Superannuation and diversified investment funds had another year of strong returns last financial year on the back of strong gains in equity and property markets.
Introduction
The past financial year saw another year of strong returns from diversified (or balanced) growth investment funds with median gains of 15.9% (after taxes and wholesale investment management fees).[1] This comes on the back of a median 14.1% return in 2003-04 and 13.1% in 2004-05. The negative return years of 2001-02 and 2002-03 are starting to seem like a distant memory.
The key drivers behind the strong returns were the continued strength in equity markets, strong returns from property asset classes and generally positive returns from most other asset classes. The same would apply to individual investors’ separately managed investment portfolios where there is a bias towards equity markets.
Naturally after such a run of strong returns there are concerns it can’t be sustained or will soon go into reverse.
Diversified fund returns v shares
Before looking in detail at diversified fund returns, there is one point worth mentioning. Over the last few years I have periodically heard it said that diversified superannuation funds have failed their investors because they have underperformed the circa 24% per annum returns from Australian shares. With respect, this is utter nonsense. Diversified funds are set up to provide a diversified exposure across a range of asset classes, along the lines of the old adage you shouldn’t put all your eggs in one basket. They do not claim to beat share markets as their objective. Fund managers also do not claim to have the perfect foresight necessary to enable them to pick the best performing asset for the period ahead and to therefore allocate all funds accordingly. If an investor is happy with having all of their funds in shares then they can put their money into equity funds or chose a “high growth” option.
Expect lower returns going forward
I will be the first to admit that I expected returns to be a bit lower over the last year, but I have been pleasantly surprised! However, just as it would have been wrong three years ago, after two years of negative returns, to assume that flat or negative returns from super funds were the norm, it would be wrong for investors to now assume that the returns of the last few years will be sustained indefinitely. The first thing to note is that the returns of the last few years are well in excess of what the long term historical record would suggest as a reasonable return expectation going forward. The table below compares nominal and real returns from a diversified growth mix of equities, bonds and cash since 1900. Since balanced funds as we know them only came into existence in the 1980s, the table uses data for equity, bond and cash returns from 1900 to provide a long term guide to “normal” returns for a typical 70%/30% growth/defensive diversified fund.
Long term returns from “diversified funds”, %pa
Period | Nominal | Real |
1900-2005 40/30/25/5 % mix of Aust equities, global equities, bonds, cash | 9.4 | 5.5 |
June 2003 – June 2006 Median balanced & growth fund, pre fees and taxes | 16.0 | 14.0 |
Source: Global Financial Data, Thomson Financial, Mercer Investment Consulting, AMP Capital Investors
History would suggest that a 5.5% pa real (or after inflation) return is a more realistic expectation going forward.
More fundamentally, there are several reasons to expect that returns will slow from the very strong pace of the last three years:
· Firstly, the strong returns of recent years look like a pretty typical rebound after a rough patch, which has now run its course. The chart below provides a long term perspective on this, showing rolling annual returns for “diversified growth funds” since the 1920s. The chart uses information for balanced and growth funds from the Mercer Investment Consulting Pooled Fund survey since 1982 and a simulated diversified fund back to the 1920s. The latter is constructed on the basis of 70% in Australian equities, 25% in Australian bonds and 5% in cash (ie, bank bills). While it excludes exposure to global assets (because we do not have a long term monthly time series for global equities and bonds), investment in international assets was limited for Australians prior to the 1980s anyway. While the simulated diversified fund series would be more volatile than a typical diversified fund of today, it nevertheless provides a good indication of the pattern of annual returns for diversified funds over the long term.
From this it is clear that periods of negative returns every few years followed by a strong cyclical rebound are a normal phenomenon. The historical record indicates that it is normal for diversified growth funds to experience a year or two of negative returns every six years, after which returns typically rebound sharply, usually on the back of stronger equity markets. This has been the experience of the last few years. After the initial rebound, returns then slowdown.
· Secondly, the low interest rates and easy monetary conditions of the last few years are now fading. Interest rates are rising in most countries and this is making life a bit tougher for share markets as the liquidity flow into share markets is slowing.
· Finally, profit growth – the major source of upside surprise over the last year – is now slowing due to rising raw material costs and slowing sales growth.
With the recovery now well behind us, the monetary environment turning a bit less friendly and profit growth slowing down, it is reasonable to expect that returns from share markets and hence diversified growth funds will slow over the year ahead. Similarly the less favourable macro economic backdrop is likely to ensure a continuation of the increased volatility we have seen over the last few months.
But returns should still be reasonable
While we anticipate more modest returns over the year ahead there is no reason to expect negative returns. There are several points to note in this regard:
· Firstly, periods of negative returns for diversified funds have been typically preceded by, or associated with, some combination of share market overvaluation, sharply rising and much higher interest rates and recession. This time around equity markets are not overvalued (eg, the price to earnings multiple for global and Australian shares remain below their ten year averages), inflation is not a major problem (beyond bananas and petrol in Australia’s case!) compared to the past, interest rates look like topping out at around neutral levels in the US and Australia and while growth may be slowing there is no sign of recession.
· Secondly, while some have pointed out that the run over the last three years is the strongest since the three consecutive years to June 1987 – ie, just before the October 1987 share market crash – it is worth noting that the magnitude this time around is much less than it was back then. Nominal post tax and wholesale investment management fee returns over the last three years have averaged 14.4% pa compared to a whopping 29.9% pa over the three years to June 1987. Similarly, real returns over the last three years have averaged 12.4% pa compared to an extremely strong 21.5% pa over the three years to June 1987. Furthermore, the recent experience was preceded by two years of negative returns and so reflects a lot of catch up in contrast to the 1984-87 period which was actually preceded by a couple of years of strong returns.
· Finally, direct property, private capital and infrastructure investments (for those funds which have a decent exposure) continue to provide strong return potential going forward.
So yes, there is good reason to expect returns to slow. But there is no reason to expect them to go into reverse. A reasonable expectation would be for a nominal return of around 9% pa over the next few years.
Lessons for investors
The biggest lesson of the past few years is to avoid the temptation to switch to a more conservative strategy after a bear market. The experience of the past few years has shown yet again that switching to cash after a bear market, as many were starting to do back in 2002-03, is not the way to maximise investment returns. Over the last three years cash has returned just 5.6% pa. Unless investors are prepared to put lots of effort into timing markets and understanding their own psychology, the best approach is to stick to an appropriate investment strategy.
Conclusion
Investors should not assume that double digit gains are here to stay. We have seen a typical cyclical recovery in returns, but higher interest rates and slower profit growth warn of a rougher and more constrained ride ahead for diversified investment funds. We expect reasonable returns from diversified super and investment funds over the next year, but they are likely to be in line with our medium term expectations of approximately 9% per annum.
Dr Shane Oliver, head of investment strategy and chief economist, AMP Capital Investors.*
[1] There are numerous surveys of super fund returns. We have used the Mercer Investment Consulting survey returns because it has a long term history. Returns after retail fees and super fund administration fees would be a bit lower but do not change the broad conclusions of this note.
