Three years of bear markets have plagued investors across Europe and around the world. In some instances falling bond yields, driving up the liabilities, have compounded the problem. Notwithstanding the recent rally in global markets, many investors continue to question whether there is a future in equity investment.
This article questions whether investors were right to rely primarily on equities to generate returns and if so, whether this remains an appropriate strategy for the future. Following from the conclusion that equities will remain an important asset class for investors there are lessons still to be learned that would ensure investors benefit fully from a well-constructed and disciplined investment strategy.
The starting point for designing an investment strategy has to be realistically defining the objectives of the fund. In most cases for a defined benefit arrangement, these can be simplified to: pay all the benefits on time at an acceptable level and volatility of contributions. A portfolio of bonds could be held to meet the benefits (albeit with some inflation or duration mismatch), however, for most sponsors, the contribution requirements would prohibit this.
For many years, investors have used asset liability models to help decide how much equity investment to substitute for the minimum risk bond portfolio to maximise the chance of meeting the fund objectives. In order for these models to operate efficiently, an understanding must be developed of what can be expected from investment in each asset class. This needs to be expressed both in terms of the expected return and the degree of certainty with which this expectation is held.
In the planning and modeling, future expectations for each asset class are characterised by three parameters: the expected return, volatility of return and correlations. In order to test whether the outcomes were consistent with the planning assumptions, we need to test whether a realistic probability was assigned to the outcomes that have been witnessed.
Figure 1 shows the funnel of outcomes that were expected by some realistic assumptions that could have been made for equities in June 1998. The percentages show the probability of outcomes falling within each of these ranges. These are based on an assumption of an expected return on equities of 9% and a standard deviation of 17%. This implied an equity risk premium of 4%. The red line shows the actual outcome for global equities. Excluding the recent rally, it can be seen that the outcomes experienced were anticipated with a probability of about 3%. Alternatively stated, an outcome this poor would be expected to occur about once in every 35 years. A causal examination of history suggests this is reasonable, with similar outcomes in the mid-1970s and early 1930s. So, although the experience is uncomfortable, it is not clear that it has been inconsistent with expectations.
It is of course one thing to observe volatility as a statistic in a table or a chart and quite another to experience it first hand.

Are investors right to continue to rely on equities as the means of achieving a return above bonds?
In planning for the future, many investors have asked whether the world has changed in a way that affects the return expectations from investing in equities. We have seen above that the recent experience has been consistent with the expectations most investors used in planning their strategies. Investors have been reminded that equities are volatile, but continue to question whether they will be rewarded for accepting this risk through equities outperforming bonds.
There has been much academic research devoted to the subject of the equity risk premium; some concentrating on historical analysis, others devoted to constructing models based on economic fundamentals.
Most of the literature recognises that returns from equities are unlikely to be as high as were observed through the twentieth century, both in absolute terms and relative to bonds. Much of the return through the twentieth century came from increasing multiples, which is a one-off gain.
Similarly most of the literature recognises that in the long-run, holding equities must produce a premium over bonds. The return on bonds is derived from a first charge on a company’s income. The returns tend to be stable, with a high degree of certainty, but with no participation in wealth creation. Dividends on equities are derived from the residual income, giving the shareholder a geared exposure to the company’s fortunes. As such, it is clearly more risky to hold equities, which must be compensated through additional expected returns.
If equity returns are assumed not to exceed bond returns then this implies that the return on capital for businesses on average fails to exceed the cost of capital. If this occurs universally across economies, then capitalism will fail. This occurred in Argentina in the 1930s. In this event, there may be bigger issues than investment returns!

Establish a long-term investment strategy and apply a disciplined approach to maintaining it.
During the 1990s, it was not difficult to convince investors of the benefits of retaining a disciplined allocation to equities. It was much easier to demonstrate the wisdom of staying committed to the market, even when it was temporarily painful. By the end of the decade, most investors were not bailing out of equities and many were (sometimes subconsciously) increasing allocations to equities.
At this point it is much more difficult to convince any investor who did bail out – and was rewarded for avoiding a horrible market – that a disciplined investment strategy has better odds of paying off over the long term. The past four months have seen a steady rise in equity markets, well in excess of long-run expectations. This is evidence that a disciplined approach is critical. Investors who have been out of the market this past quarter will feel the effects for some time.

Are there strategies we can employ which improve the return available from holding equities?
q International diversification. As has been described, the rationale for holding a portfolio of equities is to benefit from the expected long-run premium over bonds. Having elected to assume capital markets risk, an investor should seek the most diversified exposure, improving the likelihood of earning this premium. Obviously, if at the outset an investor knew with certainty which market or security was going to provide the greatest return over the required time period, there would be no need to diversify. In the absence of clairvoyance, a diversified portfolio is the best approach to capturing the equity premium.
“Diversification has failed recently, as rising correlations have meant international equities have fared as badly as my domestic market.” Statements similar to this are often heard. It is true that correlations are high by historic standards. Inter-market correlations are at similar levels to those experienced in 1975 and 1990. History has shown, however, that current levels, based on relatively short time periods, provide a poor guide to the future. The key reason to diversify is that the home market might be the worst performer for a long time. There are a number of examples of markets showing 10-year negative returns. The easiest to remember is Japan throughout the 1990s and there were similar experiences in the UK from 1964–74 and France from 1985–95. In each one of these examples, and others, the world market produced positive returns. A diversified approach would have mitigated the losses suffered in the domestic market.
q Active management. While certainly not exclusive to equity portfolios, active management can serve to enhance the returns achieved from the asset class exposure. It is not a simple exercise to add value through active management and investors should apply the same principles to selecting active managers as those managers apply to selecting stocks for the portfolio.
Research is key. Before purchasing a stock for a portfolio, an active manager will research that stock and build expectations for its performance. The approach adopted will vary by manager; for some the emphasis is on fundamental qualitative assessment of the company; others will focus on quantitative factors; or a combination of both. Investors need to undertake a similar level of research into the managers they employ to understand from where the alpha will be derived and to identify the risks of achieving the expected level of alpha.
Diversify! When constructing a portfolio of securities, one would not hold only a single stock. This would involve accepting unnecessary idiosyncratic risk. A diversified portfolio will capture the market performance and added value, while controlling the downside risk. Designing a manager structure is an analogous exercise. Each manager can be expected to deliver market performance plus some added value. If one is confident that outperforming managers can be identified, then why take the risk of hiring only a single manager? Clearly it is better to hold several managers to increase the stability of the expected excess return.
In the same way that a stock portfolio will be constructed to minimise unanticipated and uncompensated bets to particular factors or sectors, combining active managers requires a similar approach to focus the bets on the strategies with the greatest probability of success.
q Implementation enhancements. There are a number of other straightforward techniques for picking up modest increments in return or closing down leakages which either have direct costs or result in carrying unnecessary risks.
All active equity portfolios tend to have frictional cash used to facilitate transactions or from the reinvestment of dividends. On the assumption that equities are expected to outperform cash in the long term, then this cash is expected to be a long-term drag on performance. This can be corrected simply and cost- effectively by establishing a futures overlay programme to equitise cash positions on a daily basis.
Transaction costs impose a further drag on the performance of equity portfolios. Effective control and management of these costs can further improve the returns achieved through the equity portfolio. A commission recapture programme aims to control the ongoing transaction costs that are a feature of active equity mandates. Soft commission is the arrangement whereby a manager uses some of the client’s commission flow to purchase services to support his business. A commission recapture programme involves the manager directing a part of the commission flow directly back to the client rather than using it to pay an outside party. This produces a transparent payment that benefits the fund directly.
The time when transaction costs can be at there most damaging and often least visible is during the process of transitioning from one manager to another. A dedicated transition manager can help to reduce costs and manage risks during this process in a number of ways. Firstly, a transition manager will reduce the volume of trading by eliminating unnecessary trades and then control the costs and market impact of the remaining trades through careful trading techniques.
At the time of a transition, a fund can also be exposed to significant unexpected and often unmonitored risks, including holding cash or significant stock or sector positions. Using a transition manager will reduce the risks to which the fund is exposed.
I have focused on the importance of equities as an asset for investors and the means of maximising the opportunities from equities. No analysis would be complete, however, without a discussion of the alternatives to equity investment as a return generator within an investment fund.
These alternatives take two forms: alternative asset classes and skill-based strategies. The former include real estate, private equity and commodity futures, among others. The latter would include hedge fund strategies, active currency management or tactical asset allocation.
The extent to which these alternatives will be appropriate for different investors will depend on the individual risk tolerance, understanding of strategies and in some cases regulatory environment.
For many of these alternatives it is more complex to derive return expectations, particularly where manager skill provides a large component of the investment return. Investors in all these asset classes and strategies are being rewarded for assuming some risk. However, the risk may well be less well quantified and less uniformly distributed than with traditional asset classes.
Investors looking to use alternative investments to diversify the equity risk within the strategic asset allocation need to set realistic objectives and assess the likelihood of meeting these objectives using different strategies.
The basic risk posture for pension funds and other long-term investors has been expressed through a portfolio comprising a mixture of equities and bonds. Equities will continue to play a key role in investment strategy. While asset liability models have typically used an equity risk premium in the range 3–4%, there has been an element of wishful thinking, conditioned by favourable returns near the end of the twentieth century, that the premium will be more like 5–6%.
The volatility inherent in equities, of which there has been a stark reminder in more recent history, has always been a painful feature of the asset class. Nothing in the recent history lies outside the boundary of what could have been reasonably expected.
Increasingly, investors are employing alternative strategies that seek to diversify the reliance on the equity risk premium to increase returns and reduce the cost of providing for long-term liabilities. Understanding at the outset the risks inherent in the investment strategy and maintaining a disciplined approach will over the long term provide the highest likelihood of a successful outcome. In addition, avoiding unnecessary leakages and risks in the strategy will further improve results in an environment of lower total returns.
David Rae is consultant with the Frank Russell Company in London

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