Paul Marsh: live with low returns

The London Business School’s emeritus professor of finance Paul Marsh admits that you have to be slightly mad to embark on the kind of research detailed in the latest edition of Global Investment Returns Yearbook. This year Marsh and colleagues Elroy Dimson and Mike Staunton – Marsh describes the three of them, pictured below, as “old men with an interest in financial history” – have pulled together over a century’s worth of historical data spanning 25 countries to forecast what investors can expect in the future from delving into the past. It’s a historical  perspective tracing returns in stocks, bonds, inflation and currencies that doesn’t bode particularly well for institutional investors in the coming 30-odd years. “The high equity returns of the second half of the twentieth century were not normal, neither were the high bond returns of the last 30 years, nor was the high real interest rate since 1980. While these periods may have conditioned our expectations, they were exceptional,” says Marsh.

Exuberance is over

Since the 1950s investors have enjoyed “pretty good” returns on bonds and high real equity returns of around 6 to 7 per cent. Since 1980, equities have done well apart from disappointment in Japan, but real bond returns have been “incredibly high” at close to 6 per cent. “World bonds actually beat world equities,” says Marsh. “Investors would have done marginally better in bonds over a period equities have also done very well. Even cash has been wonderful.”

But from a historical perspective, the high bond returns since 1980 were more a blip than anything normal. “Real returns will revert to 1 per cent, not the 3 per cent we have gotten used to over last 30 years of bonds,” Marsh forecasts. He puts real returns for long-term index-linked bonds at zero or marginally negative. Reflective of their riskier qualities, long-term conventional bondholders can expect a marginally positive return. The prospect for cash is marginally negative. “Don’t think of 2 to 3 per cent real interest rates on cash as something we are going to get back too.” 

Similarly, equities offer little relief. “Equities won’t bail you out,” he warns. Colour-coded lines on Marsh et al’s historical charts indicate that low interest rates imply low prospective returns on all assets, including equities. “When real interest rates are low, real equity returns can also be expected to be low,” he says. “We have shown that there is a strong association between low real interest rates and low subsequent equity returns, and high real interest rates and high equity returns.” The trio estimate that the prospective real return on world equities has fallen to 3 to 3½ per cent per annum in the long term, disputing those asset managers promising 7-per-cent returns or higher still, as in the US where Marsh says forecasts are “plain crazy”. He isn’t swayed by the fantastic returns investors have enjoyed in equities in recent months or talk of a great rotation. “It doesn’t pull the rug from under us,” he says. “There is zero relationship between the first few months of a year and the rest of the year. Our prediction is that the rest of 2013, and the next generation, will find it tougher in terms of returns.”

Historical data shows that volatility damps down surprisingly quickly after shocks like the 1987 crash when stock markets around the world plummeted, or the recent financial crisis. “The world will not stop shocking us but the remarkable thing about volatility is that it reverts to its long-run average quickly after a shock.” He suggests that for “serious long-term investors” with horizons beyond 10 years strategies to manage volatility may not be worth the cost. Only for funds with a particular need for cash at distinct points in the future would strategies to manage volatility actually pay off.

Learning to live after the golden age of returns

Marsh qualifies their findings: “The projections we have made for asset returns over the next 20 to 30 years are simply our own best estimates. They will almost certainly be wrong, but we cannot predict in which direction. There will also be large year-to-year variations in return and they should be viewed strictly as long-run forecasts.” They aren’t compatible with short-term optimism or pessimism about particular asset classes, he says. However, as long-term forecasts for the next 20 to 30 years, he is convinced their estimates are realistic.

His advice to investors in a low-return world is diversity. He doesn’t recommend any smoothing of assets and says pension schemes should put away a lot more now than they did in the old days. He also warns funds to be wary of consultants peddling strategies that are more likely to increase costs rather than returns. Funds seeking yield are also said to be on the wrong track. High yielding equities or risky corporate bonds take investors into higher risk areas. “High returns need higher risk strategies, but these don’t guarantee higher returns,” he says. His message to investors is to “live with it”.

Part of the challenge is the fact institutional investors have grown used to a golden age of returns. But Marsh says the returns are still there to be had. “If we are right and investors get an equity risk premium of 3.5 per cent over the next 20 years, they will still double their money over any cash returns.” All figures are also in real terms, so add inflation and returns on equities look bigger. “Other academic figures agree with us. We might be gloomy in our predictions, but we are not alone.”