KEY POINTS:
Hands up those investors who have heard of the efficient market hypothesis?
This theory or some variation of it is one of the most important in finance. It simply argues that the combined effect of millions of investors trying to find bargains means that, in aggregate, at any
point in time the stock market will be fairly priced because everything that is known about each stock is already built into its price.
Given the degree of efficiency in the pricing of individual stocks and the effort the likes of Ibbotson and Associates in the United States and Dimson Marsh and Staunton in London have gone to chronicle and understand historic returns over the very long term, one might also think there is a reasonable level of agreement as to what future returns are likely from the market.
Just what level of return one can expect from shares is particularly important for the many New Zealand investors embarking on a long-term savings plan with KiwiSaver. How much should they save a week to provide for their retirement?
Obviously, the higher the return the less they need to save and, conversely, the lower the return the more they need to save. The compound growth rate at which savings grow is a critical variable but what is reasonable?
Common sense and investment theory tells us there are three variables determining the return from shares: the dividend that companies pay; the rate at which profits grow (remember, economic theory says the value of any asset is equal to the sum of the profits it will produce into the future); plus any movement as shares get more or less costly in terms of their multiple of earnings.
One answer to this question was published in the winter 2008 edition of the US Journal of Portfolio Management.
Written by investing legend John C. Bogle, founder of the Vanguard Group, one of the largest managed fund providers in the US, the article says returns from shares in the next 10 years will most likely average 7 per cent a year before fees, tax and inflation.
"Sure over the last 100 years stocks have averaged 9.6 per cent a year but that was made up of a 4.5 per cent dividend yield back then plus average growth in earnings per share of 5 per cent," Bogle says.
Today, the dividend yield is just 2 per cent so with profit growth per share of 5 per cent a year you can expect a total return of 7 per cent. For further comparison, Bogle shows that the high return of 12.5 per cent a year in the last 25 years is also consistent with expectations of 7 per cent a year in the future, as that 12.5 per cent return was made up of a 3.4 per cent dividend, plus 6.4 per cent growth in earnings per share, plus a further 2.7 per cent a year in speculative gain as shares became more expensive1.
The bottom line is that the return from shares is equal to the current dividend yield, which is low, and long-term earnings growth per share, which is pretty stable.
Research in the Global Investment Returns Yearbook suggests long-term earnings per share growth is on average 2 per cent less than broad economic growth as measured by GDP. Research by Rob Arnott and Cliff Asness suggests this difference is due to the creation of new shares.
Bogle then calculates that average annual fund costs - including sales commission payable to financial planners, expense ratios payable to fund managers and custodians and hidden turnover costs payable to brokers - total, in the US, 2.5 per cent a year. Inflation is forecast to be 2.3 per cent a year in the US in the next 10 years so the real return before tax is 7 per cent minus 2.5 per cent minus 2.3 per cent - that is, just 2.2 per cent a year.
All of which seems to make good sense. Indeed that view is consistent with the thoughts of various other experts such as Warren Buffett, Asness, Arnott and the trio of professors from the London Business School who produce the yearbook.
But as noted earlier, some experts seem to believe much higher returns are possible.
Another, altogether more optimistic scenario was recently proposed by New Zealand Stock Exchange subsidiary Fund Source to calculate the likely performance of various KiwiSaver plans.
Last June, the Herald, in a detailed analysis of the offerings of 26 KiwiSaver providers, estimated the terminal sum an individual earning the average wage could accrue after 40 years of saving 4 per cent of his/her annual salary of $45,147 with additional contributions from his/her employer of 4 per cent and the government hand-out of $1043 a year.
The rate of return for growth funds was forecast at 10 per cent a year pre-fees and pre-tax but after inflation by the Herald on the basis of advice from Fund Source and, using this data and their own level of costs, the various KiwiSaver providers forecast a terminal sum of between $634,000 and $1.4 million in 2007 dollar terms.
While it would certainly be nice that someone on the average wage could put aside 4 per cent of his/her wages and retire on $1 million or so, sadly, given the low yields of financial assets and the high cost of investing, this scenario does not look at all realistic.
Firstly, the 10 per cent growth rate is a nominal (with inflation) return so the terminal sum is in 2047 dollar terms rather than real terms. Secondly, as Bogle points out, international shares will probably return closer to 7 per cent pre-fees, pre-tax anyway.
So what is achievable? Besides incorporating realistic return, asset allocation and tax assumptions into a model2, the other critical variable is costs - how much does it cost to invest in KiwiSaver?
It seems the total annual fee for ASB's KiwiSaver growth plan is a reasonable 0.54 per cent a year, which includes the cost of investment management and other general expenses. The www.sorted.co.nz website says that fee is about half the cost of most other KiwiSaver options. ASB uses low-cost index funds to get much of its exposure to equities and bonds and, at 0.54 per cent, the annual charge is less than one-third of that typical of many retail savings products. If we plug this into the model the terminal sum for someone saving 4 per cent of the average wage with the standard employer contribution for 40 years in 2007 dollar terms is about $350,000.
For higher fee structures of 1 per cent and 2 per cent it's $318,000 and $275,000.
Fees are important. On a fee basis, KiwiSaver thus looks far and away the best savings medium for regular savers.
The only reservation I have is there is always a risk that some future government will only allow an annuity to be withdrawn from KiwiSaver. This happened in the UK and upset a lot of people. With an annuity the seller takes the risk that Mum and Dad live longer than average or returns from financial markets are less than forecast. Institutions thus price annuities quite conservatively to protect their profit margins.
1. In the period price/earnings ratios doubled from nine times to 18 times. As Clifford Asness points out in this column in August 2005, as shares get more expensive the prospective return from shares goes down.
2. See model KiwiSaver in IFPS personal.
Brent Sheather is an Auckland stockbroker/financial adviser and his adviser/disclosure statement is available on request and free of charge.
