Managing for real returns


I have previously made the case that real return outcomes are crucial for those saving for retirement and living off their retirement savings. Yet institutional super funds do not explicitly manage the risk of real return outcomes. The typical mix of assets in a default super fund results in the risk to real outcomes (that is, the returns adjusted for inflation and the more important outcome) being greater than the risk to nominal outcomes (that is, returns before adjusting for inflation, a less important outcome). This article explores the concept of managing for real returns.

In a nominal return portfolio construction framework, investors think of the major asset classes as follows: cash is our risk-free asset, bonds are a defensive asset class which should perform well in a difficult economic environment, and equities are a growth asset which participates (less consistently than you may think) in the strength of the broader economy.

As a result we see higher levels of risk, as displayed in the rolling nominal return volatility table below. Table 1 below looks at the volatility of annualised returns for both nominal and real outcomes over a period from 1900 to 2012.

Asset Class

Volatility (Nominal)

Volatility (Real)




Domestic Bonds



Australian Equities



Global Equities (unhedged)



Table 1: Volatility of annualised returns for different asset classes (1 January 1900 to 31 January 2012). Source: Schroders; “Why SAA is Flawed?” March 2012, Schroder Investment Management.

The nominal results are in accordance with the expectations described above. However, the returns from bonds and cash have, over the very long term, been more volatile than one may expect, since the last 20 years has been a period of low volatility for these asset classes. Once we switch our mindsets to focusing on the risk to real return outcomes, the risk profile changes:

  • The historical real return from cash is more volatile than the nominal return, which may surprise, given the current setting we have become accustomed to whereby the Reserve Bank adjusts the cash rate to control medium term inflation.
  • The return profile of nominal bonds becomes more volatile when viewed from a real return perspective rather than a nominal return perspective. The reason why is that in high inflation environments it is common to see nominal bond yields rise (based on inflation expectations). Rising bond yields results in falling bond prices so investors in bonds may take two hits in an inflationary environment: the purchasing power of their capital falls (due to rising inflation), and the value of their nominal portfolio falls.
  • The return profile of equities remains volatile when outcomes are viewed in real terms. There is no clear pattern whether companies are able to pass on input cost increases (including labour). Indeed there are many other factors at play such as government policy and macroeconomic effects such as changes to exchange rates and interest rates. So we see the volatility of real outcomes remain high.

Overall, when we are focused on managing the risk to real return outcomes we are considering outcomes relative to inflation. In this sense inflation becomes what we call the numèraire (the basis for comparison). Observing and hence managing nominal return risk assessment is easier because risk is measured as variability in the nominal outcomes. When considering real return risk assessment, we need to consider the nominal return against the inflation outcome. That is why nominal bonds appear more risky in a real return context: they often experience negative returns at the same time that inflation is high (so a double whammy), as illustrated previously.

In terms of other assets and investment strategies:

  • Inflation-linked bonds are often viewed as a low risk investment when we are focusing on real return outcomes. However this is only true over a long term holding period. Over shorter periods of time indexed bonds often have very long maturities and carry significant duration risk, so the short term variability in the bond price may be quite large even though the risk to inflation outcomes is offset by the indexation of the coupons payments. This is an important consideration if you have a range of investors in a fund all retiring at different times (we call this sequencing risk, as discussed in Cuffelinks on 6 March 2013).
  • Real assets are often regarded as good inflation hedges. Examples include property and infrastructure where the income stream may be linked to inflation. However the real outcomes could still be volatile due to other factors. For example, if interest rates rise significantly in response to inflation, the asset price may fall if based on a discounted cash flow technique.
  • Investments in commodities are also viewed as inflation hedges. There is logic to this argument but there will still be large variability as there are many supply and demand factors (besides inflation) which affect commodity prices.

Overall the challenge of managing real outcome risk is significant. Managing real outcome risk is more complex than managing for nominal outcomes (because the numèraire, inflation, is itself a variable quantity). It creates the challenge to think more strategically about inflation itself and the role of each potential investment in different inflationary environments. The starting point of a real return focussed asset allocation framework would be:

  1. Create expectations of real returns for each asset class. For each asset consider the underlying ability for its return stream to change with inflation.
  2. Consider the risk to real return outcomes for each asset class. How could each asset class perform in different inflationary environments?
  3. Consider the likelihood for the inflationary setting to change.

I’m yet to see any super funds that explicitly manage for real outcomes. There is also an opportunity for asset consultants to frame their asset allocation advice in this manner as well. There are some managed funds in the real return or target return space that are heading down this path. There is a significant leadership opportunity for super funds to manage real return risk and ultimately improve the outcomes of those in Australia’s retirement income system, where the inflation risk represents a potential erosion of their retirement outcomes.

This is the third of three articles which makes the case that we need to have a greater focus on real return outcomes. Simply stated, real return outcomes are more volatile than nominal outcomes, and of course have been lower. However there is a dangerous tail risk element evident as well, due to periods of higher inflation. By explicitly targeting real return risk we are better positioned to manage the risk that most directly relates to retirement outcomes.


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One Response to Managing for real returns

  1. Harry Chemay July 1, 2013 at 2:40 PM #

    Well done on the ‘trilogy’ of articles on the importance of focusing on real returns David. I’ve enjoyed your insights into the money illusion of nominal returns, and hope that your contributions spark more interest in measuring investment outcomes from an after-inflation perspective.

    Your use of long-term real asset class standard deviations highlights how that which is assumed to be ‘low risk’ can be anything but once inflation is taken into account. The 113 year standard deviation of Cash has been 5.4% p.a. The annualized real return over that time (based on the DMS database) averaged 0.7% p.a.

    This suggests that in any one year period (if the future approximates the past 113 years) there is a 68% chance that the real return from Australian cash will be between -4.7% and 6.1%.

    So yes, there have been periods in Australian history when people have parked their investments in cash, often to shield these amounts from ‘risky assets’, only to have the purchasing power of these cash holdings erode over time. At a 2.75% RBA Cash rate and headline inflation (All Groups CPI) hovering around 2.5% we aren’t far off that outcome now.

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