Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 21

Managing for real returns

I have previously made the case that real return outcomes are crucial for those saving for retirement and living off their retirement savings. Yet institutional super funds do not explicitly manage the risk of real return outcomes. The typical mix of assets in a default super fund results in the risk to real outcomes (that is, the returns adjusted for inflation and the more important outcome) being greater than the risk to nominal outcomes (that is, returns before adjusting for inflation, a less important outcome). This article explores the concept of managing for real returns.

In a nominal return portfolio construction framework, investors think of the major asset classes as follows: cash is our risk-free asset, bonds are a defensive asset class which should perform well in a difficult economic environment, and equities are a growth asset which participates (less consistently than you may think) in the strength of the broader economy.

As a result we see higher levels of risk, as displayed in the rolling nominal return volatility table below. Table 1 below looks at the volatility of annualised returns for both nominal and real outcomes over a period from 1900 to 2012.

Table 1: Volatility of annualised returns for different asset classes (1 January 1900 to 31 January 2012).

Asset Class Volatility (Nominal) Volatility (Real)
Cash 3.9% 5.4%
Domestic Bonds 10.7% 12.1%
Australian Equities 17.7% 17.7%
Global Equities (unhedged) 18.7% 17.6%

Source: Schroders; “Why SAA is Flawed?” March 2012, Schroder Investment Management.

The nominal results are in accordance with the expectations described above. However, the returns from bonds and cash have, over the very long term, been more volatile than one may expect, since the last 20 years has been a period of low volatility for these asset classes. Once we switch our mindsets to focusing on the risk to real return outcomes, the risk profile changes:

  • The historical real return from cash is more volatile than the nominal return, which may surprise, given the current setting we have become accustomed to whereby the Reserve Bank adjusts the cash rate to control medium term inflation.
  • The return profile of nominal bonds becomes more volatile when viewed from a real return perspective rather than a nominal return perspective. The reason why is that in high inflation environments it is common to see nominal bond yields rise (based on inflation expectations). Rising bond yields results in falling bond prices so investors in bonds may take two hits in an inflationary environment: the purchasing power of their capital falls (due to rising inflation), and the value of their nominal portfolio falls.
  • The return profile of equities remains volatile when outcomes are viewed in real terms. There is no clear pattern whether companies are able to pass on input cost increases (including labour). Indeed there are many other factors at play such as government policy and macroeconomic effects such as changes to exchange rates and interest rates. So we see the volatility of real outcomes remain high.

Overall, when we are focused on managing the risk to real return outcomes we are considering outcomes relative to inflation. In this sense inflation becomes what we call the numèraire (the basis for comparison). Observing and hence managing nominal return risk assessment is easier because risk is measured as variability in the nominal outcomes. When considering real return risk assessment, we need to consider the nominal return against the inflation outcome. That is why nominal bonds appear more risky in a real return context: they often experience negative returns at the same time that inflation is high (so a double whammy), as illustrated previously.

In terms of other assets and investment strategies:

  • Inflation-linked bonds are often viewed as a low risk investment when we are focusing on real return outcomes. However this is only true over a long term holding period. Over shorter periods of time indexed bonds often have very long maturities and carry significant duration risk, so the short term variability in the bond price may be quite large even though the risk to inflation outcomes is offset by the indexation of the coupons payments. This is an important consideration if you have a range of investors in a fund all retiring at different times (we call this sequencing risk, as discussed in Cuffelinks on 6 March 2013).
  • Real assets are often regarded as good inflation hedges. Examples include property and infrastructure where the income stream may be linked to inflation. However the real outcomes could still be volatile due to other factors. For example, if interest rates rise significantly in response to inflation, the asset price may fall if based on a discounted cash flow technique.
  • Investments in commodities are also viewed as inflation hedges. There is logic to this argument but there will still be large variability as there are many supply and demand factors (besides inflation) which affect commodity prices.

Overall the challenge of managing real outcome risk is significant. Managing real outcome risk is more complex than managing for nominal outcomes (because the numèraire, inflation, is itself a variable quantity). It creates the challenge to think more strategically about inflation itself and the role of each potential investment in different inflationary environments. The starting point of a real return focussed asset allocation framework would be:

  • Create expectations of real returns for each asset class. For each asset consider the underlying ability for its return stream to change with inflation.
  • Consider the risk to real return outcomes for each asset class. How could each asset class perform in different inflationary environments?
  • Consider the likelihood for the inflationary setting to change.

I’m yet to see any super funds that explicitly manage for real outcomes. There is also an opportunity for asset consultants to frame their asset allocation advice in this manner as well. There are some managed funds in the real return or target return space that are heading down this path. There is a significant leadership opportunity for super funds to manage real return risk and ultimately improve the outcomes of those in Australia’s retirement income system, where the inflation risk represents a potential erosion of their retirement outcomes.

This is the third of three articles which makes the case that we need to have a greater focus on real return outcomes. Simply stated, real return outcomes are more volatile than nominal outcomes, and of course have been lower. However there is a dangerous tail risk element evident as well, due to periods of higher inflation. By explicitly targeting real return risk we are better positioned to manage the risk that most directly relates to retirement outcomes.

 

RELATED ARTICLES

Hold the champagne, that’s not a recovery yet

The utmost importance of real returns - but does the industry care?

The role of financial markets when earnings are falling

banner

Most viewed in recent weeks

16 ASX stocks to buy and hold forever, updated

This time last year, I highlighted 16 ASX stocks that investors could own indefinitely. One year on, I look at whether there should be any changes to the list of stocks as well as which companies are worth buying now. 

2025-26 super thresholds – key changes and implications

The ABS recently released figures which are used to determine key superannuation rates and thresholds that will apply from 1 July 2025. This outlines the rates and thresholds that are changing and those that aren’t.  

Is Gen X ready for retirement?

With the arrival of the new year, the first members of ‘Generation X’ turned 60, marking the start of the MTV generation’s collective journey towards retirement. Are Gen Xers and our retirement system ready for the transition?

Why the $5.4 trillion wealth transfer is a generational tragedy

The intergenerational wealth transfer, largely driven by a housing boom, exacerbates economic inequality, stifles productivity, and impedes social mobility. Solutions lie in addressing the housing problem, not taxing wealth.

What Warren Buffett isn’t saying speaks volumes

Warren Buffett's annual shareholder letter has been fixture for avid investors for decades. In his latest letter, Buffett is reticent on many key topics, but his actions rather than words are sending clear signals to investors.

The 2025 Australian Federal election – implications for investors

With an election due by 17 May, we are effectively in campaign mode with the Government announcing numerous spending promises since January and the Coalition often matching them. Here's what the election means for investors.

Latest Updates

World's largest asset manager wants to revolutionise your portfolio

Larry Fink is one of the smartest people in the finance industry. In his latest shareholder letter, the Blackrock CEO outlines his quest to become the biggest player in private assets and upend investor portfolios.

Economy

Australia's economic report card heading into the polls

Our economy grew by a nominal rate of 7% per annum from 2017 to 2024, but it benefited from the largesse of fiscal and monetary policies, both of which are now fading. We need a new, credible economic growth agenda.

Preference votes matter

If the recent polls are anything to go by, we are headed for a hung parliament at the upcoming federal election. So more than ever, Australians need to give serious consideration to their preference votes.

SMSF strategies

Meg on SMSFs: Tips for the last member standing

It’s common for people as they age to seek more help in running their SMSF if their capacity declines. An alternate director may be a great solution for someone just planning for short-term help in the meantime.

Wilson Asset Management on markets and its new income fund

In this interview, Matthew Haupt from Wilson Asset Management discusses his outloook for the ASX, sectors such as REITs that he likes, and his firm's launch of a new income-oriented listed investment company.  

Planning

‘Life expectancy’ – and why I don’t like the expression

Life expectancy isn't just a number - it's a concept that changes with survival rates over time. This article breaks down how age, survival, and societal factors shape our understanding of life expectancy, especially post-Covid. 

The shine is back on gold, and gold miners

Gold mining stocks outperformed in 2024 and are expected to do well in 2025. At this point in the rally, it's worth considering what has driven gold prices higher and why miners could still have some catching up to do.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.