PERSPECTIVE3-5 min to read

Beating the market in an era of lower expected returns

Ultra-low yields are driving down returns – and destabilising the traditional correlations – across asset classes. In the second piece in an occasional series we examine what these factors mean for portfolio construction.



Ben Minter
Portfolio Director

Interest rates on cash have fallen by approximately 60% in the wake of the COVID pandemic. Since long-term investors use these rates and yields on government bonds as key building blocks in their forecasts, expected returns across the board have been dragged lower.

Long-term historical data indicates, for example, that developed market equities generate an annual return of 4.75% above the interest rate on cash. An assumed cash rate of 1% will result in a very different overall return versus a rate of 2.5%, which was the approximate level of US deposit rates before the pandemic.

The 60/40 rule of shares and bonds now looks shakier

The classic asset mix of 60% equities and 40% government bonds, which has served generations of investors well, looks less attractive when bond yields are so low, according to recent research by Schroders.

The problem, so argue the multi-asset team at Schroders, is that government bonds no longer offer the same risk/return characteristics as has been the case historically. With such low yields, government bonds are vulnerable both to rising inflation (eroding the real value of coupons) and from rising interest rates (potentially causing capital loss).

Historically, the team points out, government bonds had a persistently negative correlation to equities. But they now expect this relationship to be less stable in future. While the team ultimately don’t think there is an adequate replacement for bonds and cash as a hedge against equity risk in a portfolio, they do suggest ways that investors can look to diversify a portfolio to enhance potential returns in a zero-yield environment.

The 60/40 2020s (forecast) dark blue line in the chart, below, is the team’s estimation of the efficient frontier (the optimal portfolio for a given risk and return level) for a traditional asset allocation, while the light pink line denotes the equivalent frontier for an unconstrained portfolio using a range of alternative assets in place of government bonds. The implication is that diversification away from an allocation to government bonds (for investors able to tolerate the additional risk) will be accretive to long-term return expectations.

The pink frontier represents the portfolio choices available to higher risk investors contemplating portfolio construction in a zero yield environment


Source: Schroders, Refinitiv, February 2021

From their analysis, it seems that investors either need to accept lower overall returns – if sticking with the “traditional” 60/40 allocation – or seek to diversify the return-generating and risk-reducing parts of a portfolio separately.

To broaden asset class exposure appears sensible, with the merits of each allocation weighted appropriately, and we advocate inclusion for our client portfolios, where appropriate. Diversifiers such as gold, absolute return funds, infrastructure and more illiquid alternative assets can all help add value when investing for the long-term, provided there is consideration of the correlation between each asset class.

Stock selection: does it remain important?

Is it still the case that asset allocation drives overarching returns from a multi-asset portfolio?

Returning to the thread of my previous article on this topic and, following the Schroders analysis above, asset allocation remains the primary consideration for portfolio construction over the long-term and is undoubtedly a key determinant of overall portfolio performance. However, there are opportunities for stock selection to enhance returns where equities form the core allocation of an investment portfolio. We believe there are three key areas which will have the greatest impact in the next decade: (1) active stock selection, (2) thematic investment and (3) incorporation of Environmental, Social and Governance (ESG) criteria into the selection process.

1. Active stock selection

The recent past has seen fund houses in a race to the bottom with low fees for market risk (beta) via passive vehicles becoming a huge part of the investment universe. These vehicles have been preferred to more expensive active strategies where managers pick stocks in the hope of providing market-beating returns (alpha). While the debate between active and passive will ebb and flow, the potential alpha to be had from active stock selection will be useful to investors if market returns are more subdued going forward. After all, investors in passive strategies hope to get a similar – but lesser by the fee charged – return to the index (unless the provider is using derivatives or other methods of enhancing the returns). And the good news is that fees for active management have become more competitive. In this environment, active stock selection can be an important source of returns.

Additionally, as the Schroders team showed in their analysis, since bonds have now become less reliable as a diversifier to equity risk, investors should make greater use of active stock selection within their equity exposure. Academic evidence also points to concentrated portfolios being the most reliable source of positive alpha, albeit investors should note that with greater concentration comes greater potential divergence from a broad-market index (if one is being targeted or benchmarked against).

A focus on stock selection should, therefore, be increasingly beneficial, especially as fees for active management become more competitive. From a performance vs. fees perspective, it is also the case that holding a standard index tracker will mean the tracker underperforms its reference index by the amount of fees paid, with no opportunity for outperformance unless the manager is making active decisions (so not passively investing).

To consider the data further, the excess returns delivered to investors in concentrated equity strategies over the past five calendar years is highlighted in the table below. The table shows the average excess return of active global equity funds over their benchmark, grouped by the number of equity holdings, with the result being outperformance for investors holding fewer stocks.

Investors considering adding to active equity exposure should focus on concentrated strategies


Source: Schroders, eVestment, February 2021. Excess returns from active global equities funds currently in operation with an AUM greater than $100m.

2. Thematic approach

We believe thematic investing can also benefit returns in the future. The skill in managing investment selection within a portfolio is to be able to identify the themes of the future that are distinct, investable and structural and to avoid those that have reached the “hype” stage. In addition, suitable resources are required to understand and manage these often concentrated portfolios. Where we choose to invest in a specific theme, we size these positions appropriately, giving regard to the risks and return characteristics.

A challenge with thematic investing is that themes often do not have a long track record to integrate into efficient frontier analysis. We also recognise that some future successful themes may overlap and more than likely result in a growth bias to a portfolio. In some cases, it may be appropriate to accept this style risk in order to benefit from these type of themes.

Examples of current themes include disruption. In the context of the global economy, disruption can be the result of:

  • Technological innovations (for example artificial intelligence)
  • Changing consumer habits (switch to digital)
  • New regulations or legislation (such as the switch towards renewable energy sources or health policies).
  • Other themes could be carbon neutrality (through equities and bonds)

Of course, a key theme for a number of investors revolves around Environmental and Social factors (see below). While we recognise these as critical “themes” more broadly, we instead incorporate Environmental, Social and Governance parameters into all of our investment decisions – recognising the challenges faced by people and planet are not distinct to investment returns.

3. Environmental, social and governance (ESG) factors

All investments have an impact on people and planet. We view this impact as the third dimension of investment, alongside return and risk.

In considering this point, Katherine Davidson, who manages the Schroder Global Sustainable Growth Fund, highlights a new paper from the University of Virginia which focuses on more minor ESG incidents such as environmental damage, discrimination, occupational health and safety issues, fractious relations with local communities, and anti-competitive practices. There were as many as 80,000 such incidents among listed US companies over the decade 2007-17.

The paper's author finds a clear relationship between the number of past incidents and future financial and stock performance: a portfolio of stocks with high ESG incident rates had lower profits and underperformed the wider market by about 3.5% per year, even when taking into account sector exposure and other risk factors. The model also held for out-of-sample data in European markets, where a similar portfolio would have underperformed by 2.5% per year.

When considering this as part of the benefit of active stock selection, it is important to note that the data used to construct passive indices is backward-looking. As a result index allocations do not reflect what companies are doing to improve. One important example is the move towards a low/ no carbon economy globally. Significant changes are needed to limit rises to the 1.5°C-2°C commitment global leaders made in Paris in 2015. What matters is investing in companies that are improving or have plans to improve.

Companies demonstrating higher ESG scores tend to show more resilient performance in downturns, while stock prices tend to benefit when investors recognise the sustainability of a business.

At Cazenove, we recognise the benefit of integrating ESG considerations into all of our investment processes, using proprietary investment tools to help inform our decision-making.

Our approach

The challenge for us as investors is to identify the right asset allocation mix and underlying stock selection ahead of time and as appropriate to the portfolio being managed.

Our investment selection process seeks to identify managers who we think are likely to add active value and who align with our themes and sustainable approach. We diversify across both asset classes and managers to help offset volatility and offer a level of diversification to returns that we believe will benefit our investors over the long-term.

All of the factors, amongst others, mentioned above will have an impact on future returns for our charity portfolios. The importance for charity trustees to take advice and partner with a trusted investment manager is paramount. If you would like to speak further about the themes in this article or find out how we can help with your investments, please do get in touch.

This article is issued by Cazenove Capital which is part of the Schroders Group and a trading name of Schroder & Co. Limited, 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. 

Nothing in this document should be deemed to constitute the provision of financial, investment or other professional advice in any way. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested.

This document may include forward-looking statements that are based upon our current opinions, expectations and projections. We undertake no obligation to update or revise any forward-looking statements. Actual results could differ materially from those anticipated in the forward-looking statements.

All data contained within this document is sourced from Cazenove Capital unless otherwise stated.


Ben Minter
Portfolio Director


The value of your investments and the income received from them can fall as well as rise. You may not get back the amount you invested.