Regulation puts good assets out of reach of Dutch institutional investors
Robeco’s forecast of long-term investment returns highlights the available premiums over risk-free return in the next five years, but it warns that far from all Dutch institutional investors will be able to take advantage of this.
Robeco’s latest five-year forecast on expected returns from different asset classes is a dense read, including two-and-a-half pages of references to academic literature.
As such, its authors believe they have built a solid argument for their conclusions for returns in the 2013-17 period. And that is important, because the conclusion is that returns look poor across pretty much all asset classes, when compared with historical long-term average returns. For example, the outlook for returns from high-quality government bonds has fallen to just 0.75% annually over the period versus a long-term average of 4.25%.
Investment grade credit will return just 2.5% annually, and emerging markets debt just 4% annually over the period, according to Robeco’s figures.
Higher returns are possible by taking on more exposure to risk. This sees developed markets returning 6.75% annually, while emerging and frontier markets are expected to return 7.75% and 8% annually respectively. However, these rates are below the long-term averages of 8.5% and 8.75%, respectively.
One of the few bright spots is commodities, which are forecast to offer investors an annual return in line with their historical average of 4.25%.
Higher risk premiums
The upside of all these below-par returns is that investors ought to be better rewarded for taking on risk versus the risk-free rate. This is because the risk-free rate of return itself has fallen against its long-term average, as indicated by the return on what Robeco terms high-quality government bonds.
The long-term average return on developed market equities of 8% and the risk-free rate of 4.25% results in a risk premium of 3.75%. However, with high-quality government bonds returning just 0.75% in the five-year period to 2017, the developed markets equities return projected at 6.75% means the risk premium rises to 6%.
Robeco says that this phenomenon is repeated across risk assets. However, while risk premiums may be higher, many investors in the Netherlands who might be considering their allocation decisions over the period are not necessarily going to be able to act on them, at least in the short term, according to Tom Steenkamp, executive vice-president of Investment Solutions & Research at Robeco.
Steenkamp says that as far as the institutional market in the Netherlands is concerned, the investment climate has resulted in investors lacking the flexibility required to adjust allocation easily. This is linked to regulatory pressure from the Dutch authorities, focused on coverage ratios between assets and liabilities.
Institutional investors are essentially being forced into adopting short-term approaches to investing, rather than being able to allocate against longer-term expectations of asset class performance, such as the five-year outlook offered by Robeco.
“The Dutch supervisory authority [central bank] and Dutch pension legislation prevents extra risk taking, because of the low coverage ratios. So what you see is the stock-bond portfolio mix is more or less the same, and they try to differentiate a little bit in the stock and bond mix themselves.
“You can call it short-termism, but it is more or less forced by Dutch pension legislation and the Dutch supervisory authorities.”
Steenkamp believes the risk-averse policy pursued by the central bank is set to remain. When pension funds have large coverage ratios, it is not a problem, but given the current environment and low ratios relative to the minimum required, then the short term becomes more important.
“It is nearly impossible if you are of the view that bonds are not attractive in the coming five years and stocks are, because the legislation means you cannot move.”
And while it is not impossible to invest more in equities, in practice it becomes so because it requires risk to be take off the ‘balance sheet’ elsewhere by the investors affected by the regulations.