Old rules still apply for equity risk premium

The equity risk premium has come in for some renewed analysis in the past couple of years as investors attempt to reconstruct their portfolios to defend against any future fat-tail events.

When correlations headed towards one at the start of the global crisis in 2007, some investors even questioned the relevance of Modern Portfolio Theory (MPT), which espouses the benefits of diversification.

Key questions are: what should the equity risk premium be? And how can investors achieve genuine diversification in a portfolio to make it more robust in a crisis?

Greg Bright

The CFA Institute (for certified financial analysts) has produced a helpful book which revisits some of the traditional theories and tenets of investing post-crisis, appropriately titled ‘Investment Management After the Global Financial Crisis’. The authors interviewed many academics from around the world for their views on lessons from the crisis.

A common theme is that the theories which have stood the test of time, such as MPT, also stood the test of the global financial crisis. The problem was not the theories but rather what investors had actually bought. Low-risk and lowly correlated fixed-interest instruments turned out to be high risk and highly correlated with other markets, including equities.

In its client note on the major issues for 2011, Mercer Investment Consulting suggests that investors will review their reliance on the equity risk premium and/or home-country bias (see separate report). The consultants say that diversifying away from developed markets and home country will improve the efficiency (risk/return) of portfolios, especially when low-volatility strategies are overlaid.

While it is true that some low-quality fixed interest securities fell alongside shares in the crisis, quality bonds did not. The important diversification of mixing bonds with equities, as in MPT, survived intact.

But after more than a decade of no returns from global equities, in a net sense, pension funds must wonder whether they are worth the effort. The book will comfort those who believe they are.

The US share market had an average return of 9.0 per cent in the 50 years between 1950 and 1999. But when you include the tech wreck (2000-2001) and the first half of the financial crisis, the average return drops to 6.8 per cent for the period 1950 to 2008. This is still higher than the average between 1900 and 2008, which was 6.0 per cent. Going back even further, the US market averaged 6.1 per cent between 1821 and 2008.

More importantly, the difference between the returns from bonds and equities has been fairly volatile. This is what most people regard as the equity risk premium – compensation for the possibility of loss of capital.

In the golden 50 years for equities, between 1950 and 1999, the average return for bonds was just 1.5 per cent, implying an equity risk premium of 7.5 per cent. But in the slightly longer period of 1950-2008, bonds averaged 2.4 per cent, for an equity premium of 4.4 per cent.

Interestingly over the very long period, between 1900 and 2008, bonds averaged 1.8 per cent, producing an equity risk premium of 4.2 per cent.

The excess return from shares – the difference between equities and bonds – over any rolling 10-year period in the past 50 years has varied between minus 10 per cent and plus 20 per cent.

The good news, though, is that the old maxim of mean reversion has also stood the test of time. Most long periods, of 10 or more years, of low or negative returns have been followed by longish periods of much better returns.

‘Investment Management after the Global Financial Crisis’ is available through the Research Foundation of the CFA Institute: