The equity risk premium is as high as it is because investors are looking at portfolios too often, according to Daniel Grioli, portfolio manager at Labour Union Co-Operative Retirement Fund (LUCRF).
Historically, the equity risk premium the market delivers tends to correlate with a 12-month horizon.
“If we genuinely were long-term investors and we cared more about the income that our portfolio would deliver in retirement, rather than the balance today, we would probably hold more in growth assets and probably be happy to pay more for those assets at a lower premium,” Grioli said.
Interestingly, he adds when equity risk premiums are discussed, in some ways, the wrong thing is being talked about.
“The real story is what’s happening with interest rates, because if you look at what investors are requiring in terms of the equity return they expect it’s a fairly steady 8 per cent.
“But the equity risk premium has widened because bond yields and expectations are now so low, that’s actually what is driving a widening in the equity risk premium.”
The danger of this is that if rates stay low there is a possibility that investors gradually will say it is not possible to earn 8 per cent and they start adjusting expectations downwards, with the market continuing to get more expensive.
“[However] I would say it’s more likely that the interest rates rise, and if the rise is accompanied by inflation as well, and you don’t see a corresponding growth in sales and earnings for companies, then that equity risk premium will get compressed and come in low, which is bad for returns.”
Good for the future
Ironically, this is good for the future because valuation is a key component to future returns, Grioli adds.
“They will be disappointing compared to the historical 5-6 per cent, but then that might set things up to be better in the future after that.”
If investors are moving into a world where the equity risk premium is going to become lower – assuming that happens because of an interest rates rise – then there are two major options for investors.
“You can say I’m earning less from equities, and the risk and volatility has gone up as the premiums are compressing, so therefore I want to diversify as broadly as possible and cut my cost, and essentially go passive.”
“Or you can say ‘well the market itself is not giving me the return I need, so therefore I have to hire very active managers that do things very differently and try and get my extra return through out-performance’.
“People are increasingly going to go one of those two ways.”