As systematic investors, we seek to continually challenge the process in order to maintain a solution which we feel gives us the best ability to meet our financial goals, as and when they come due. We understand that trying to predict the time and direction of market movements over shorter time periods is a fool’s errand. Any change in portfolio structure or investment approach, therefore, must be guided by a change in the evidence or our investment goals.
The interest rates set by central banks have been rising around much of the world in recent times. One will have done well to avoid such headlines in the news. In the UK, the base rate set by the Bank of England was just 0.1% three years ago and now sits at 5%, at time of writing. This considerable increase – much of which happened in 2022 – led to historically low returns on bonds, as bonds fell in price in order to align with market yields. Despite rates not having been at such levels for some time, it is not unchartered territory. In fact, since 1975 rates have been above current levels more than half of the time.
For investors with intermediate to longer term liabilities (i.e. 5-10 years and beyond) these rate rises, and corresponding price falls, have significant benefits. Given the structure of portfolios, the - now higher yielding – bonds should get through the price falls experienced and thereafter be enjoying a higher return. It also opens up other options for savers – annuity rates and fixed term instruments now become more viable, in some circumstances.
However, when it comes to the expected returns on portfolios, the evidence remains the same. We fundamentally believe that risk and return are related, and thus if the expected return on cash has risen on the back of interest rate rises, so must the expected return on all other (riskier) asset classes. If this did not happen there would be an opportunity for arbitrage, whereby investors simply own cash for a period of time before re-entering capital markets.
We can look at historical figures to give an insight into whether there is a relationship between current rates on cash and subsequent portfolio returns. The figure below illustrates – at a given level of starting interest rate – the proportion of times in the subsequent year the portfolio outperformed this starting cash rate. In essence, this is seeking to answer the question: ‘if I lock up my cash today for the next twelve months I am guaranteed x%, so why take on the additional risk of investing in a portfolio?’.
Note that anything above 50% implies the portfolio performed better than locking cash up. The cash rate used is represented by the yield on a 1-year UK government bond, with an additional 1% added to reflect the higher rates that might be achieved through other entities offering fixed term cash accounts.
The reader will notice that there is no clear relationship between the level of cash rates and subsequent outcome of portfolio returns relative to cash. Over all 1-year periods in the sample, the portfolio outperformed locked up cash in 2/3rds of observations. The average excess return of the portfolio over cash in the 1-year periods was 4%. As we extend the holding period to 5- and 10-years the proportion of outperforming periods rises over 80%.
Other practical implications are worth considering. Locking up cash reduces liquidity, and may only be withdrawable outside of the agreed period with a significant penalty. Also, savers with larger sums of cash need to be congnisant to spread cash across banking groups to remain under FSCS protection limits. Bank failures in the US this year offer a cautious reminder to savers not to naively ignore protection limits.
Risk and return remain inextricably linked. The baseline has increased for all asset classes. Stick to the program.
