STATS.
TABLE 1: ASSET CLASS RETURNS: JANUARY 1989 TO DECEMBER 1998
EQUITIES (INCLUDING DIVIDENDS)* BONDS** COMMODITIES**
Emerging US Investment High
UK US Japan markets Germany Treasuries Grade Yield
Annual return 17.5% 20.9% -3.9% 11.7% 16.6% 9.9% 10.1% 11.4% 5.1%
Standard deviation 15.3% 13.4% 21.7% 24.5% 19.4% 4.3% 4.6% 6.1% 16.7%
Return / SD 1.14 1.56 -0.18 0.48 0.86 2.29 2.19 1.86 0.31
Source: Bloomberg, Russell calculations. * In local currency except emerging markets which is in US dollars ** In US dollars
“Blindly allocating a large part of assets to equities would have
resulted in enormously disappointing results over the past decade”
concepts of market effi ciency which assert that indicate that pension funds allocated about 60% to
prices fully refl ect all available information. equities in the latter part of the 1990s and that this
proportion had been rising for about 10 years, as
WHERE DID IT ALL GO WRONG? shown in fi gure 1.
Investors do not know with certainty the pattern of Yet blindly allocating a large proportion of assets to
future return streams and so must form expectations equities (based in part on expectations formed using
about how diff erent assets will perform. One way in history as a guide) would have resulted in enormously
which expectations are formed is based on historical disappointing results over the past decade.
experience. At the end of 1998 an investor may have
formed return expectations for the following 10 RETURN EXPECTATIONS AND RATIONALITY
years based on the experience of the preceding 10 Could an investor reasonably be expected to have
years. Th is is shown in table 1. anticipated a decade of poor returns? Th ere are a
Th ese numbers could then have been used to number of tools one could use to help answer this
construct an effi cient frontier. For example, a question, ranging from the simple to the
portfolio comprised of 70.8% US equities, 7.5% exceedingly complicated.
high-yield debt and 21.7% in US treasuries is the One of the most basic methods would be to
point on this effi cient frontier with annualised appeal to the mean reversion of PE ratios. A
volatility of 10%. Had an investor owned such a potential problem is that earnings may be infl ated
portfolio at the end of 1988 and held it (with or depressed by the stage of the cycle, so it would
monthly rebalancing) until the end of 1998 it be desirable to adjust the basic PE ratio
would have generated attractive annual returns of accordingly. Following Graham and Dodd, one
17.7%. However, applying these weights to the could smooth the earnings stream over the cycle by
10-year period starting in January 1999 would taking a longer term average over, say, 10 years
have yielded annual returns of only 1.1% with (PE10). An alternative methodology assumes that a
annualised volatility of 11.2% – much less competitive economy will support an equilibrium
attractive, if not downright disappointing. return on equity (RoE) above which capital is
Based on the belief that higher-risk assets attracted in, so driving down returns, and below
generate higher returns, it is standard practice which capital is driven out, allowing returns to rise.
within the fi nancial industry to recommend that Th e PE ratio can then be adjusted to take this into
investors with longer-term horizons dedicate a account. Both adjusted PE measures are shown in
larger proportion of their assets to higher-risk fi gure 2 alongside the unadulterated PE ratio.
investments. Data from the Federal Reserve Figure 3 shows how the RoE adjusted measure
24 SUMMER 2009
23-27 mean variance.indd 24 1/6/09 11:50:44Professional Investor Summer 09.26 26 4/6/09 15:40:55
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