Investors’ faith in bonds can lead to long-term loss – report – Nairametrics
Nigerian pension fund administrators have favored the fixed income market for 13 years, adopting an almost 100% allocation to debt instruments. Despite the profitability of fixed income securities, long trends and studies by portfolio managers show a considerable risk of capital loss.
Predicting the results of investments is a difficult endeavor as economic and financial variables change for market participants without warning. Empirical evidence, sensory assessment and a bit of luck therefore tend to influence the allocation of capital by asset class.
Therefore, in the absence of definitive empirical evidence, the guidelines of the Nigerian Pension Commission (“PENCOM”) are anathema. In Nigeria, mutual fund managers have their investment guidelines, and pension fund administrators (“PFAs”) have guidelines stipulated by PENCOM in seeking return and asset allocation. significant.
These were disclosed in a study titled “The Curious Case of Nigerian Asset Allocations,” published in 2021 by the author, Oladayo Oduwole. The study reviews the results of various asset allocation programs in Nigeria over the past 35 years. Nigerian stocks have generated an average annual real return of 3.52% over the past 35 years without including dividends.
During the review period, the Nigerian economy experienced periods of excessive inflation, causing yields on bills and bonds to lag behind. Bonds and bills produced a negative real return. If appropriate inflation management measures are implemented, Nigeria’s long-term inflation rate is expected to decline from its 35-year average of 18.20%.
According to this research, despite the higher rate of return on equities, the significant decline in the market over the past fifteen years has resulted in a reduction in terminal portfolio levels for biased equity portfolios. With negative returns on bills and bonds over the past 35 years, portfolio managers may need to rethink their asset choices.
What do Nigerians currently hold?
According to the report, “Financial assets in Nigeria held by mutual fund managers and PFAs are currently unbalanced with a bias in favor of bonds and similar instruments. This type of pronounced allocation is problematic because it conflicts with long-term empirical asset returns and may lead to reduced levels of final wealth for retirees if the equity asset class performs better over the years. next two decades.
Nigerian Style Asset Allocations Today
In Nigeria, equity contributions to pension assets have increased from 30% to 9% over the previous 13 years. The current rules given by PENCOM to fund administrators show a bias for government securities. Should a government regulator be biased in favor of government securities, although historical real returns for the asset class have been detrimental? PENCOM’s current investment standards set a global limit of 70% in government securities for Fund II assets. Prior to 2010, the overall limit for investments in retirement savings accounts was 100%, according to Itodo (2014).
For the past 35 years, the simplest approach for Nigerians has been to invest primarily in debt securities in the hope of increasing contributions to their portfolio. A more sophisticated system incorporating a bond and an option, known as PPN (Principal Protected Notes) beats the debt-only strategy because it captures the best stock returns while avoiding the large drawdowns suffered in 2008 and beyond. . The PPN strategy also has the largest cash return multiple of any equity or debt allocation approach.
What do we know about the historical world and Nigerian asset returns?
According to the report, in 2019, a group of researchers released “a rate of return on everything,” the results revealed that in 16 advanced economies since 1950, stocks have generated the highest rate of return, followed by housing with government bills returning the lowest rate of return. The shares returned in absolute terms 9.45% per year. The researchers’ work covered a period from 1870 to 2015, with returns reported in dollars.
For “world returns”, before 1950, housing offered the highest rate of return to investors or asset owners. If the history of the last 145 years were to repeat itself, the rates of return presented would have to repeat themselves with a slight variation.
In Nigeria, the recorded history of financial instruments is much shorter. The Lagos Stock Exchange was incorporated in September 1960, with trading beginning in June 1961 with six government bonds, one industrial stock and three stocks. The Lagos Stock Exchange price index was not calculated until 1984.
From 1985 to 2020, stocks returned 3.52% per year in real terms, while bonds returned minus 2.51% in real terms and bonds returned less than 4%. 37% in real terms each year. The stock return was derived from the Nigerian All Stock Index, published by the Nigerian Stock Exchange; the bills are drawn from average historical treasury bill rates, and bond yields are a mix of several federal government instruments and the S & P / FMDQ Nigeria Sovereign Bond Index during the reporting period.
Is there a correct portfolio allocation?
The report stated, “It’s hard to say there is a right or wrong asset allocation for a portfolio. Allocations are subject to various factors; however, one can suggest the types of allocation that may generate the highest risk-adjusted return.
The financial literature suggests various allocations; Thaler and Williamson (1994) suggest a 100% allocation to stocks in a portfolio to generate the highest risk-adjusted return, regardless of obvious losses. Asness (1996) proposes a 60/40 leverage scheme, where 60% is invested in stocks and 40% in bonds but with the leveraged portfolio.
Traditionally, investors have been advised to hold a 60/40 allocation and other variations in the management of their portfolios. “
What the report says
The nearly 100% capital allocation to fixed income securities in Nigeria has been beneficial over the past 13 years (2007-2020).
However, a 35-year review suggests that a more sophisticated asset allocation system may be a more sustainable approach to capital allocation. Looking at other markets with a longer history, the primary debt allocation pattern may be problematic in the medium term.
The report said, “A dynamic reallocation favorable to similar equities and opportunities is expected to be pursued in the future. Questions should be asked about the wording of the PENCOM guidelines as they do not conform to the empirical evidence on real returns and allocations to assets with the highest real returns.
The past 35 years in Nigeria have shown that investor portfolios should be skewed in favor of investing in equities, emphasizing the potential declines that weigh on investor returns.
A simple hedging system should be introduced in the composition of assets invested in pensions. The current allocation could lead to terminal wealth levels 10-20% lower than they should be. For those looking to improve their performance, a well-balanced portfolio of foreign stocks and some commodity contracts for the low-carbon economy could improve long-term performance.
A regulator’s insistence on its guidelines may require a catch-up fund if it turns out in two decades that the specified allocations are problematic and flawed.
What are the experts saying?
Udegbunam Dumebi, a bond trader at United Bank for Africa Plc said the Nigerian situation is more complex due to the high levels of uncertainty in the economy and the stock market.
“While diversifying your portfolio is a good idea, loss aversion plays a huge role for investors. Indeed, the uncertainty of the stock market can cause investors to lose all of their money. However, this is not the case in the Nigerian fixed income market. Therefore, fund managers should be responsive to the dynamics of the Nigerian market and only favor more stocks when there is a strong indication of economic normalcy ”, he said.