Op-Ed: Using the Risk-Free Rate as a Basis to Optimize Investment Costs (Part 1)
Art by John Jay Cabuay
Experienced allocators know that even with rigorous processes and keen judgement, investment outcomes still cannot be guaranteed. There are simply too many factors beyond their control. As such, allocators must often make investment decisions while accepting a fairly high degree of uncertainty and unpredictability. However, the best allocators seek to optimize those inputs that are within their control. One such input is investment expenses.
The goal for the investment office is not—nor should it be—to simply lower expenses, but rather to increase “net” returns. In other words, paying high(er) fees could be very prudent if doing so avails the investor to high-performing products and managers.
Nevertheless, cost controls are important, and, in today’s column, I demonstrate why cost controls in a low rate/low return environment are paramount. In the next column, I will explain why allocators should examine their investment costs by making a direct connection between investment fees and expenses and the yield of the 91-day Treasury Bill (T-Bill). This approach will enable the allocator to determine how much of the “free” return they are willing to give up to pursue alpha. In the third and final piece, I will illustrate why connecting fees and the risk-free rate can be especially relevant when underwriting high fee products, such as hedge funds.
To explain the suggested approach, let’s begin by:
- Reviewing the inputs to a portfolio’s expected return;
- Observing the direct correlation between the risk-free rate, beta, and expected returns; and
- Illustrating why fees matter more in low rate environment.
Inputs to a Portfolio’s Expected Return
A portfolio’s expected return is simply the combination of beta and alpha expectations. Beta can be further decomposed into the risk-free rate + the risk premium. Therefore, the expected return of a portfolio is:
ER (portfolio) = Risk-free rate* + risk premium + alpha (Note: Risk-free rate + risk premium is your beta.)
(*For the purposes of this article, the 91-day T-Bill is being used as the risk-free rate.)
Correlation Between the Risk-Free Rate, Beta, and Expected Returns
Because the risk-free rate is an input to beta and beta an input to a portfolio’s expected return, the correlation between the risk-free rate and a portfolio’s expected return is obvious. As the yield on the risk-free rate declines, so too does the expected return for both beta and the entire portfolio. The opposite is also true.
A review of historical returns shows that the relationship between the risk-free rate and beta has held up well. Consider the data below, which shows the average annualized returns for a passive 60/40 S&P 500/Barclays Aggregate portfolio (beta) and the 91-day T-Bill (risk-free rate) during the past 40 years and 20 years.
Long Term Returns
Average annualized returns ending June 30, 2020
| 40-year | 20-year | |
| 60/40 portfolio (Beta) | 10.2% | 5.9% |
| 91-Day T-Bill | 4.2% | 1.5% |
| Risk Premium (beta-RF) | 6.0% | 4.4% |
Source: Marquette Associates
As would be expected, the decline in the average annualized return of the passive 60/40 portfolio coincides with the decline in the yield of the risk-free rate. The decline in the risk-free rate from 4.2% to 1.5% from the last 40 years to the last 20 years can explain 270 basis points (bps) of the 430 bps decline in the average annualized return of the 60/40 portfolio across the same two time periods.
If you need further convincing on the relationship between the risk-free rate and beta (the return of a 60/40 portfolio), take a look at the chart below produced by Marquette Associates. The chart shows the rolling 20-year average annualized returns of the risk-free rate and the 60/40 portfolio. You can easily see high correlation of the downward sloping trend line for both the 91-day T-Bill and the 60/40 portfolio.
Rolling 20-Year Annualized Returns
91 Day T Bill
60/40 Portfolio
18%
16%
14%
12%
10%
8%
6%
4%
2%
0%
1996
2000
2004
2008
2012
2016
2020
91 Day T Bill
60/40 Portfolio
18%
16%
14%
12%
10%
8%
6%
4%
2%
0%
1996
2000
2004
2008
2012
2016
2020
91 Day T Bill
60/40 Portfolio
18%
16%
14%
12%
10%
8%
6%
4%
2%
0%
1996
2000
2004
2008
2012
2016
2020
91 Day T Bill
60/40 Portfolio
16%
12%
8%
4%
0%
1996
2000
2004
2008
2012
2016
2020
Source: Marquette Associates
Notice too that the risk premium compressed from 6% to 4.4% between the 40- and 20-year time periods. A compressing risk premium is significant to investors (it lowers the “passive” portfolio expected and realized return); however, many factors can contribute to this compression, and most factors are unpredictable. Although the expansion or compression of the risk premium is important, investors will not know or be able to reliably predict its level or direction. Later, in a follow-up article, I will suggest that allocators focus only on the risk-free rate, not the risk premium, when examining investment costs, so for now, we will not address the factors driving changes in the risk premium.
Fees Matter More in a Low Rate (Low Return) Environment
Using the historical data provided above, we can easily explain why fees matter more in the low rate environment.
Let’s assume, for illustration only, that an investor has total program expenses and manager fees of 1%. In this example, the 1% is the aggregate fee for all program expenses (staff, consultant, custodian, legal, technology, travel, etc.) plus all manager fees for both active and passive strategies.
Further, let’s assume this same investor captured 100% of the available passive return over the 40-year and 20-year periods, or 10.2% and 5.9%, respectively, for the 60/40 portfolio. For now, we will assume that part of the 1% in fees was used for active management, but the portfolio generated no alpha during these times periods.
Under these scenarios, after paying the 1% in total fees and expenses, the investor would have netted a return of 9.2% (10.2% -1%), capturing 90% of the available beta after fees over the 40-year period. However, over the more recent 20-year period, this same investor would have only netted 4.9% (5.9% - 1%), capturing only 83% of the available beta after fees.
Investor Retained Portion of Gross Returns
40-Year Period
Average annualized returns ending June 30, 2020
| RF Rate | Risk Premium | Total Beta | Investor Retained Return | |
| 60/40 Portfolio (gross) | 4.2% | 6.0% | 10.2% | |
| 60/40 Portfolio (net) | 9.2% | 90.2% |
20-Year Period
Average annualized returns ending June 30, 2020
| RF Rate | Risk Premium | Total Beta | Investor Retained Return | |
| 60/40 Portfolio (gross) | 1.5% | 4.4% | 5.9% | |
| 60/40 Portfolio (net) | 4.9% | 83.1% |
Source for Gross Returns: Marquette Associates
We can easily see that fees represent a higher proportion of the available passive portfolio return in a lower rate return environment. Assuming that all fees are used for the pursuit of alpha (for many investors, most, but not all fees, are used for the pursuit of alpha), then we can see that the pursuit of alpha is relatively more expensive in a lower return environment. Specifically, the pursuit of alpha in a low rate/low return environment requires the investor to be willing to give up a higher percentage of the available passive return.
This point becomes even more clear when fees are specifically compared to the risk-free rate, so in the next column, I will explain how and why allocators should examine their investment costs by making a direct connection between program expenses & manager fees and the yield on the 91 Day Treasury Bill.
Until then, I hope it is clear that in a low rate/low return environment, our programs and managers must generate a higher return premium in order to justify their fees and expenses. In no way does this mean that it is wrong to pay high fees or that the pursuit of alpha is a fool’s errand, but rather, we all need to recognize that the cost to pursue alpha increases as return expectations decline.
Tony Waskiewicz has nearly 30 years of financial services, investment advisory, and CIO experience and most recently served as chief investment officer for Mercy Health in St. Louis.
This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of Institutional Shareholder Services or its affiliates.
Check for Part 2 next week.
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