February 2, 2010
LISTEN: mp3 audio (6:44 min)
5-MINUTE FINANCIAL THOUGHT:
Suppose you could swap all your financial assets in exchange for a contract that guarantees you a risk-free return for the next 50 years. What is the minimal annual rate of return (after inflation, fees and taxes) you would accept in order to make this exchange?
Total-Return Swaps, Unrealistic Expectations, And Why Experts
Will Only Guarantee 1% Annual “Real” Returns (A 5-Minute Answer)
Total-Return Swaps
The hypothetical trade in the 5-Minute Financial Thought is a simple form of a total-return swap. In a total-return swap, one party receives a guaranteed payment in exchange for surrendering all returns generated from their non-guaranteed assets. Sophisticated versions of total-return swaps are used by financial institutions, particularly hedge funds.
When they come to agreement, the terms of the total-return swap indicate the expectations and risk tolerance of both parties. For example, suppose you would accept a guaranteed 6% annual rate of return. This means you feel the risks required to achieve a return greater than 6% are not worth the value of the guarantee. In contrast, the institution or individual offering the 6% guarantee believes that the returns from your non-guaranteed assets will yield more than 6%. Researchers often use some form of total-return swap question when surveying investor expectations.
Unrealistic Expectations
It’s one thing to assess your risk tolerance within the framework of a total-return swap. It’s a completely different question as to whether most investors’ assessments of their risk tolerances and return expectations are reasonable. Consider the following:
The question asks for a minimal rate of return after inflation, fees and taxes. Historically, inflation has averaged 3% a year, and most experts would estimate that fees and taxes eat away another 2 to 4 percentage points. Thus, in any given year, these factors have the potential to reduce annual returns by 5 to 7%.
Ibbotson Associates calculates that, since 1926, U.S. stocks have averaged 9.8% on an annual basis. This means the average “real” return falls somewhere between 3 and 5%. (There are certainly other investment options beside U.S. stocks, but many financial analysts would say stocks have achieved the best long-term results of any asset class.)
With this background information, Jason Zweig, who writes a regular column in the Wall Street Journal, asked several prominent investment experts which guaranteed “real” return they would accept in a total-return swap. William Berstein of Efficient Frontier Advisors said he would accept 4%. Laurence Seigel, a consultant and former head of the Ford Foundation said 3%. For John Bogle, the founder of the Vanguard group of mutual funds, the number was 2.5%. Elroy Dimson, an expert on the history of market returns was even lower: 0.5%. In essence, the experts’ understanding of the risks and rewards seems in line with actual performance.
But what about non-institutional, individual investors? From the research, most don’t have a clue. A Vanguard survey from October 2009 found the median investor expects annual returns of 7.5%, but 15% of respondents expect annual returns of 15% or higher. Zweig cited another survey in which investors expected returns averaging 13.7% over the next 10 years.
Just 1%? Why?
As president of the Investment Fund for Foundations, David Salem posed the total-return swap question to several institutional money managers, asking them what rate of real return they would be willing to guarantee in exchange for a mixed portfolio of assets (containing stocks, bonds, cash and a small amount of commodities and real estate). The answer: 1%. Considering the way stock markets have rebounded in the past year, why is the guarantee so low?
Remember, the guarantee is based on a net return after inflation, taxes and fees. An institutional manager may be able to manage the effect that fees and expenses would have on the net return, but who knows about inflation and taxes? Stimulus spending and record deficits have many analysts worried about inflation. If the rate of inflation were to rise to 8%, it might require gross returns of 12% just to realize a 1% real return. And increasing tax rates would only make the challenge greater.
Because inflation is an unknown (and sometimes subjective) variable, and because taxes vary with individual circumstances, most reports of annual returns are not after expenses – they are not “real” returns. When individuals combine unrealistic expectations about returns with an ignorance of the costs associated with investing, they are setting themselves up for disappointment.
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