INVESTING in equities has often been held up as a means to generate wealth in the long run, but new research finds that expectations of long-term returns are still far too optimistic.
If so, the finding has major implications for savers, pension funds and even fund-management firms as it raises the prospect of pressure for lower fund fees.
"To assume that savers can confidently expect large wealth increases from investing over the long term in the stock market - in essence, that investment conditions of the 1990s will return - is delusional," say the study's authors, Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School.
The study, The Low Return World, is published in the Credit Suisse Global Investment Returns Yearbook 2013. It looks into what equity risk premium might be reasonable going forward, based on world equities rather than US alone.
While long-run expectations of equities may be muted, the asset class still offers an 'enormous' pick-up over bonds and cash.
Giles Keating, Credit Suisse's head of research for private banking and wealth management
Until recently, it was thought that the annualised equity premium over bills was 6 per cent. This, says the study, was strongly influenced by the Ibbotson Associates Yearbook in early 2000, which showed a historical US equity premium of 6.25 per cent between 1926 and 1999. This number appeared in textbooks and was applied worldwide to the future and the past.
But this figure overstates the long-run premium for the United States, say the authors. Between 1900 and 2012, the premium was a percentage point lower at 5.3 per cent, as the early years of the 20th and 21st century were disappointing.
Also, focusing on the US reinforces the upward bias as the US was the most successful economy of the 20th century.
The Credit Suisse yearbook covers 22 countries and three regional markets. Three new countries are included - Austria, Russia and China. The academics' estimate of world equity premium ex-US is significantly lower at 3.5 per cent. After adjusting for non-repeatable factors, the study infers that investors can expect an equity premium relative to bills of 3 to 3.5 per cent on a geometric basis. This implies an arithmetic mean premium of 4.5 to 5 per cent.
Giles Keating, Credit Suisse's head of research for private banking and wealth management, says that while long-run expectations of equities may be muted, the asset class still offers an "enormous" pick-up over bonds and cash.
Higher inflows
In recent months, investors have actually rotated out of cash into equities, and this is reflected in sharply higher inflows.
"The professors make an important point that. . . Even if the equity premium is as low as 3.5 or 4.5 per cent, that's in a low return world where bond yields don't give much more than cash. In that sense investors have very little choice. (Equities) still offer a decent pick-up compared to elsewhere."
Equities also offer a significant premium over inflation, he adds. "Compounded over time, it still spells a large increase in value of your fund."
There are also opportunities over the next one to three years that investors can be alert to. "There is enormous potential for money to keep flowing into equities and equity multiples to expand, and expand probably above the long-term average. . . As earnings grow, you can get a very handsome return from equities well in excess of the 3.5 per cent long-term rate. One needs to balance the long term against realities on the ground."
Meanwhile, the study points out that while institutional investors' top concern is the low-return world, many appear to be in denial. Target returns remain too high and fund managers still state that their long-run performance objective is to beat inflation by 6 to 8 per cent. These claims, says the study, are unrealistic.
In the UK, the Financial Services Authority (FSA) stipulates projections of 5, 7 and 9 per cent before costs for a notional product two-thirds invested in equities and the balance in fixed income. After analysis of yearbook data and other data, the FSA has reduced the assumed returns that can be used from 2014 to 2, 5 and 7 per cent.
"The middle, or most likely, rate of 5 per cent is closer to what we would regard as realistic, though it is noteworthy that the 'pessimistic' projection is still for positive returns," say the authors.
For savers, a low-return world suggests that they will have to save significantly larger amounts to reach their goals. There are also implications for asset managers. "If the fee for a retail savings or personal pension product is 1 per cent, then it may be eating up as much as half the gross real return. Eventually this has to translate into demands for asset managers to cut fees."
In a separate study on mean reversion, the authors look into whether investors can profit from it through market timing signals. Mean reversion refers to the tendency of markets to revert to some long-term trend line. This typically is manifested in bounce-backs following periods of poor performance, and the expectation that strong performance presages a reversal.
The study concludes that having examined the long-term historical evidence for return predictability, "much of the popular evidence for mean reversion is attributable to optical illusions that employ perfect hindsight". The process of mean reversion, in any case, may take a long time. "Since we do not know whether prices have hit their peak or trough, investors may have to be patient for a protracted period until historical norms resume. Worse still, in some cases those norms may never recur. . . We cannot know in advance what valuation level is going to prevail at some point in the (possibly very distant) future."
For most investors, including pension funds, the aim is to save over a number of years, to grow the assets and eventually withdraw the assets over a long period. "For such investors it is helpful to adopt a framework that offsets the temptation to follow the herd."
Dollar cost averaging, say the authors, ensures that some assets are bought at the bottom and relatively fewer assets are bought at the top.
This should be combined with a disciplined spending or withdrawal rule "which smooths the amount taken out of the fund, (and) can ensure that portfolio withdrawals do not give rise to excessive withdrawals at the bottom of the market".
