Equity markets can be notoriously unpredictable. Imagine a super fund’s investments team had been told 10 years ago that over the next decade US stocks would outperform international developed and emerging markets stocks, and, further, that US growth stocks would outperform US value stocks.
Would the investments team have believed them? Probably not. Yet this is exactly what has occurred.
For the 10-year period ending 31 July 2019, the Russell 1000 Index returned an average 15.58 per cent annually, while the MSCI All Country World and MSCI Emerging Markets Indices returned 11.32 per cent and 6.54 per cent respectively. Within this US equity universe, growth stocks averaged 17.40 per cent annually, while value stocks lagged growth at 13.69 per cent. That’s not what the substantial research on the equity value factor suggests should happen.
In Australia, the S&P/ASX 200, with a yearly 9.56 per cent return on average, did not keep pace with the US or an all-countries equity portfolio. But it did substantially outperform emerging markets, something that would also have surprised investment professionals based on their predictions 10 years ago.
What does this tell us about our ability to predict equity markets going forward? Once again, funds find themselves having to make predictions about what will happen in equity markets over the next decade. There will be considerable effort in feeding data into (most likely) a mean-variance optimisation framework to determine the outlook for Australian, developed and emerging market equities, relative to other asset classes, and adjust asset allocations accordingly. The process rolls on.
But where is our process taking onboard the lessons of the past decade; in particular, that we could not have predicted what happened in equity markets last decade, and may not be able to do so for the decade ahead?
Perhaps the humbling equity market experiences of the past decade require a new starting point in how super funds approach equity allocations and portfolio construction. Perhaps the important thinking about how to get the best outcomes for super fund members should begin with a brave acknowledgement that: “we cannot predict what equity markets will do over the next decade, so how do we design equity portfolios with this realisation in mind?”. Active equity managers who have struggled to deliver “alpha” in recent times do not have the freedom to adopt this new premise as a starting point for their approach to equities – but super funds do have this freedom. How could they use this freedom?
With humility as a starting premise for equity portfolio construction, two important ideas come to mind. The first is to start with the things a fund can control – fees, costs and taxes. The Productivity Commission’s report released early this year made a link between lower fees on super fund portfolios and a putative super fund member being $100,000 (12 per cent) better off in retirement. Of course, a fund (or regulator) could take this principle too far and dismiss good ideas that add value net of fees, costs and taxes simply because of an increase in headline fees – this is, surely, oversimplifying the point. We used the Productivity Commission’s own assumptions to show in our own research, published in January 2019, that tax efficiency on super portfolios could make an even higher contribution to retirement balances – around $196,000 (27 per cent). Add to this mix the idea of transaction cost efficiency – understanding whether every dollar of equity trade brokerage and other costs are valuable to the fund and are the best deal the fund can get. In prior research, we have highlighted that a wide range of “all in” trading cost outcomes is possible on Australian equities (21-119 basis points per trade) and international equities (11-32 basis points per trade).
Do funds even know how much each equity trade is costing them?
Our second idea is to be clever about how to build defence into an equity portfolio. If done cleverly, the super fund gets a healthy share of equity market rallies but limits how much the portfolio can drop in value in the event of a sudden market downturn. This idea is also more consistent with our humble starting premise and means the stakes are not so high in getting the fund’s equity market predictions right. We stress the importance of intelligent portfolio design here, which has to mean more than bearing an ongoing cost of expensive downside protection which may actually become prohibitive in cost at the time the fund needs it most.
What is striking about these ideas is that these sources of value do not rely on being able to accurately predict what’s going to happen next in equity markets. They fit well with our humble, courageous starting premise: “we cannot predict what equity markets will do over the next decade."
Super fund members are agnostic about where their retirement dollars come from. Perhaps the successful equity portfolios of the next decade will rely less on heroic equity market predictions and more on a “back to basics” look at defensive portfolio construction and the weeding out of day-to-day implementation frictions.
Raewyn Williams, managing director, research, Parametric – Australia
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