inv-mag---feb-2011-coverEquity investments are the largest made by superannuation funds, and for good reasons. The equity risk premium, believed to be an ongoing phenomenon in listed markets, suits the needs of accumulation funds and – even better – active management promises to beat this embedded return. Or so we thought. Something has gone wrong in the last decade as markets boomed, crashed and in the end went nowhere. Does this mark the death of the great equity cult? SIMON MUMME and GREG BRIGHT report.

For the past 10 years, global equities have not delivered any returns to investors. Depending on the currency of origin, most have endured negative outcomes. For the past 10 years the world’s largest equities market, the US, has also delivered zero or negative returns. What’s going on? Even before the global financial crisis, the lacklustre performance of major markets since the technology bubble burst in 2000 caused some people to wonder whether the great equity cult of the past 50 years was coming to an end. The equity risk premium, a key phrase in the investment professional’s vocabulary, was starting to sound odd. Where was the premium? Of course the risk premium – the return from equities over the risk-free, or cash, rate – has not gone anywhere.

It’s just that the risk-free rate is so low, particularly in the US, it seems that there’s no more equity premium. The returns from bonds, until the past few months anyway, have been so high that everything else has been negative or negligible. And to make matters worse, equity market turnovers have dropped and expected returns from the three main styles of investing – value, growth and momentum – have become almost impossible to predict. Even if some active managers can consistently beat the market and even if pension funds and their advisers can correctly select those managers in advance, it doesn’t matter much if the market itself is not delivering on its embedded risk. Back in 2002, the late investing legend Peter Bernstein and champion of fundamental indexing Rob Arnott declared the 5 per cent equity risk premium, which is “embedded in the collective psyche of the investment community” was gone.

Their study, What Risk Premium Is “Normal”?, which focused on the US market, argued the lofty real returns and high dividend yields that had driven the premium had diminished, and their revival was not likely any time soon. Without unprecedented economic growth, or a massive boost in corporate earnings as a percentage of the economy, they argue that real stock returns would be about zero. Maybe even less. But in Australia, many investors are not jaded by the uninspiring equity returns of the past decade. “There has been ample evidence around the world of decades of poor returns from investing in equities. This last decade is just one of those periods,” says Ken Marshman, head of investment outcomes at JANA Investment Advisers. “However, over the longer-term, equities have delivered superior returns compared to other asset classes.” Such is the steadfast belief in equity investing, which seems to have been reinforced by the financial crisis, held by all the investment professionals interviewed by Investment Magazine for this story.

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