Brent Sheather: Oh dear! Forecasting long term returns

A central component in the reform of the financial planning industry is education but this notion comes with problems explains Brent Sheather. Photo / Thinkstock

As we saw a couple of weeks ago a central component in the reform of the financial planning industry is education. Good luck! One big problem with this notion is that any academic teachings that doesn't fit with the industry standard business model goes into the rubbish bin.

For example research that suggests in any way, shape or form that annual fee structure of fund managers and financial advisors might be, dare we say it, a bit high inevitably provokes a vehement response.

A fine example of this sort of behaviour occurred the other day in an exchange on a specialist financial advisors website where in a discussion of annual fees and their fairness or not an advisor argued that his monitoring fee of 1 per cent pa was fair given historic returns. Whilst that 1 per cent fee might be good value there is no way that citing historic returns is appropriate.

Let's start at the beginning. A fund manager was quoted on the website as saying that returns from a balanced portfolio would average 7.5 per cent to 8.0 per cent pa. Whilst this is possible in the short term it is highly unlikely in the long term.

Your correspondent noted that a balanced portfolio for the last 30 years has had an average asset allocation of 40 per cent bonds and 60 per cent shares. A high quality bond portfolio like that typically owned by a pension fund has a weighted average yield to maturity of maybe 4.0 per cent.

All the academics tell us global equities are priced to return 6.0 per cent pa in perpetuity. With the higher yields locally and in Australia we can assume 8 per cent from those markets to give an optimistic weighted average of 7 per cent from our share portfolio.

Given the 40/60 weighting we get a total return from a balanced portfolio pre tax, pre fees of 5.8 per cent. Knock off one or two per cent pa in fees and 8.0 per cent doesn't look all that likely. Overstating returns is an old favourite of advisors globally so much so that in the UK the FCA regulates advisor projections. Put it on the list of things to do FMA.

Nothing is certain in this world but it is a pretty fair bet that if you make any disparaging remarks about fee levels, residential property investment or gold you will receive immediate feedback from someone whose business model or belief system has been threatened.

Sure enough an authorised financial advisor, presumably qualified and who undertakes continuing professional development, disagreed stating that my numbers they were just someone's forecasts thus were of little value. He made the point that the 8.0 per cent pa figure was consistent with historic returns over the period 1926 - 2013 and elaborated that over that period international shares had returned 9.75 per cent pa and NZ bonds and hedged global bonds had returned 6.0 per cent and 7.0 per cent respectively.

That provoked an "Oh Dear!" comment from this writer because the certainty of low long term returns from financial markets going forward has been rehearsed by academics and experts ad nauseam for the last few years.

There is a huge body of research which shows that historic returns from financial markets can't be repeated unless markets fall greatly first. Luminaries such as Robert Arnott, Peter Bernstein, John Bogle, Warren Buffett, Dimson Marsh and Staunton and the authors of the Barclay's Equity Gilt Study have made that point.

So why should we expect returns from shares be lower in the future? It's not rocket science. For a start, there is the fact that just about every independent expert in the world is saying that's the case. Note we aren't forecasting next year's return or even 10 year returns because that is virtually impossible.

Forecasting long term returns however is made much easier thanks to the Gordon Growth Model. This model shows that the future long term return on shares is equivalent to the dividend yield that you buy the shares at plus the growth in dividends that will occur in the future.

Numerous studies have shown that growth in the long run is pretty constant at inflation plus 1 or GDP growth minus 1. But, historic return believers, the dividend yield today is much lower than it was in 1926. Robert Arnott and Peter Bernstein writing in the Financial Analysts Journal state that the dividend yield from US stocks back in 1926 was 5.1 per cent. Today the dividend yield is about 2.5 per cent so that is one unimpeachable reason why returns on shares will be lower in the future.

The other big reason is that in the last 100 years shares became more expensive and the simplest way of understanding that is to see that the dividend yield has dropped from 5.1 per cent to 2.5 per cent.

In a landmark paper Arnott and Bernstein reckon that shares becoming more expensive has added 1.8 per cent pa to the historic growth of shares in the past. This is highly unlikely to be repeated so now we have two reasons why future returns will be about 4 per cent pa less than those of the past. There are others but these are the main ones.

Now let's look at future bond returns. Arnott says "as with stocks we prefer to take current yields as a fair estimate of future bond returns". All he is saying is that with the 10 year US bond yielding 2.3 per cent we can be pretty confident that "buy and hold" investors will receive a return of about 2.3 per cent pa.

For 30 year government bonds the current yield is 3.05 per cent pa and that in itself is a good forecast of what returns from bonds will be in the long term. But what were 10 year bond yields in 1926? Arnott advises they were 3.7 per cent so historic returns have again benefited from a higher starting yield, a much higher average yield over the period and recently the benefit of bonds becoming more expensive.

In summary Arnott and Bernstein say : "Stock returns in the past have been extraordinary, largely as a result of important non recurring developments. It is dangerous to shape future expectations based on these lofty historic returns".

What this advisor's view really highlights is the huge failing in training for financial advisors. How on earth can someone have become qualified as an Authorised Financial Advisor, be oblivious to these facts, and rehearse the old nonsense that past returns will repeat?

This advisor isn't alone, indeed in another paper Arnott asks the obvious question - why the finance sector never underestimates future returns. Clearly this issue suggests there is a huge hole in the training of financial advisors and that is not surprising either because any training provider who had a realistic view of returns in their course material would find there was no demand for their services from financial advisors with 2-3 per cent pa fee structures.

But, hold on, it gets worse. Arnott's paper is available on the web but if you have the good sense to read it you don't get any Continuing Professional Development (CPD) credits. If however you attend a course promoting an Australian small cap share fund which alludes to an ability to produce 10 per cent pa returns in perpetuity the CPD credits come rolling in. Oh Dear.

The advisor then argued that his annual fee of 1 per cent was value for money because he provides clients with lots of help besides financial advice including assisting clients write their wills. This is a reasonable point and as we all know you get what you pay for.

So retail investors looking for an advisor need to be aware that some AFAs may not provide marriage guidance tips, cooking advice, dog walking or horse whispering but the upside is, with prospective returns so low, every 1 per cent you save on fees might mean you are able to retire a year or so earlier than otherwise might be the case.

Brent Sheather is an Authorised Financial Adviser. A disclosure statement is available upon request. Brent Sheather may have an interest in the companies discussed.