Twenty years ago, the long-term investment approach of many private individuals was simple: construct a large portfolio of equities, add a little cash and fixed interest as you get older, and sit back and wait. Or, better still, sit back in a leather armchair at your stockbrokers and have a discretionary portfolio manager do this for you – while you wait.
The strategy has served many investors well, delivering a return from UK equities of just under 300 per cent, or 5.6 per cent a year compound, as measured by the FTSE 100 index between November 1 1987 and October 31 2007. But, as the events just preceding and just following that period also show, long-term investing is not without its short-term volatility.
So, more recently, individual investors have been advised to adopt a lower-risk, more diversified “institutional” approach: construct a portfolio of lowly correlated assets, monitor it regularly, and be more active in managing your tactical asset allocation. This strategy has served hedge funds and pension funds well over longer time frames. And now, thanks to the new products and services, it is delivering lower-volatility long-term returns to the private investor, too.
“If you were a long-term investor 20 years ago, a broker might have said to you: ‘Have a bit of UK equity through a direct share portfolio, chuck in a few gilts, and have you thought about a wine cellar?’” says Mark Dampier, head of research at independent financial advisers Hargreaves Lansdown. “But the market is so much more sophisticated now. There are more asset classes in the armoury, more weapons at the disposal of wealth managers than ever before.”
One reason for this is that asset managers are sharing the latest research findings with their clients – and much of the latest research points to a less equity-intensive approach. In the past, however, private investors were encouraged to base their long-term
plans on the past performance of equities, studied in isolation. It was all that the fund management houses provided in the way of data, and all that individual investors – who lacked the research resources of institutions – had to go on.
So, during the bull markets of the 1980s and 1990s, a preference for heavily equity-weighted portfolios held sway, based on two fundamental tenets. First, over the long term, the reinvestment of share dividends would provide rising real returns. Second, the equity-risk premium – defined as the excess return on shares relative to the return on relatively risk-free Treasury bills – was above 7 per cent and would remain significant.
As a result, the textbook investment theory was to increase equity exposure in line with your investment term. Burton Malkiel, in his classic investment study A Random Walk Down Wall Street, recommended “more common stocks for individuals early in the life cycle” and “the longer the time period over which you can hold on to your investments, the greater should be the share of common stocks in your portfolio”.
In the US, many investors followed the advice of The Wall Street Journal Guide to Planning Your Financial Future, which advocated that the percentage of wealth they have in bonds should be no more than their age. In the UK, some IFAs used the corollary that clients’ percentage equity holdings should be 100 minus their age.
However, this thinking has been revised by academic and institutional research over longer periods. Elroy Dimson, Paul Marsh and Mike Staunton of London Business School have estimated that the equity risk premium is lower than the 7 per cent quoted in many surveys. In a recently revised paper, they explain: “We use a new database of long-run stock, bond, bill, inflation and currency returns to estimate the equity risk premium for 17 countries and a world index over a 106-year interval. Taking US Treasury bills (government bonds) as the risk-free asset, the annualised equity premium for the world index was 4.7 per cent…. From a long-term historical and global perspective, the equity premium is smaller than was once thought.”
A further distortion of long-term investment performance is the survivorship bias inherent in stock markets. In a paper for the Yale School of Management, William Goetzmann and Philippe Jorion pointed out that the rate of capital appreciation seen on US markets had to be “subject to survivorship, as the United States is arguably the most successful capitalist system in the world”. By contrast, the median real appreciation rate for other countries was about 1.5 percent.
But too much long-term investment strategy has been based on short-term data. “With the exception of one country, namely, Japan, real equity returns between 1990 and 1999 were typically high,” writes Prof Dimson. “Over this period, US equity investors achieved a total real return of 14.2 per annum, increasing their initial stake five-fold. This was a golden age for stocks, and golden ages are, by definition, untypical, providing a poor basis for future projections.”
But more worryingly, these long-term strategies ignore the timing and volatility risks that clearly existed for private investors in 1987, and exist again today. As Ravi Jagannathan and Narayana Kocherlakota of the Federal Reserve Bank of Minneapolis put it: “They have to be concerned about the potential for enormous losses that can be incurred by holding stocks over long periods of time. In fact, in a well-defined sense, portfolios composed entirely of stocks may become less attractive over longer horizons to households that are sufficiently risk averse.”
It is this combination of a lower equity-risk premium and the volatility of an equity-heavy portfolio that is now leading more asset managers to recommend a mix of asset classes. In 2004, Simon Benninga, Iddo Eliazar and Avi Wohl of the Leon Recanati Graduate School of Business concluded: “If risk premia are as small as predicted… then an all-stock portfolio has very undesirable properties: the probability that, in the long run, all-stock portfolio returns underperform bonds or the returns of a mixed portfolio becomes very large. There exist mixed portfolios, which almost surely outperform both an all-stock portfolio and an all-bond portfolio.”
It was about the same time that many UK asset managers started putting more assets into the mix. “The obvious things to buy were hedge funds,” says Mr Dampier of Hargreaves Lansdown. “Until recently, they were only really available to the seriously wealthy or professionals. Now, private investors can get in with the first-class people.”
Hedge funds, if they use short-selling strategies and hold assets that have low correlations to equities, can produce positive returns with lower volatility. “Real hedging is about capital preservation,” explains Mr Dampier. “You don’t want to take huge risks but if you can make 8-10 per cent and compound that over years, you’ll do very nicely.”
Private equity holdings can also diversify some of the market risk in a long-term portfolio, and these are now available to private investors via funds and partnership deals. Andy Gadd, head of research at IFA group Lighthouse Group, recommends a maximum holding of 10 per cent, depending on clients’ needs. “You could look at limited partnership deals for high-net-worth individuals,” he says.
Many of the wealth management groups do just that, discussing these assets plus commodities and real estate if they fit a client’s long-term plans. For example, UBS Wealth Management runs 11 relative-return model portfolios. The first five use three traditional asset classes: cash, bonds and equities. But investors who understand the risks of hedge funds, real estate, commodities and private equity can have a portfolio tailored from all seven asset classes. “One non-traditional area is commodities, another is private equity,” says Gavin Rankin, head of products and investment consulting at the bank. “Both should be seen as having equity-type risk, and equity-type returns, but our aim is targeting diversification.”
But private investors do not have to use one of these services to realise long-term diversification. Many fund managers offer retail products than can help diversify away equity risk. “With the introduction of the UCITS III rules, fund managers have access to more tools, such as derivatives,” says Mr Gadd. “Does that mean they’re offering more institutional style products? Yes.”
“You can even invest in Brazilian agricultural land now!” adds Mr Dampier.
It doesn’t get more long-term than that.
