More investors will need to turn to smart beta over the next decade as current passive and active strategies will continue to struggle to deliver far less than 5% real returns, suggests Research Affiliates.

Pointing to the performance of a notional 60/40 equities and bonds portfolio over the past 150 years, the team from Newport Beach suggests return expectations are understandably higher for mainstream stocks and bonds despite the actuality in recent decades of returns being lower than hoped.

Looking ahead to the next decade, the team forecasts most asset classes will deliver annualised returns below 4% with only emerging market and developed markets ex-US set to deliver returns above 6%.

Looking at the probabilities of either an ‘average investor’ or ‘public pension’ portfolio delivering returns above 5%, the team predicted the chances of this happening are vanishingly slim at less than 1%.

In such circumstances, investors will have to consider diversifying their portfolios into the aforementioned asset areas alongside local currency bonds and even commodities and REITs as well as alternative asset classes such as global macro and systemic alternative risk premia strategies.

In particular, the team suggests “passives just will not cut it” over the next decade and they predict institutions will increasingly look to smart beta options to give their portfolios the chance of returning anywhere near 5% annually.

Looking at how far down the road investors are in realising that they might need to look beyond simple index-hugging strategies, Tzee Man Chow (pictured), head of smart beta strategies at Research Affiliates, says there is already evidence of institutional take-up.

“My observation is institutional owners are already pretty far (advanced) in adopting smart beta strategies,” he tells ETF Stream. “They are sophisticated and they understand the research behind why other alternative factors may add value, and are comfortable in systematic rebalancing investment process.”

Indeed, such is the extent of their comfort with smart beta, Tzee believes that it is “not uncommon” to see large pension funds dissecting their overall equity allocation into pure passive, active stock picking, and a new bucket of systematic rebalancing/smart beta.”

He added, however, that retail investing is far behind and he predicted growth in smart beta would not match the take-up seen in the past decade.

“I expect smart beta to continue to grow over the next decade, yet probably wouldn’t match the same rapid rate of increase as the early 2010s,” Tzee continued. “The end of last decade, especially in the US, we saw a huge momentum in the returns of passive benchmark and setbacks for most of the active strategies.”

2020 macro outlook: Look beyond the noise

While the poor performance for active strategies should provide a spur to investors in these types of strategies to start looking at smart beta as a better and cheaper alternative, those already heavily weighted in passive are more likely to “sit on the fence for a little bit”.

The extent to which the asset management industry in the US is attuned to the meagre predicted returns suggests the possibility that simple passive strategies might well disappoint in the years to come. Brandon Kunz, partner and member of the multi-asset strategies team at Research Affiliates, said that most investors overestimate the probability their current portfolio will achieve their real return targets at this point in the cycle.

He notes that a couple of years ago, Research Affiliates asked investors to take up the challenge of seeing whether their portfolios were priced to deliver 5% real returns according to the company’s long-term expectations. He said the results were unsurprising; of the 35,000 people who tried, less than 10% had a portfolio that had more than a 50% chance of hitting that target annualised return in the next decade.

“Because investors potentially do not realise how low the return prospects of their portfolios are, they are unwilling to take action to improve their probabilities of success,” Kunz suggested.

“Instead, it appears they are artificially increasing their expectations of the future based on their experience of the lofty returns provided by mainstream portfolios in three of the last four decades.”

This bias leads to less movement than should be occurring in terms of assets being shifted into under-owned or unpopular asset classes or, more pertinently for the sake of this discussion, it means investors do not fully embrace the "outperformance potential of non-capitalisation weighted smart beta and/or factor strategies".