In my last article, I discussed some of the key differences in how institutional investors tend to manage their assets relative to how retail investors manage theirs. This article addresses the target rate of return approach that institutional investors employ and how that target rate of return has been adjusted over the past number of years.

Most institutional investors (pension funds, endowments and foundations are examples of institutional investors) have a target rate of return that they expect to achieve for their stakeholders over a stated period of time. The asset mix they employ to achieve that return is set accordingly, that is, their asset mix is set using the efficient frontier, so they take on the least amount of risk to achieve that given return objective. Retail investors should do the same. As part of their process, retail investors should determine their investment goals and the return objectives required to meet those goals. The asset mix should then be implemented that gives retail investors the most efficient means to achieve those goals, so they take on the least amount of risk to achieve a given expected return.

Expected rates of returns have declined over the past number of years. Below is a chart showing the percentage of S&P 500 companies’ pension plans and the ranges of expected returns.  The shift from expectations in 1999 (the grey bars) to 2017 (the orange bars) is quite dramatic. In fact, the average expected return of defined benefit pension plans of the S&P 500 companies has moved from 9.2% in 1999 to 6.6% in 2017. This reduction is a result of lower yields on fixed income and lower return expectations on equities.

Click here to expand chart

Source: JP Morgan Asset Management

Retail investors should have a clearly defined target rate of return for their wealth and the asset mix they employ should be aligned with that target. Rebalancing back to the asset mix on a regular basis will give investors a built in discipline of selling high and buying low, in that rebalancing back to a target asset mix means that investors will be trimming the weight of assets that have performed well relative to their other assets, while adding to those assets classes that underperformed relative to others. Too often retail investors get caught up in chasing returns; utilizing a target rate of return will provide a discipline to their approach.

Institutional investors have a stated target rate of return set out within their investment policy statement. The asset mix is set according to the efficient frontier such that they take on the least amount of risk for that given level of expected return. The returns investors expect to achieve must be set in a reasonable manner and consistent with those achieved over long periods of time. Institutions have reduced their return expectations over the past number of years as evidenced above. Retail investors should have an investment policy statement that outlines the expected rates of return and the asset mix they intend to utilize to achieve those objectives.



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