Sustainable investment returns & strategic asset allocation

OPINION: THE slump in shares has boosted their medium term return potential. But low investment yields generally point to sustainable returns of around 8.5% for a diversified mix of assets.

Introduction

Thanks to the credit crunch, high oil prices and rising interest rates in Australia most super funds had negative returns over the last year and investment markets remain very difficult. The current set back provides an opportunity to consider what is a sustainable rate of investment return. Such set backs also throw up opportunities in terms of the relative attractiveness between asset classes.

There’s always a cycle and the starting point matters

The chart below highlights how investment markets go through bull and bear phases that may last 10-20 years.

There are several points that follow from this:

·       First, very long-term returns measured over say the past 100 years are not necessarily a good guide as to what may happen over any 10 year period. The average real return on Australian shares since 1900 was 8.2% pa, whereas 10 year ended returns over the same period ranged between -4% and +19%.

·       The last 10-20 years is also not a reliable guide to the next 10-20 years. Eg, the dismal 1970s provided no guide to the 1980s and 90s bull market in shares.

·       As most investors’ investment horizons don’t extend much beyond 10 years, the 10-20 year investment cycle should be allowed for in setting their strategic asset allocation to each asset class. A good place to start is to look at the starting point yield for each asset class. Put simply, the higher the better.

Very high return drivers have run their course

Since the early 1980s equities and most other asset classes have generated very strong returns. The following table provides a comparison of “balanced fund” returns over the last few years with those that would have been implied by asset class returns over the last century or so.

Super normal investment returns in recent times

* Global Financial Data, AMP Capital Investors.

# Mercer Investment Consulting Pooled Fund Survey, pre taxes and fees

The 2003 to 2007 period and indeed the last 25 years saw returns well above what appears to be sustainable on the basis of returns over the last century. The key drivers were the shift from high inflation in the 1970s to low inflation which boosted equity and bond returns as price earnings multiples pushed higher and bond yields fell; the “chase for yield” over the last five years which pushed down yields on other assets and hence pushed up their returns; and unsustainably strong profit growth. All of these drivers have arguably run their course.[1] The broad downtrend in inflation appears to be over, investment yields were pushed to very low levels and profit margins and profit shares of GDP have reached record levels.

Indicative return expectations for the medium term

For most assets, current investment yields provide the best starting point for assessing likely medium term returns.

·         For equities, a simple model of current dividend yields plus trend nominal GDP growth (as a proxy for earnings and hence capital growth) does a good job of predicting medium term returns. This approach allows for current valuations (which are picked up via the yield) but avoids getting too complicated in making assumptions about whether yields (or price to earnings multiples) will rise or fall. The next two charts show this approach applied to the US and Australian equities, where it can be seen to broadly track the big swings.

·         For property, sustainable returns can be proxied by current rental yields and likely trend inflation as a proxy for rental and capital growth.

·         For bonds, the best predictor of future medium term returns is the current bond yield – because if you hold a bond to maturity the return will be the bond yield.

Using current yields, this framework results in the following medium term (ie, 5 to 10 year) return projections.

Projected medium term returns, %pa, pre fees & taxes

# Current dividend yield for shares, distribution/net rental yields for property and 5 year bond yield for bonds. * Dividend yield discounted by 5% for Aust shares and by 15% for Aust REITS assuming dividend cuts. ^ Assumes forward points averaging 1% point pa. Source: AMP Capital Investors

One drawback of this approach is if dividends are cut dramatically during tough times, as has recently been the case for several Australian companies, particularly in the highly geared infrastructure and property sectors. However, dividends for the market as a whole are normally relatively stable as most companies like to manage dividends smoothly. They rarely raise the level of dividends if they think it will be unsustainable. As can be seen below, dividends per share are relatively smooth compared to earnings. Only when earnings collapsed in the early 1990s did dividend payments fall significantly. It’s also worth noting that the dividend pay out ratio has actually fallen in Australia from just above 80% a decade ago to 63% now. While earnings may slow over the year ahead a collapse is unlikely and so a big fall in dividends is unlikely. But just as a precaution we have discounted the dividend yields for Australian shares and REITs by 5% and 15% respectively.

Implications for investors

The following points are worth noting:

·         The projected returns imply an 8.5% pa nominal or 5.5% pa real return for a portfolio with a traditional 70%/30% mix of growth/defensive assets. While this is well below the average of the 1980s and 1990s and over the 2003 to 2007 period it is still reasonable.

·         The single digit return projection for global equities reflects their low starting point dividend yields. For equities to do better either profit growth must exceed nominal GDP growth or share prices must rise faster than profits. Both seem unlikely as profits in most countries are already high relative to GDP and price to earnings multiples are high versus 25 years ago.

·         By contrast, Australian equities come out much better than global shares because Australian shares have much higher dividend yields and better growth prospects. The return from Australian shares will be further boosted by franking credits by over 1% pa and the ongoing resources boom should also help Australian shares over the next five to ten years.

·         Asian shares look particularly attractive given their relatively high dividends and high growth potential. Emerging markets generally are in a similar situation.

·         REITS or listed property, both in Australia and globally also look very attractive, even after discounting current distribution yields for potential cuts.

·         Thanks to their low yields both bonds and cash offer relatively medium term low returns.

The key implications for investors in setting their strategic exposure to each asset class are to maintain a bias towards Australian shares, favour Asian/emerging shares over traditional global equities and to favour listed property over unlisted property. In a world of high single digit returns over the medium term there is also a role for hedge or absolute return funds as the potential for returns from beta (ie, market returns) will be constrained relative to alpha (ie, the potential value added by investment managers).

By Dr Shane Oliver, head of investment strategy and chief economist, AMP Capital Investors.*

Australian Property Journal