By Andrew Perrins Long-term returns are relatively easy to forecast. Short-term returns are dominated by randomness, but long-term forecasts for most asset classes can, in part, be derived mathematically (give or take some arguing about the assumptions). But why bother with long-term return expectations – for example, 10-year forecasts? For most multi-asset managers or tactical asset allocators, 10 years is an eternity. Investment managers are judged on much shorter time frames. For asset owners or asset managers compiling a strategic asset allocation, however, long-term forecasts are relevant and necessary. When combined with estimates for risk and correlation, these forecasts allow investors to fine-tune their long-term benchmarks and consider trade-offs between asset classes to enhance the implied risk and return profile of the fund. In the following table, I have aggregated the results from three major asset managers – JP Morgan , Northern Trust , and BNY Mellon – that publish their long-term return forecasts for major asset classes. Here are the average expected returns: Average Long-Term Return Forecasts Asset Class Average Forecast (per annum) US inflation 2%-2.5% US cash 2%-2.5% US 10-year bonds 2%-2.5% Commodities 2%-3% Hedge funds 4%-5% US equities 6%-7% Global equities 6%-8% Private equity 8%-9% Let’s think about how these estimates are derived and whether they are realistic. Fixed-income securities are the obvious starting point. If we buy a 10-year Treasury today with a redemption yield of 2.5% and hold it to redemption, we know that the return will be 2.5% per annum (assuming that the US government doesn’t default). The Return from US Equities Now, let’s consider US equities. The simplest expression of the truly long-term return from US equities follows a classical formula, as described by Richard Grinold and Kenneth Krone r: Long-term return from equities = Dividend yield + Inflation + Real earnings growth Long-term return from equities = 2.0% + 2.25% + 2.25% = 6.5% So, at first glance, if you believe the assumptions – that inflation will be around 2.25% and that dividends will grow pretty much in line with long-run GDP expectations – then the forecast above is reasonable. What’s not to like? Let’s unwrap this in more detail. First, should we adjust for buybacks? In reality, the payback to long-term (buy and hold) investors will be both in dividends and in capital return from share buybacks. It’s reasonable to assume that substituting buybacks for dividends makes no substantive difference to total long-term returns, although some of the publications linked in this post explore the building blocks behind this in impressive detail. Second, is it reasonable to assume that dividend growth (or earnings growth) will keep pace with the real economy? Can the profit share of GDP hold at its current level? A recent report from McKinsey & Company is forecasting that more competitive world markets will trigger a 20% fall in global profit share by 2025. Also, even if profit share holds near to recent highs, can the companies that currently make up the index maintain their own profit share as new players and technologies emerge? My personal expectation is that earnings growth will not match real GDP growth in the long run. You may have your own view. Third is the question of equity market valuation. If we are considering a finite time horizon (let’s say 10 years), then our formula above only holds if the dividend yield remains constant. If it is likely to change, we need to make a valuation adjustment. It is for this reason that the estimate of long-term US equity returns from from our fourth research publication is starkly different from those above. Rob Arnott’s team at Research Affiliates forecasts that, over the next 10 years, the valuation of the US equity market (as measured by the Shiller CAPE ratio) will revert halfway back to its long-term average. This implies a valuation adjustment of 2.4% per annum. When added to a dividend yield of 2% and their estimate of dividend growth of 1.4% per annum, this gives a prospective 10-year total return from US equities of just 1.0% per annum. Whom do you believe? Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.
We humans are doers. We want to move, to make, to accomplish, to act. We do not take kindly to sitting idly by. We do not enjoy being bored and most of us struggle to sit quietly alone. It is increasingly easy to distract ourselves, to push away the quiet. Unless I’m asleep I am within arm’s reach of my phone about 95% of the day. Why sit quietly when Twitter and Instagram await?! Last year I read 10% Happier: How I Tamed the Voice in my Head by Dan Harris (at the recommendation of this post by Shane Parrish at Farnam Street). It is a great reflection on the difficulty of our busy lives and our ability to focus and slow down. Harris, after having a panic attack on national television, explores a path towards meditation and trying to relieve his anxiety. In doing so, he finds that meditation is hard. It’s really hard. Sitting and trying to focus on a single thing (typically breathing) without being distracted by thoughts of work, family, hobbies, to-do lists, dentist appointments and everything else. We are just not very good at doing nothing. This is especially true as investors. And we really don’t like it when are portfolios do nothing. We’re sitting in the doldrums right now. Returns everywhere are nowhere. Here’s a quick rundown of 12-month returns through 9-15-15: S&P 500: 1.77% Russell 2000: 3.05% Barclays Aggregate Bond: 2.32% MSCI EAFE: -6.34% MSCI Emerging Markets: -23.58% US Real Estate: 1.89% Other than Emerging Markets being pretty painful, those are some pretty unexciting numbers. A weighted average of those for a balanced investor is probably going to put you in the -3%ish range for twelve months. A little painful, but probably not panic-inducing for most. And yet, it itches. You get your statement and look at the numbers and it just tickles your nerves a little bit. “Should I do something?” it asks. “What’s not working?” it wants to know. “Have I made a mistake?” “What should I do?” “How do I fix it?” They are quiet questions, but there they are, lingering in the back of our minds. We only get one chance at this investing thing, and we’re terrified that we’ll get it wrong. We’ll miss out on opportunities or hire the wrong advisor or buy at the wrong time or have to listen to our brother-in-law at Thanksgiving talk about how he nailed it AGAIN this year. Hopefully, we have the other voice too. The calm, rational one that reminds us that we have a plan. A pretty well-thought-out plan. A plan that involves boring years and periods where returns don’t meet our expectations. This voice should remind us that we knew about that going in. It doesn’t necessarily make it easier to remember that, but it ought to handcuff us. Even though we simply hate to do nothing, we should. We are not built for it. We are built for action! If it looks broken, fix it! The problem is that what “looks broken” to us is based on our desperate need for immediate gratification and split-second feedback about our decisions. But split-second feedback makes us absolutely terrible investors. In the moment, we can’t take the long view, so we need to listen to our past selves about why we made the plans we did and how we already know what to do in these situations. Generally: nothing.
By Valentin Schmid Leave it to the pros. That’s what mutual fund companies tell the layman when he wants to invest in the stock or bond market. After all they know better, right? Right. However, they don’t know better than the benchmarks they are supposed to outperform, according to a recent study by Standard and Poors, the parent of the famous S&P 500 index. For the period of June 30 2014 to June 30 2015, 65.34 percent of U.S. large cap equity portfolio managers underperformed the S&P 500, which was up 7.42 percent. They did even worse over 5 and 10 years, when 80 percent of fund managers didn’t manage to beat the benchmark. The same is true for fixed income and municipal bond funds as well as international stock funds-a large majority of them underperform their benchmarks over different periods. Why? Gordon Gekko from the 1987 movie “Wall Street” thought he knew the answer: “Ever wonder why fund managers can’t beat the S&P 500? Cause they’re sheep, and sheep get slaughtered,” he opined. Maybe it’s just the opposite. Of course, you can’t accuse fund managers of being greedy, which Gekko would have said was good, but it has to do with the fees they charge for their management. They are relatively modest, around 1.15 percent on average per year, but that amount alone is often enough to make the difference between being better than the index or not. On top, you have hidden trading fees (brokers usually charge funds 0.2 percent on stock trades, which is directly deducted from the fund’s assets), and market impact: this means the stock price goes up if the fund is buying in large quantities. The S&P 500 doesn’t have these problems. It just exists in a computer database. S&P collects the prices of the stocks and calculates the index in a massive excel spreadsheet. No trading costs, no market impact, and no fees. And it gets even better: By definition, companies that do poorly just get kicked out of the index (because their market cap declines) and strong companies on the rise get included, again at no cost, whereas the mutual funds have to turn over a good chunk of their portfolio to make the necessary changes. So what can you do? Obviously investing in the S&P 500 spreadsheet, which doesn’t have all the costs won’t do any good, but there are lower cost alternatives. John Clifton Bogle, former CEO of the Vanguard Group pioneered the concept of index trackers. They slash costs to the bone and just replicate the index. This will still cost you, but it will cost you much less than people charging more and failing to beat the index. Over 10 years, Vanguard is the winner : “For the 10-year period ended June 30, 2015, 10 of 10 Vanguard money market funds, 48 of 52 Vanguard bond funds, 18 of 18 Vanguard balanced funds, and 110 of 121 Vanguard stock funds-for a total of 186 of 201 Vanguard funds-outperformed their Lipper peer-group averages”-without even trying. (click to enlarge) An infographic showing the hidden fees in 401ks. ( Personal Capital )