I’m concerned about product trends that I’ve noticed lately. First, some newer equity fund strategies claim to generate returns with lower volatility. Second, some bond funds – once a portfolio’s conservative core – are adopting multi-faceted and “unconstrained” strategies. My concern: unrealistic expectations.

Stock market returns have doubled or tripled since 2009. Although stocks have decent return potential over the next decade, we should expect lower equities returns in the future. Some equity funds use options to capture additional returns in a lower-risk fashion, but I’ve long been skeptical of these lofty promises.

An example is the group of covered-call strategies. Supporters argue that most options expire unexercised, so selling the options on volatile stocks can generate lots of income to add to a portfolio’s return and cushion any decline.

I examined actively managed covered-call equity funds and their passive counterparts. As expected, the income from selling options cushioned bear market losses. But the same strategies didn’t fully participate in post-bear recoveries – i.e., these strategies took much longer to recover. And because markets have spent much more time rising than falling, these strategies have disappointed.

Some newer equity funds employ “options collar” strategies. Assuming that stocks generally continue rising in the longer term, these strategies will underperform unless active portfolio managers can predict when stocks will remain range-bound and when they’re poised for a strong ascent. This is possible, but unlikely.

Similarly, bond portfolio managers are exposing newer, unconstrained funds to a longer list of risk factors in the spirit of lowering total risk exposure. This often amounts to reaching for yield. But reaching for yield eventually ends badly.

Emerging markets bond funds are a prime example. Some sponsors boasted in recent years that emerging-markets countries boasted much lower debt levels than their more mature counterparts (namely, the U.S.) and – for that reason – could be considered lower risk.

But research has shown that emerging nations historically have had a lower capacity and tolerance for debt. As a result, these issues have tended to default at much lower debt levels vs more mature economies. This invalidates the idea of assessing sovereign credit risk purely on debt levels.

Floating-rate funds seem to offer the best of both worlds: good yields with protection against rising interest rates. But most floating-rate strategies involve lots of credit risk and – more important – significant liquidity risk that’s often misunderstood.

This all means that there’s no free lunch. It’s not reasonable to expect vastly lower equities risk without a reduction in return potential. Similarly, it’s unreasonable to expect 5% bond yields in a 2.5% bond market without much higher-risk exposure.

We have to accept that future returns will be more modest compared with the recent past. Client conversations should include this reality. Your job is to control what you can to tilt the odds into your clients’ favour as much as possible to minimize the likelihood of your clients having to save more or adjust their goals. That’s a more reliable strategy than investing in exotic and risky strategies that are likely to disappoint.

Dan Hallett, CFA, CFP, is vice president and principal with Oakville, Ont.-based HighView Financial Group, which designs portfolio solutions for affluent families and institutions.

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