A reality check for your clients

“Our expectations for government bonds — such as Canadian bonds, U.S. treasuries, or government bonds in Europe or Japan— are for very low single-digit returns,” says Stephen Lingard, senior vice president and portfolio manager with Toronto-based Franklin Templeton Investments Corp.’s multi-asset solutions team.

In addition, yield spreads between government bonds and corporate issues are relatively low by historical standards, so investors aren’t being rewarded generously for assuming higher credit risks, he adds.

Bonds still play an important role in asset allocation, says Lingard, who co-manages the $7.6-billion Franklin Quotential suite of six fund-of-funds portfolios. But, he adds, “they’re more of a diversifier for risk than they really are a significant generator of returns, just because interest rates are so low.”

Nor should clients have unduly bullish expectations for equities markets returns either in what remains a low-inflation environment. Franklin Templeton’s multi-asset solutions team projects average equity returns to be mostly in the high single-digits during the next seven years, with emerging markets returning somewhat more than North American and developed overseas markets.

The Franklin Templeton multi-asset team’s assumptions translate into projected average annual returns of at least 7.5% for all-equities portfolios; 4.5-5.5% for portfolios that are balanced between equities and fixed income; and 2.5-3.5% for portfolios invested entirely in a combination of domestic and foreign fixed-income.

These seven-year projections are broadly in line with the “projection assumption guidelines” the Financial Planning Standards Council (FPSC) and Institut québécois de planification financière (IQPF) published earlier this year.

Assuming holding periods of at least 10 years, the FPSC projections are for average annual returns of 6.4% for Canadian equities; 6.7% for developed-market equities, including the U.S.; and a somewhat higher 7.4% for emerging-market equities.

The two other asset classes for which projections have been made — fixed-income and short-term — are 3.9% and 2.9%, respectively. Updated annually, the FPSC/IQPF guidelines are derived from sources that include Canada Pension Plan and Quebec Pension Plan projections and historical returns from major benchmark index providers.

The projections from the FPSC/IQPF and Franklin Templeton’s multi-asset team are similar, in some instances, to the actual experience of mutual fund investors during the past 10 years. For example, according to Morningstar Canada, the average 10-year return as of Sept. 30 was 5.8% for the Canadian equity category, 6.4% for international equity and 3.6% for Canadian fixed-income.

But the projected returns are far more modest than the robust actual 10-year return of 11.3% for U.S. equities, and much higher than the miserly 0.4% 10-year average return for mutual funds in the Canadian money market category.

“If we could say that the past would be indicative of the future, then we could rely only on historical rates of return,” says Joan Yudelson, vice president, professional practice, with the FPSC. “But we understand that’s not necessarily the case. What this guideline does is actually weighs historical returns, but it also uses forecasts of the future in order to create returns that financial planners can rely on.”

In using the guidelines, Yudelson says it’s important for financial planners to exercise good judgment and take every client’s situation into account. For example, if a client has a tendency to want to buy high and sell low, the financial planner may want to factor in a projected return that’s below the guidelines, “recognizing that human behaviour may actually negatively impact clients’ expected returns.”

Yudelson also notes that the projected returns of asset classes are before advisory fees charged directly to clients. Thus, fee-based “advisors need to be very cognizant that they need to deduct [their fees] when projecting investment returns.”

In making asset-allocation decisions for the Franklin Quotential program, tactical considerations play a role. Lingard expects the U.S. equity market, which has been the top performer during the current market cycle, to lag other major markets, including Canada, during the next seven years. Yet, for now, he’s still overweighted in U.S. equities.

“We are willing to own markets that are stretched in terms of valuation,” Lingard explains, “because of the momentum component, or because their outlook is still positive over the next three to six to 12 months.”

For various reasons, the equity portions of the Franklin Quotential portfolios are overweighted in Japan, which has been a poorly performing market. Lingard cites positives in Japan, such as growing profitability, share buybacks, rising dividends and improvements in corporate governance. “The earnings have outgrown the valuations, so the stock market today is cheaper than it was five years ago when Abenomics came.”

Projections of single-digit returns for equities go hand in hand with the assumption that inflation rates will continue to be relatively low. After adjusting for inflation, Lingard estimates real returns of 4%-5% on U.S. and European equities. This is consistent with the FPSC’s projected inflation rate of 2%, similar to where it is now.

As a guideline for clients who are considering whether to borrow to invest, the FPSC’s projected interest rate is 4.9%, which is only 1.5 percentage points higher than its projected return for Canadian equities.

In deciding whether to employ leveraging, both advisors and their clients should make sure they feel confident the strategy makes sense, says Yudelson: “In other words, your rate of return on investment will exceed the expected borrowing costs.”