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Results of AFM Research on Expected Returns and Risks

In Short

• Investment firms use very different methods to determine expected returns for different investment categories. This is evident from AFM research into 18 investment firms.
• The AFM is concerned about the significant differences in the market. This may mean that a portion of the expected returns is not realistic.
• The methods used to determine the risk of a portfolio are less varied.

Expected returns on neutral portfolios held by investment firms vary considerably

In the third quarter of 2021, the AFM asked 18 investment firms what expected long-term gross annual return they calculate for a portfolio with a neutral profile. This ranged between 2.7% and 7% per year.

The chart below shows that it makes a huge difference whether an investment firm calculates with an expected gross return of 7% or 2.7% for long-term investment. This leads to enormous differences in outcomes in the feasibility analysis. (In the chart, net returns of 1.2% to 5.5% per year are calculated, assuming a fictitious cost percentage of 1.5%). With an investment of €50,000 and an investment horizon of 20 years, the expected final capital at a 1.2% net return is €63,472. With an expected net return of 5.5%, the expected final capital is more than double, namely €145,888. This means that investment firms present investors with very different expected final capitals for equal investment and equal profile. When the expected returns are not realistic, the intended final capitals cannot be achieved. This can mean disappointment for the investor who has been presented with an unrealistically high final capital.

Chart: Spread in expected gross returns of neutral portfolios from 2.7% to 7%

• X-axis: Number of investment firms (0 to 20)
• Y-axis: Expected gross return (0% to 8%)

Chart: Expected final capital

• X-axis: Years (0 to 20)
• Y-axis: Expected final capital (€50,000 to €145,888)
• Lines represent net returns of 1.2%, 3.35%, and 5.5%.
• Data points: €63,472 (at 1.2%), €96,645 (at 3.35%), €145,888 (at 5.5%).
• Note: With an equal investment of €50,000 and different expected net returns, enormous differences arise in the expected final capital.

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Naturally, one neutral profile is not the same as another; the precise asset allocation differs per company. However, the high degree of spread in expected return cannot be explained solely by the risk in the portfolios.

Chart: Differences in expected return are not explained by standard deviation

• Scatter plot: Expected return vs. Expected standard deviation.

Chart: Differences in expected return are not explained by the percentage of risk-bearing investments

• Scatter plot: Expected return vs. Percentage of risk-bearing investments.

The spread (largely) stems from the fact that investment firms use different expected returns for the different investment categories: the expected gross annual return on equities used by the investment firms surveyed ranged from 5.7% to 11.1%, that on government bonds (high quality) ranged from -0.1% to 3.0%, that on investment grade corporate bonds from 0.7% to 3.7%, and that on high yield corporate bonds from 2.3% to 7%. Not all surveyed investment firms use the same subdivision of investment categories. The charts below are based on the investment categories that companies themselves distinguished and reported to the AFM.

Chart: Lowest and highest observation

• Equities: 5.7% to 11.1%
• Government Bonds: -0.1% to 3%
• Investment Grade Corporate Bonds: 0.7% to 3.7%
• High Yield Corporate Bonds: 2.3% to 7%

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An important reason that investment firms use different expected returns is that they determine expected returns in very different ways. Most investment firms state that they determine this based on the risk-free interest rate and the prevailing risk premiums set by external parties. Some base themselves on the Parameters Commission, which sets the expected returns to be used for pension investors. Other investment firms go (partly) from returns they have achieved themselves or their own assumptions.

Chart: Method Used

• X-axis: Number of investment firms (0 to 6)
• Categories:
  • Own assumptions
  • Combination of historical returns based on reference indices and current interest rate
  • Combination of own historical returns and current interest rate
  • Historical returns on the company's investment portfolios
  • Survey of expected returns of third parties
  • Risk-free interest rate plus risk premiums, set by the company
  • Parameters Commission
  • Historical returns per investment category, based on reference indices
  • Risk-free interest rate plus risk premiums, set externally

Investment firms use varying methods to arrive at an expected return

AFM Position
The AFM is concerned about the significant differences in the market. This may mean that a portion of the expected returns is not realistic. This can lead to expectations among investors that cannot be fulfilled.

A portion of the investment firms bases the expected return on historical returns. The strongly decreased interest rates in recent years have led to high historical returns on bonds, equities, and other investment categories. A large part of the (euro-dominated) bond universe had effective returns that were negative at the time of this research. This has led to an investment environment that is unique and deviates significantly from the environment we have known for years. The question is therefore whether historical returns can be extrapolated unaltered or almost unaltered into expected returns in the future.

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The AFM also asked what risks investment firms take into account when determining the risk of a portfolio. Standard deviation appears to be the most important risk measure for all investment firms. The majority of investment firms use CFA-VBA as a source. Figures are updated annually by CFA-VBA and the data is calculated over a long history.

Chart: Most important risk measure (multiple answers possible)

• X-axis: Number of investment firms (0 to 16)
• Categories:
  • Standard deviation (highest count, approx 14-15 firms)
  • Deviation from comparison index
  • Interest rate risk
  • Drawdown
  • Counterparty risk measure
  • 2.5% Value at Risk
  • Own risk indicator
  • Concentration risk

Most investment firms use standard deviation as the most important risk measure

Justification
This research is a follow-up to a 2020 study on the suitability of investment portfolios. The 2020 study revealed that investment firms use widely varying starting points for calculating expected returns and risks of portfolios.

The AFM bases the information in this document on a questionnaire filled out in September 2021 by 18 (bank) investment firms of various sizes. In this questionnaire, the AFM asked investment firms about the characteristics of a 'neutral portfolio', which we explain as a portfolio with approx. 50% risk-bearing investment categories and approx. 50% risk-averse investment categories. If an investment firm offers multiple concepts with a neutral profile, they were asked to provide data for the concept with the lowest entry threshold in terms of invested assets.

AFM Position
The AFM emphasizes the importance of taking into account other risks than just volatility. This research generally shows that other risks, such as currency and liquidity risk, are recognized and addressed by most investment firms. However, the AFM concludes that investment firms can look better at the alignment between their own portfolios and the assumptions used in the calculation of standard deviation.

Additionally, in-depth conversations were held with some companies, and questions were asked via email or phone to some companies for clarification. The AFM trusted the answers of the investment firms and did not verify them.

The importance of realistic expectations is also recognized by industry organizations. In the 'Guideline Investment Policy for Private Clients' from 2015, drawn up by several industry organizations, it is noted that there is an incentive for investment firms "to work with as favorable assumptions as possible because that ultimately allows a higher expected return or lower expected risk to be offered to the client. The investment firm must clearly determine on what its assumptions are based and ensure realistic expectations."