Maybe I am getting old and boring but one of the highlights of this job each year is reviewing the latest iteration of the Global Investment Returns Yearbook (GIRY) by three London Business School professors, Elroy Dimson, Mike Staunton and Paul Marsh.
They are the global authority on long run investment returns and their database spans 25 countries detailing the performance of stocks, bonds, bills, inflation and currency back to 1900. The 2013 yearbook incorporates data for three new countries; Austria, China and Russia. It is full of interesting information and if long term returns are your thing it doesn't get much better than this!
Whilst much of the GIRY is raw data it offers readers far more than just a 113 year historical record of the world stock markets each year you get, free of charge, views on the big investment issues on the day from three of the best investment minds in the world and what is more they are independent of any fund manager, stockbroker or financial adviser.
Given these credentials the GIRY should feature in just about every CPD (Continued Professional Development) offering in NZ it is reported in the London Financial Times and the Wall Street Journal for goodness sake. But, at least as far as I am aware, it doesn't rate a mention in any local CPD.
Why you might well ask? That is pretty obvious. The "truths" that the professors speak frequently threaten the business models of local financial planning firms and stockbrokers so there is no way they would buy any CPD that said, like this one does, that long term average stock market and bond returns are going to struggle to beat 5 per cent pa.
That sort of heretical talk will get you moved sideways in most stock broking firms. What is also sad is that because the industry has, thus far anyway, "captured the Code Committee" studying the good works in the GIRY doesn't count for structured CPD credits whereas if you go to a six hour course, sponsored by the fund manager of a small cap Croatian biotech fund with a value bias on .... you guessed it .... how your client will benefit from owning a small cap Croatian biotech fund with a value bias you do get CPD credits. This wouldn't be a big issue if advisers knew that this sort of product was stupid but because specialized funds promise high returns and high fees they love them.
All very depressing so let' get back to the GIRY and see what gems the professors have for us this year. The first chapters heading is ominous it is entitled "The Low Return World". The current "spin" in the investment world is that bonds are overpriced and shares are the way to go. Like everybody else the professors see low returns from global bonds in the next 20 to 30 years but unlike everybody else they see low bond returns as implying low returns from shares as well. That is the conclusion that the professors reach but let's start at the beginning.
First up the professors attempt to forecast returns for bonds and they advise that extrapolating from the past is ridiculous because since about 1980 interest rates have fallen dramatically thus enhancing bond returns. They say "there is a simpler and better predictor of bond performance and that is their current yield".
At the end of 2012 twenty year government bonds were yielding 2.5 per cent in the US, 2.7 per cent in the UK and in NZ, where the closest thing we have to twenty year government bonds is the 2023 government bond, the yield is 3.52 per cent. Bonds typically represent about 40 per cent of a local pension fund's portfolio spread equally between NZ and overseas. If this sounds bad the professors reckon the prospective return on cash is even worse and they deduce this from looking at the yield curves of long dated bonds and spot rates.
All this is very complicated but the end result is that they reckon that the prospective real return on cash in the US is going to be less than zero. The professors are also sceptical of the simplistic view (frequently held by people who want to sell you shares) that global bond yields are artificially low suggesting that many of the alleged short term distortions are likely to be permanent and they argue that given the main factor causing the distortions, quantitative easing, is well known then they wouldn't expect an immediate rise in yields once it is withdrawn.
Where the commentary gets really interesting however is when the professors forecast expected returns on shares. They show that historically returns on shares have moved proportionately to real interest rates ie. when real interest rates are low like they are now prospective returns from shares are also low.
The professors state the obvious the theory says the return on shares is equal to the risk free rate of return plus the risk premium and that "it follows that if the risk free rate is low then the return on equities should also be low". They then compare two thousand odd historic observations of real interest rates and the real return from shares and bonds in the next five years.
The data shows that low real interest rates are associated with low returns from shares and bonds in the future. So to put a number on future returns they forecast that shares are going to exceed returns on cash by 3-3.5 per cent per year over the next twenty to thirty years and they reckon cash will produce a negative real return of about 0.5 per cent over twenty years.
The difference between ten year US government bonds and similar maturity US government inflation indexed bonds is 2.55 per cent. This figure is the market's expectation for US inflation in the next ten years. If you think this is conservative consider that US inflation has averaged just 2.19 per cent in the last ten years according to Bloomberg and the current rate of inflation is 1.7 per cent pa. Putting all this together the professors' forecast return from shares for the next twenty years is equal to inflation (2.55 per cent) less the real return on cash (-0.5 per cent) plus the equity risk premium (3.0 per cent-3.5 per cent) to give a forecast figure of 5 per cent-5.5 per cent pa.
If we are optimistic and assume a 3.5 per cent return for a blended portfolio of international and local high quality bonds we get a prospective return for a portfolio invested 40 per cent bonds and 60 per cent equities of just 4.7 per cent pa. Let's be clear that this is pre-tax, pre-inflation and pre-fees.
The Financial Services Authority in the UK stipulates what level of return advisers can use in their projections for clients. After reviewing this year's yearbook they have lowered the base case rate to 5.0 per cent for a portfolio two thirds invested in shares. The professors conclude "to assume that savers can expect large wealth increases from investing over the long term in the stock market is delusional."
With annual fees of 2-3 per cent pa implicit in most financial plans offered in NZ today it is easy to see why it is unlikely that the GIRY will be included in CPD offerings anytime soon.By Brent Sheather Email Brent