Review Your Portfolio Mix

KEY POINTS:

• Relatively low yields point to restrained medium-term (five-year) returns from traditional equities and bonds.

• This indicates the need for investors to look more broadly for sustained decent returns.

• Assets still offering relatively attractive medium-term returns include Australian shares, Asian shares, non-residential property and infrastructure.

Strategic asset allocation should be dynamic. Setting the strategic (or longer-term) asset allocation to each asset class (global shares, bonds, property, etc) within a diversified investment portfolio is the most important decision most investors make. Our assessment is that strategic asset allocation (SAA) should not be a “set and forget affair” but should be reviewed regularly. (Note that SAA, which refers to the longer-term benchmark allocation to each asset class, needs to be distinguished from tactical asset allocation, which refers to any deviations from the benchmark allocations based on the very short-term considerations '” less than a year.)

First, investment markets are subject to long-term bull and bear cycles that may last 10–20 years. This is most evident in sharemarkets, where there was a bull market in the 1950s and 1960s, a bear market in the 1970s and a bull market in the 1980s and 1990s. As such, long-term average returns, say over 100 years, provide little guide as to what will happen over the next 10 years and nor do returns for the past 10 years.

Second, as most investors’ investment horizons don’t go much beyond five years, strategic asset allocation should be set on the basis of a similar return horizon.

Finally, reflecting the longer-term bull and bear cycle, the price an investor pays for an asset can have a massive impact on the return that will be achieved over realistic return horizons. Generally speaking, the higher the starting point yield for an asset the higher the subsequent return will be.

As a result of these considerations, strategic asset allocation should be focused on the medium-term horizon, say the next five years, and be reviewed at least annually with starting point valuations being a key driver.

LOWER EXPECTATIONS

It is tempting to conclude that after three years of double-digit returns from diversified investment portfolios, we have returned to a world of sustained double-digit investment returns. However, our assessment is that this is unlikely to be the case. The economic and financial backdrop continues to point to relatively constrained medium-term returns from traditional financial assets:

In contrast to 20 years ago, equity and bond market yields are now relatively low. Current low yields for both bonds and shares contrast dramatically with the early 1980s, when Australian and US bond yields were about 14% or more and dividend yields were 6% or more (and price/earning [P/E] multiples were below 10 times). This suggests there is little scope for the sort of equity and bond revaluation that occurred in the 1980s and 1990s as the shift to low inflation led to lower bond yields and higher P/Es and thus big capital gains.

Profit margins and the profit share of GDP in Australia and elsewhere are at or around record levels. Although a collapse is unlikely, the rate of profit growth is likely to slow and be more in line with nominal GDP growth.

Finally, the shift to economic rationalist policies that helped boost profits has now largely run its course.

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. (All sorts of adjustments can be made to this formulation. But such changes are dubious or have little impact on the broad message.) The following charts show this approach applied to US and Australian equities, where it can be seen to broadly track the big swings.

For property, we use current rental yields and likely trend inflation as a proxy for rental and capital growth.

For unlisted infrastructure, we use current average yields and capital growth just ahead of inflation.

For bonds, the best predictor of future medium-term returns is the current bond yield. This framework results in the following return projections.

PROJECTED MEDIUM TERM RETURNS (%PA)
	Div yield	Growth	= Return
US equities	1.8	5.2	7
UK equities	3.7	4.7	8.4
European equities	2.4	4.7	7.1
Japanese equities	0.9	4	4.9
Asia ex Japan, equities	3	8	11
Wld, local currency, eqs	2.1	4.9	7
World, $A *, equities	2.1	5.9	8
Australian equities	3.9	6	9.9
Unlisted Property	7	2.5	9.5
Aust Listed Property	6.4	2.5	8.9
Global Listed Property ^	5.6	3.3	8.9
Unlisted Infrastructure	7	3	10
Aust Bonds	5.4	0	5.4
Aust Cash	5.5	0	5.5
* Assumes the $A falls 1% pa. ^ Assumes forward points averaging 1% pa. Source: Thomson Financial and AMP Capital Investors

The chart below plots the above medium-term returns against the expected risk for each asset class.

Key points to note are that:

• The single-digit return projections for equities and bonds reflect low starting point 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 are already high relative to GDP and P/E multiples are already high.

• In terms of return Australian equities, non-residential property generally and infrastructure come out relatively well because of their high yields. Asian shares benefit from their high growth potential.

• In terms of the risk and return trade-off, unlisted infrastructure and unlisted property come out well, although illiquidity and availability are issues for both.

• Bonds and global shares don’t come out so well.

FOR INVESTORS

What it all means is that the projected returns imply an 8% pa nominal or 5.5% pa real return for a portfolio with a traditional 70/30 mix of growth/defensive assets. Although this is well below the average of the 1980s and 1990s. it is still reasonable. These medium-term return projections are little different from our estimates over the past few years. Quite clearly, the challenge for investors remains to boost returns without taking on extra risk. From a strategic perspective, specific areas to look at remain the following:

• Maintain a bias to Australian equities. Australian shares should benefit from their high dividend yields, which are even higher if franking credits are allowed, and their exposure to China via resources.

• Favour non-US markets within global equities. Non-Japan Asian equities come with a higher dividend yield and a higher growth potential than the US.

• Maintain a decent exposure to non-residential property and infrastructure.

• Maintain a low traditional fixed-interest exposure in favour of property/corporate debt, infrastructure and cash. Low government bond yields suggest low returns from bonds going forward. One way to offset this is to take on more yield via property investments and corporate and infrastructure debt, but take on more cash to offset the extra risk involved.

• Finally, assets such as small cap shares, private capital and hedge funds should also be looked at given the potential for fund managers to add value in these areas. However, don’t forget the extra risk involved.

CONCLUSION

After three years of strong returns it is tempting to conclude we have returned to a world of sustained double-digit returns driven by equity markets. Unfortunately this is unlikely to be the case. We don’t foresee a resumption of the earlier bear market, nor are the conditions in place for continued double digit returns over the medium term. Investors need to look at their strategic asset allocation to ensure it will achieve the maximum return for their given risk tolerance. A strategic bias towards investments that provide decent yields, value adding potential and exposure to areas of strong global growth such as China remains desirable.