History delivers the best returns

History is bunk according to Henry Ford but the same doesn't necessarily apply to the financial world where history can often provide valuable pointers to the future. For a financial planner, having a well-founded view of the likely future returns from financial markets gives a basis of confidence on which to frame advice to clients. And that, in the uncertain world we work in, is a major competitive advantage.

Of course if hindsight were converted into perfect foresight all of us would be investment geniuses. But then if it were possible to look at the past and accurately forecast the future perhaps clients would have no need for investment advice.

The benefit that advisers offer their clients is that as professionals they know the limitations of history as a predictor of future returns.

They know how misguided it is simply to extrapolate from historical data and assume that the years ahead will be a repeat of years past.

At present large sums of money are pouring into equity-based funds. Why is this important now? It is because the evidence suggests that, without proper guidance, clients are in danger right now of taking on undue and unnecessary risks in their portfolios.

Research data from Assirt for the year end to March last year and the year end to June this year show that despite the bull run that has led Australian and overseas sharemarkets into fully-priced, and in many cases over-priced territory, more and more investors' portfolios are being channelled into equities.

The figures show that inflows into cash have dropped by 36 per cent and into fixed interest by nearly 500 per cent, while inflows into Australian and international equities have both risen by more than 200 per cent.

In an examination of inflows for pension and annuity products it appears even older investors are becoming more tolerant of risk. Of all the multi-sector products, it is the equity-oriented offerings that are attracting the biggest increases in new money.

What should we infer from these numbers? Are clients really becoming so much less risk averse? Or has the industry become so good at selling the equities story that clients really expect the boom times to continue indefinitely and to receive double-digit returns even when inflation is below 3 per cent?

In this case history can help us form rational expectations of future performance. Certainly there are limits on how useful history can be.

That doesn't mean we can't apply some relatively simple analysis to past performance and come up with some sensible expectations of what the future, such as the next 10 years, is likely to look like for different asset sectors.

This is exactly what Jack Bogle, founder of the Vanguard Group, has done in the US with remarkable accuracy for rolling 10-year periods dating back to the 1930s. The methodology Bogle uses is equally applicable to the Australian market.

Bogle's simple proposition is that equity and bond market returns can be attributed to three key factors, one of which is already known at the start of the forecasting period. So by making reasonable estimates of the other two variables we can, with a fairly high degree of confidence, generate forecasts of likely returns for asset sectors and, therefore, different portfolios over periods of a decade or more.

For equities, for example, the three vital factors are: the initial dividend yield; the rate of growth in earnings; and the P/E effect as measured by the change in the price/earnings ratio.

Bogle's back testing showed that these factors had a correlation of over 0.95 with actual US sharemarket returns over at least six decades.

Bogle's analysis has a lot of advantages over more complex models. It is simple, it is mathematically sound and it produces reasonably stable outputs (in other words, the range of possible outcomes is not so wide as to be useless). Note that the emphasis is on portfolios of securities and the long term. Bogle would not, and we should not, attempt to apply the analysis to individual securities or to periods much shorter than 10 years.

When we input our assumptions and apply Bogle's method to the Australian and US equities sectors we come up with the following forecasts for the decade ahead if PEs stay at current levels of 19.5 and 29.6 respectively.

Australian shares will show growth in their EPS of 5.5 per cent per annum while US shares will return a figure of 7 per cent. Income for these sectors will be 4.5 per cent and 1.2 per cent per annum giving annual returns of 10 per cent and 8.2 per cent respectively.

As the data shows, even if PEs stay at current levels for the next decade, equities returns are likely to be much lower than the past decade.

However we expect PEs to drop back to more sustainable multiples, having run up during the 1990s to levels far in excess of their long-term averages.

If this occurs, we expect shares will deliver returns that are little better than risk-free bonds over the decade

In our view, the funds flow data and the relaxed attitude to equity exposures are all danger signs of clients taking on inappropriate and unwarranted risks.

The risks are inappropriate because the over-weighting to equities leaves them exposed to the high volatility that we expect from overheated equity markets. The risks are also unwarranted because we don't believe they will be sufficiently rewarded by way of higher returns.

This analysis goes some way to explaining Macquarie's view that the best strategy for current market conditions is to be defensive in growth assets and aggressive in income assets. We believe this strategy will reduce the chance of clients becoming unnerved by volatile equity markets or disillusioned with the returns they get for the degree of risk in their portfolios.

<I>Tim Farrelly is an executive director at Macquarie Investment Management