Lower returns over the next 10 years will require advisors to be more disciplined in their portfolio strategies, according to Patrick Nolan, director and portfolio strategist of BlackRock Portfolio Solutions.

During a session at the Investment & Wealth Institute's Investment Advisor Forum in Midtown Manhattan, Nolan looked at the past 10 years of returns in the United States and then forecasted what those returns may look like for the next 10 years. And he spoke about what effect this could have on portfolios.

Nolan looked at the S&P 500 and the Bloomberg Barclays US Aggregate Bond Index for the past 10 years — from January 2009 to December 2018 — and determined a 60/40 stock/bond blend return of 9.3%.

Meanwhile, BlackRock's 10-year capital market assumptions suggest that a hypothetical 60/40 stock/bond blend would return 5.5% for the next 10 years. This refers to 60% of a hypothetical portfolio achieving the expected stock return of 7% and 40% of the portfolio achieving the expected bond return of 3.2% over the next 10 years.

“We're looking at close to 400 basis points of less return per annum over the next decade versus the last decade,” Nolan explained. “This to me represents a challenge. Think about that client that needs 6 [percent return]. We had an easy time delivering it in the last 10 [years], we'll have a really hard time delivering it in the next 10 [years].”

Nolan then discussed the portfolio attributes that advisors need to be successful in the next decade.

According to Nolan, investment success will require a disciplined process, low drag, and the ability to execute portfolio tilts with precision.

Ultimately Nolan thinks portfolios over the next 10 years are going to need to demonstrate these four characteristics in order to be successful in this lower-return environment.

1. Reduce the drag on returns.

“As it relates to capturing what the market actually delivers us, we're going to need to reduce the drag on returns. If the market's only going to give me 5.5% for this 60/40 blend, I need to capture as much of that 5.5% as I can.”

Largely, sources of drag on returns are fees and taxes.

Based on 9,940 advisor model portfolios collected by BlackRock in the trailing 12 ended Sept. 30, 0.54% of returns were spent on model expenses, on average. The average annual return lost to taxes was 1.18%. Also, 1% of returns was spent toward the typical advisor fee, according to Nolan.

2. Gain efficient exposure to the real drivers of excess return.

Advisors will need to figure out “ways to generate excess returns if in fact my client's required returns are higher than what this 5.5% projects,” Nolan said.

According to Nolan, low returns for 10 years will test investors' confidence, and excess returns will matter more in this environment.

One way to do this is through factor products.

According to Nolan, factor product usage is broadening and becoming more consistent.

Based on BlackRock's model portfolio analysis, 4% of conservative portfolios were allocated to factor products, along with 10.6% of moderate portfolios and 16% of aggressive portfolios.

3. Allocate more to assets with the highest expected return assumptions.

“We're going to need to find ways to get clients more comfortable with owning things they are less comfortable owning today,” Nolan explained.

In particular, Nolan meant addressing investors' home-country bias.

“It's easy in this moment with the way U.S. markets have run to say, 'why wouldn't I be overweight U.S., they've been doing great,'” he said.

According to BlackRock's capital market assumptions, the estimated annual returns over the next 5 years are 6.8% for U.S. large-cap stocks, 8.7% for European stocks and 9.4% for emerging market stocks.

4. Be deliberate when using active managers.

According to Nolan, there is crowding by active managers within a portfolio.

He adds that there are lots of great managers, but limited alpha potential. Nolan suggests advisors asking “What does the right manager look like?”

Advisors who execute with discipline in this more challenging environment will emerge in a stronger position, he concluded. READ MORE:

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