Cash Rates and Portfolio Returns

As systematic investors, we seek to continually challenge the process in order to maintain a solution which we feel gives us the best ability to meet our lifestyle and financial goals.  We understand that trying to predict the time and direction of market movements over shorter time periods is a fool’s pursuit. Any change in portfolio structure or investment approach, therefore, must be guided by a change in the evidence or our investment goals.

The interest rates set by central banks have been rising around much of the world in recent times. One will have done well to avoid such headlines in the news. 
In the UK, the base rate set by the Bank of England was just 0.1% three years ago and now sits at 5.25%, at time of writing. 
This considerable increase, much of which happened in 2022, led to historically low returns on bonds, as bonds fell in price in order to align with rising market yields. 
Despite rates not having been at such levels for some time, it is not uncharted territory. 
In fact, since 1975 rates have been above current levels more than half of the time.
For investors with medium to longer term liabilities, i.e. 5 to 10 years and beyond), these rate rises, and corresponding price falls, have significant benefits. 

Given the structure of portfolios, the - now higher yielding – bonds should get through the price falls experienced and thereafter be enjoying a higher return. It also opens up other options for savers – annuity rates and fixed term instruments now become more viable, in some circumstances. However, when it comes to the expected returns on portfolios, the evidence remains the same. We can look at historical figures to give an insight into whether there is a relationship between current rates on cash and subsequent portfolio returns.

Historical data reveals at a given level of starting interest rate, the proportion of times in the subsequent year, that the investment portfolio outperformed this starting cash rate. In essence, this is seeking to answer the question: ‘if I lock up my cash today for the next twelve months I am guaranteed x%, so why take on the additional risk of investing in a portfolio?’. 

Well, our research reveals that between January 1970 and June 2023, the proportion of periods that a 60% equity portfolio outperformed cash in the subsequent year were higher than 50%.  There is no clear relationship between the level of cash rates and subsequent outcome of portfolio returns relative to cash. Over all 1-year periods in our sample, the 60% equity portfolio outperformed locked up cash in 2/3rds of observations. The average excess return of the portfolio over cash in the 1-year periods was 4%. As we extend the holding period of our portfolio to 5- and 10-years the proportion of outperforming periods rises to over 80%. Other practical implications are worth considering. 

Locking up cash reduces liquidity, and may only be withdrawable outside of the agreed period with a significant penalty. 

Also, savers with larger sums of cash need to be wise and spread cash across banking groups to remain under FSCS protection limits. Bank failures in the US this year offer a cautious reminder to savers not to naively ignore protection limits.
In closing, risk and return remain inextricably linked.  The baseline has increased for all asset classes so please stick with the program. 

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