Case 003Strategic and tactical allocationWarm up

A family office asks: if you had to put Rs 1 lakh into one asset for ten years, which would it be? Build the expected return for bonds, equities, gold and a REIT from building blocks and choose.

InvescoDallas · 2023

The situation

The chief investment officer of Dhruvtara Family Office gives you four choices for Rs 1 lakh held for ten years, and these inputs, all illustrative. A ten-year government bond yields 7.0%. The equity index has a dividend yield of 1.3%, real earnings growth of 6% a year and inflation of 4.5%, and trades at 23 times earnings, which you expect to settle at 18 times by year ten.

Gold is expected to earn inflation plus 1%. A listed office REIT yields 7% and its rents are expected to grow 3% a year.

Your task

Build an expected ten-year return for each asset from its parts, then choose one and defend the choice.

Quick check

Roughly what does the equity index return a year once the de-rating is included?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

The equity index, at about 9.4% a year, with the de-rating already inside that number. Bonds give 7.0%, gold 5.5% and the REIT shows 10.0%, but the REIT's figure assumes its yield never moves. Hold it to the same standard as equities and a drift from 7% to 8% takes it to about 8.7%. Rs 1 lakh in equities at 9.4% becomes about Rs 2.45 lakh.

Step 1How do you turn a vague question into an answer you can defend?

Break every asset's return into the pieces that produce it, so you compare mechanisms rather than moods. For anything that pays income, ten-year return is roughly the income yield, plus the growth of that income, plus or minus any change in what the market pays for it. A flat you let out works the same way: rent as a share of the price, plus how fast rent rises, plus whatever happens to flat prices per rupee of rent in your area.

Step 2What do the blocks give for each asset?

Bonds are the simplest: a ten-year government bond held to maturity returns close to its 7.0% yield, whatever happens in between. Equities add a 1.3% dividend, 6% real earnings growth and 4.5% inflation, 11.8% before valuation. Then comes the block people forget. A multiple falling from 23 to 18 times over ten years costs 2.42% a year, taking equities to about 9.4%. Gold has no income, so inflation plus 1% gives 5.5%. The REIT adds a 7% yield to 3% growth, 10.0%.

The relationship
(1823)1/10−1=−2.42%1.3+6.0+4.5−2.42≈9.4%\left(\frac{18}{23}\right)^{1/10} - 1 = -2.42\% \qquad 1.3 + 6.0 + 4.5 - 2.42 \approx 9.4\%
18/23the ending multiple over the starting one
1/10spreads the change across ten years
1.3, 6.0, 4.5dividend yield, real earnings growth, inflation
What it says in wordsA price that falls by the ratio of the two multiples over ten years loses about 2.4% a year, and that comes straight off equity's return.
Ten-year expected return, built block by block, % a year04812Yield7.0= 7.0%Govt bondsDividend 1.3Real growth6.0Inflation4.5De-rating-2.423x to 18x= 9.4%EquitiesInflation4.5+1 1.0= 5.5%GoldYield7.0Growth3.0= 10.0%REITif yield7 to 8%: -1.3Blocks add approximately; each stack is a yearly return over ten years
Equities build to 11.8% before valuation and about 9.4% after the multiple falls from 23 to 18; bonds give 7.0%, gold 5.5% and the REIT 10.0%, or about 8.7% if its yield drifts from 7% to 8%.
Step 3Why not pick the REIT, which shows the highest number?

Because the comparison is not like for like. You charged equities for a falling multiple and charged the REIT nothing. A REIT's yield is its valuation: if the market demands 8% instead of 7% by year ten, the price falls about 12.5% and the return drops to about 8.7%. Its rent growth of 3% is also below 4.5% inflation, so the income shrinks in real terms every year, and one office REIT is a narrow bet on one kind of building against an index spread across the economy.

AssetExpected return, % a yearRs 1 lakh after 10 years, Rs lakhReal return, % a year
Government bond7.01.972.5
Equity index, after de-rating9.42.454.9
Gold5.51.711.0
REIT, yield unchanged10.02.595.5
REIT, yield drifts to 8%8.72.304.2
Rs 1 lakh grows to about Rs 2.45 lakh in equities after the de-rating, Rs 1.97 lakh in bonds and Rs 1.71 lakh in gold; the REIT's lead disappears once its own valuation is allowed to move.
Step 4How do you close?

Give the pick, the margin and the thing that would change it. Equities win by about 2.4 points a year over bonds, and that margin rests almost entirely on the de-rating assumption. If the multiple held at 23, equities would return 11.8%; if it fell to 15, the drag would be 4.2% a year and equities would barely beat bonds. A client who cannot sit through a 30% fall in year three would be better placed in the bond, because a ten-year horizon only helps someone who stays for all ten years.

Where candidates lose it

The usual loss is adding dividend, growth and inflation for equities and stopping at 11.8%, as if today's multiple were permanent. Valuation is the largest single block over a decade and the one interviewers are listening for.

The mirror error is charging one asset for valuation and not the others. The REIT looks best only because its yield was treated as fixed while the equity multiple was allowed to fall.

What the interviewer asks next

  • What ending multiple would make equities and the government bond return the same?
  • Why does a bond held to maturity have no valuation block, and when does it get one?
  • How would you build the blocks for a corporate bond with a default rate of 1% and a 40% recovery?
  • The family office pays tax on bond interest each year but on equity gains only at sale. How does that change the ranking?

Asked at Invesco, Real Estate, Dallas, 2023 (Wall Street Oasis): If you had a $1 today, what would you invest it in?

Company names and figures are illustrative.