth each year.

The low level of interest also pumped air into the real estate market, which is another effective channel to transfer wealth from the have-nots to the haves, leading many investors to increase the risk in their portfolios.

So at the moment everything’s rising, interest rates are low and the huge gains seem unremarkable. When that changes, we will gain a better perspective on what’s been happening in recent years.

Say bye-bye to double-digit gains

Naturally, prophecy is a pastime for fools when it comes to investments and market movements. The one sure thing is that when interest stays as low as it has in recent years, the ability of investment portfolios to generate double-digit gains or anything like what you gained in 2013 declines. High returns in a low-interest environment can only be achieved at extreme risk.

That doesn’t mean your portfolios are in extreme danger; but the lower interest falls, its ability to fall further diminishes, and thus the probability of capital gains on investments diminishes too. In any case, the risk in your portfolio is certainly much higher than it was three years ago.

In the last five years Israeli provident funds accrued double-digit real returns. The heavy loss, 15% to 20%, during the financial crisis of 2008 was forgotten. But at some point the trend will turn, if it isn’t happening already.

The problem is one of expectations. Most savers mistakenly believe real gains of 5% to 8% a year in 2013 (after adjusting for inflation − the figures I cited above, 8% to 12%, include inflation) are normal.

That’s why some of you still don’t care that your investment managers are taking heavy management fees of 1% to 2% of the portfolio’s value each year. If you think real returns will run at 5% to 7% a year in the future, maybe you’re prepared to pay that. But when you realize you can expect real returns of maybe 2% to 3% a year over the next decade, you may want to rethink your tolerance.

What people don’t get is that in the bond market, there is no free lunch. The capital gains and interest income in the last five years will be at the expense of the years to come.

Just look at net real returns on five-year Israeli government bonds: It’s negative. An investor buying it to hold to redemption assures himself of a net loss on the money. And much of the holdings in pension funds, provident funds and the like is in just such bonds.

Riskier investments like in long-term bonds, government or corporate, can also cause heavy losses if interest rates rise. Therefore, real returns of 5% to 8% (after inflation) in 2013 should really be seen as returns for three years. That’s how the capital market is: In one year it sprints, generating the kind of returns generally accrued over years; and in other years it can take back gains built up over years, as happened in 2008.

But if you started feeling wealthy in 2013, restrain yourself, because 2013 was an extraordinary year, not an average one. The next two years may be very lean ones, wiping out at least some of last year’s gains.

This is a good time to study the composition of your portfolio. The bottom-scraping interest given on bank deposits has been pushing you to take risks, which did well by you in recent years. But that doesn’t mean your strategy will pay off in the years to come.

Your portfolio has become riskier; the only way the small investor can defend against the volatility is to increase holdings in short-term assets, government bonds and if possible, linked to inflation. They won’t gain you any returns worth notice, and after 2013 they may look pathetic. But they look very different after a year like 2008.

Corporate bonds were responsible for much of the gains in pension funds last year. They did well, thanks to the low level of interest and the narrowing spread between government bonds and high-risk ones. Hence the danger is double. But if you choose to hunker down in government bonds, take into account that you’re locking in vanishingly small real gains in the coming years.

Or, as Warren Buffett said: “Rule No. 1: Never lose money. Rule No. 2: Never forget Rule No. 1.”

The skies may have been blue but dark clouds are growing closer.Credit: Eliahu Hershkovitz

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