KEY POINTS:
Most of us are or should be wary of salesmen promising us returns of 10 per cent a month.
If it sounds too good to be true, it probably is. But the same investment practitioners who tell us to beware of high returns are often happy to endorse their latest "fund manager of the year" on the basis that they have achieved extraordinary returns for the last three years or whatever, with, of course, the obligatory disclaimer in small print that past returns are not indicative of the future.
There are a 1001 reasons why the savings industry needs to perpetuate the myth of high returns from shares. These range from the obvious - competing for funds from the residential property alternative to the not-so obvious like the fact that higher assumed returns mean some companies have to contribute less to their corporate pension schemes. Overestimating the forecast returns from shares is endemic in the savings business and represents a fraud on a huge scale. But the pay-off is enormous - high returns or, at least, the promise thereof, mean you can charge high fees.
So what sort of return can we expect from a diversified international share portfolio before fees? The world stockmarket returned 19.2 per cent in the 2006 calendar year.
Everyone can be "fund manager of the year" at this rate. Or maybe we should take a slightly longer-term perspective - in the five years ending December 2006 the same index fell 0.2 per cent per annum. Better to have had the money in the bank. Fortunately, the trio of professors from the London Business School, Dimson, Marsh and Staunton (DMS), have just published some new research looking at just that question over the period 1900-2005.
Their conclusions, based on the most extensive database available, are obviously more realistic than the couple of years of good luck behind the performance of the average "fund manager of the year".
Even so, they caution that there are a number of features of the last 106 years of data that make even using these numbers to forecast future returns problematic.
But first the results. Using DMS' new database of long-run stock, bond, bill, inflation and currency returns for 17 countries over the 106-year period shares returned on average in US dollar terms a premium of 4.7 per cent per annum above that of short-term treasury bills.
But their best estimate for the future is just a 3-3.5 per cent per annum equity risk premium which, in the context of even the present high short-term US interest rates of 5 per cent, suggests a sustainable, long-term return before inflation, taxes and management fees of just 8-8.5 per cent per annum. Deducting typical New Zealand management, mastertrust and monitoring fees of 3 per cent leaves 5.5 per cent for Mum and Dad, before tax and before inflation.
But why do the professors calculate a historic 4.7 per cent equity premium over short-term Government bills but estimate just 3 per cent or so for the future and how is that relevant to someone saving for their retirement here?
DMS argue that the historic 4.7 per cent number is not indicative of future returns because certain factors supporting the performance in the 1900-2005 period will not persist, specifically:
* Shares became more expensive in terms of the price/dividend ratio by 0.6 per cent per annum over the 1900-2005 period. Shares obviously can't keep getting more expensive forever, thus the future risk premium should be 0.6 per cent per annum lower than historic.
* Current dividend yields are much lower than the long-term average of 4.2 per cent. Adjusting to present levels would reduce the risk premium by "at least 0.5 per cent to 1 per cent".
The significance of DMS' work for Mum and Dad, retired in Tauranga, is that with a risk premium of 3 per cent and a fee structure of a similar magnitude, investors are better off forgetting international shares and sticking to a direct investment in government bonds or even, dare we say it, residential property.
The harsh reality of high fees in a "normal" return world is that for New Zealand investors typical annual management and monitoring fees will eliminate the risk premium on international shares for the average retail investor.
This sort of practical advice should be all over the Retirement Commissioners website and a core component of their efforts to educate the public on a sensible savings strategy. Annual fees are much too high.
Simply advising Mum and Dad to save for their retirement via managed funds whereby they incur high fees and high risk for no additional return is arguably the single biggest reason so many investors drop out of long-term savings plans.
Brent Sheather is a Whakatane-based investment adviser
