Hedge Clippings | Friday 25 October, 2019

Equity Returns - are investors expecting too much?

An article published in the business section of the ABC News website on Thursday provided an insight and research into investor's expectations of annual returns from the share market.  Australian investors at 10.7% came in around the global average of 10.9%, while American investors at 12.4% were more optimistic, and Europeans were more cautious at 9% (understandably, in Hedge Clippings' opinion).

The article quoted Sally, an investor who, having been invested in the local market via ETF's for the last 18 months, is happy with her return of 9% but would like a little more - in line with the survey results. With interest rates and returns on cash at close to zero, or term deposits at 2% if you're lucky, we understand the attraction of equities at around 10% plus the potential for some franking credits.

Our concern is that Sally (and others) haven't factored in equity risk, and the potential loss of her capital. Has she been lulled into a false sense of security by a market buoyed by low interest rates, and marketing of ETFs and passive investing at low fees?

Taking a look at the ASX200 Accumulation Index, she's on track over 5 years, and the same over the longer term, 25 years. However, her risk is hidden in the 1 to 5 year returns:

The sting, of course, is in the tail, or in this case the GFC, which some might consider a one-off event. However, the market fell around the same amount in 1987, and while the trigger might have been different, the pain was the same.

Those in favour of index investing and ETF's can and will say you can exit when you want to, but will Sally know when to do so, particularly when everyone else, including mutual funds, are doing the same?

So, how have actively managed equity funds performed over the same period? Taken as an average, as follows:

Whilst the may have underperformed over the shorter time frames, the key is the reduction in risk, as shown by the maximum drawdown of -23% in the GFC.

That's the average of all equity-based funds in AFM's database, but using the old "head in the freezer, toes in the oven = average" analogy, what about the top tier funds:

Of course, selecting the top funds - which can vary over time - is not easy. However, careful research, and appropriate diversification across manager, strategy, market sector and geographic region could provide Sally with attractive returns without the same level of risk.