Brent Sheather: Things that make you go hmm

Many people investing for the future, certainly those who read the Herald, have heard that the present era of low inflation and high share and bond prices means prospective investment returns will probably be low too.

Whatever the coming years hold, investors might be wise to expect less of the same. At any rate that's what many of the academics writing in investment journals have been saying. But exactly what does this new world mean if you are about to retire in NZ and intending to live off your savings?

Don't expect too much in the way of intelligent comment on the subject from the local savings industry, as most participants have huge vested interests and desperately cling to the fantasy of double-digit returns - commodity funds being the latest manifestation of this sort of wishful thinking.

While research in the US and UK shows that funds with high management fees generally achieve lower returns after fees, the reality here is that the higher the fees your financial adviser charges, the higher their "forecast" returns are likely to be too, so as to project a worthwhile result after those fees are paid. To acknowledge the reality of low returns is usually to admit that one's fees are far too high.

For this reason, fund managers and financial planners are loath to acknowledge the era of low-inflation, low-return investing. The marketing goes sure the dividends are low but, get real, you buy international shares for GROWTH and that has been spectacular over the long term.

Excessive optimism wouldn't be a problem if mum and dad could see it for what it is - salesmanship. Unfortunately, many believe their advisers and genuinely expect double-digit returns from their portfolios over the long term. When they fail to materialise, they get depressed and sell out, usually at the bottom which just compounds the problem and gives the savings industry a bad name.

But before we mortgage the house to buy an international share fund, let's rehearse the arguments for those low returns, one more time. International shares have returned about 6.7 per cent a year after inflation over the last 100 years in US dollar terms. So is it safe to assume 6.7 per cent real from our international share portfolio?

No way says an influential report in 2002 by two US academics, writing in the Journal of the US Society of Investment Analysts. Historic returns were an aberration due to several non-recurring events.

Economics tells us that returns equal the dividend yield plus the rate at which those dividends grow. Dividends on international shares today are about 2.5 per cent. In 1900, dividends were about 4.2 per cent a year. Returns also benefited to the extent of about 2 per cent a year by rising valuations.

The (g) component - real dividend growth was only good for 0.6 per cent a year. Today, dividends are 2.5 per cent and, even if we optimistically assume 1.5 per cent pa real dividend growth, we get to 4 per cent real. Add inflation at 3 per cent and that is a 7 per cent nominal, pre-tax, pre-fee return.

The disturbingly low dividend growth has also been confirmed by a British study, written by three London Business School professors and entitled Triumph of the Optimists. The study calculates returns for 16 major stockmarkets over 101 years. In real terms, averaged out over the entire sample, dividends fell rather than rose. So much for the growth illusion.

Cliff Asness, PhD in finance from the University of Chicago and former research director of Goldman Sachs, writes in the journal that high share prices today means lower future returns for two reasons: dividends are low and because valuations regress towards their average (lower) level.

This analysis was confirmed by Tim Bond, investment strategist for Barclays Capital, writing in the 50th issue of the Barclays Equity Gilt study who adds that the current low yields on bonds suggests negative real returns over the next 15 years.

In the UK, the chief regulatory body, the FSA, is aware of the tendency of investment advisers and fund managers to overestimate returns. So they have ruled that advisers have to use the FSA-approved returns in their projections less actual costs. In the FSA's opinion, the appropriate pre-tax, pre-fee, pre-inflation returns for bonds and shares are 4.5 per cent and 6.5 per cent respectively.

So, with all this academic evidence suggesting that double-digit returns from international shares and bonds in the long run are about as likely as peace in Iraq, what level of returns do the local financial planning industry experts use in their forecasts of mum and dad's retirement savings?

You might think you were still in the early 1900s judging from a financial plan from one of NZ's largest firms which crossed my desk last week. The plan forecast total returns of 5 per cent a year after tax, inflation and fees which sounds modest enough. But with inflation of 3 per cent, tax at 33 per cent and annual fees of around 3 per cent a year, this means the portfolio would have to earn 15 per cent a year to deliver 5 per cent real, after tax and fees.

An extraordinary forecast. To get to a 15 per cent return on the whole portfolio when half of it was in bonds yielding 6.5 per cent, the financial planning firm was actually forecasting 23.5 per cent a year from its international share portfolio. Hmm.