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How to cope in a world of lower returns

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Investors — with the possible exception of the very wealthy —will have to get used to a world with lower returns, according to a distinguished Wharton School professor.

For advisors, that means being “that much more careful” when advising on asset management, says Dr. Richard Marston, professor of finance at the University of Pennsylvania and faculty director of Wharton’s private wealth management program.

But wealth managers with ultrahigh-net-worth clients need to do something in addition, Marston says.

“The number one thing I tell wealthy families to think about [when they are looking for a wealth advisor] is to take sure they will have access to the best private equity firms,” he told advisors at the Investments & Wealth Institute’s annual investment conference in New York. “It’s very, very important.”
Those investors should have at least $5 million in investable assets, Marston cautioned. “Otherwise there’s too much illiquidity in private equity,” he explains.

Stock investments — measured by the S&P 500 — have brought a real return of 7.1% from 1951 to 2018 and the real return on Treasury bonds has been 2.5% for the same period, Marston noted.

But over the last 20 years, the real return on stocks was over 2% lower than in the period from 1951 to 2018, he pointed out, while bond yields have cratered.

Return prospects for the next 20 years will be similar, according to Marston.

“I don’t think productivity is coming back,” Marston says. “I think it’s safe to assume that the trends of the last 20 years will continue.”

He surveyed four major financial institutions, whose estimates for long-term expected returns on stocks —adjusted for an expected inflation rate of 2% — ranged from 2.4% to 5.1%. Expected bond returns were around 1.5%.

Culprits for ongoing low returns include an aging population that will require more social programs and a slowdown in productivity as the economy continues to shift towards services and away from manufacturing.

“I don’t think productivity is coming back,” Marston said. “I think it’s safe to assume that the trends of the last 20 years will continue.”

What about alternative investments as a way to escape this trap?

While real estate has outperformed stocks, “the long run average hides a lot of variations over time,” Marston said. Emerging market returns surged from 2001 to 2010 but “have been very disappointing” since then, he noted.

Hedge funds gave investors huge returns of over 18% in the 1990s, but as the industry grew rapidly (today there are over 10,000 hedge funds with $3 trillion under management), returns plummeted. Hedge funds only returned 3.4% from 2010 to 2018.

Over the last 20 years private equity returns have outpaced stocks by almost 6%.

While there are still some excellent hedge fund managers, it can be difficult to identify them and gain access to the funds, Marston said.
That leaves private equity.

Over the last 20 years, Marston pointed out, private equity returns have outpaced stocks by almost 6%.

“There is no question investors should consider adding private equity to their portfolios,” Marston declared. “If I were rich, I would have a significant allocation of my portfolio to private equity. It clearly has great advantages.”

But the advice appears to be limited to UHNW investors.

“There is a huge gap between the median private equity managers and the top managers,” according to Marston.

Only endowments or very wealthy investors can afford the illiquidity risk of tying up funds for 10 years or more, Marston pointed out. What’s more, with valuations of all assets at high levels, it’s “not a great time to start investing in PE,” he added.

Accessing the top managers is a challenge with PE as well.

“There is a huge gap between the median managers and the top managers,” Marston said.

Because of the asset classes’ illiquidity, most investors don’t put more than 10% — or at most 20% — of their holdings in private equity, Marston said. That limitation severely curtails the excess return the portfolio can earn, he noted.

But Marston does believe investors willing to put a significant chunk of their cash into private equity will be rewarded.

“Private equity has earned a sizable excess return relative to all forms of public equity over the last 20 years, and while returns will come down, the gap will stay high,” he maintained.

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