3 March 2014

What the last 20 years of returns really tells us

We’re often told that the past doesn’t predict the future and some may even dismiss the idea that asset classes move through their own cycles. Either way, looking back on the performance of asset classes over the last 20 years can certainly reveal some interesting insights that are worth paying attention to.

Looking at the relative performance of seven widely used asset classes over the last 20 years reveals a few interesting insights:

  • Cash has only been the top performing asset class once in 20 years and regularly features in the bottom three asset class returns.
  • Australian Fixed Interest has shown reasonable performance, demonstrating an ability to perform strongly and regularly.
  • International Fixed Interest has performed well surprisingly, regularly delivering strong relative returns although in the last two decades it was never the best performing asset class.
  • AREITS has shown very strong relative returns to other asset classes over many of the last 20 years.
  • Australian Equities is also an asset class that regularly does well on a relative basis and has the distinction of not once being the worst performing asset class over the last two decades.
  • Small Caps has certainly lived up to its reputation, either delivering very strong or very poor returns on a relative basis. This has been the number one asset class more times than any other, but equally has rivalled international shares for the number of years it has been the worst over this 20 year period.
  • International equities (unhedged) has had more than its fair share of poor years in the past two decades, however it has also clearly demonstrated the potential for strong returns as seen in 2013 where the benchmark was up 48%.

Absolute returns over the last 20 years
It’s important to note that while relative performance can tell us a lot, many investors focus on absolute return which can tell a different story.

Essentially this means that if an investor is heavily overweight in an asset class that is the top performer over multiple years with a 2 per cent return, there is no guarantee that this asset class will generate strong real returns across the market cycle.

Don’t forget the critical role of macro influences

In considering ultimate portfolio returns, appreciating the critical role of macro influences is essential. For example, the disinflation seen throughout the 90’s and more recently central bank monetary policy in the large developed markets  (which recently included use of unconventional monetary policy tools), has resulted in a major bull market for bonds, reflected by a consistent fall in key ‘risk free’ interest rates over the last two decades. Interest rates also have a cycle, albeit a long one. So in a rising rate environment, using assumptions derived from falling interest rate environments would be quite dangerous.

Helping your clients understand the benefits of a well-constructed portfolio

The question remains “By looking at the performance for each asset class over the last 20 years, how can you use this information with your clients when they are asking questions about their portfolio?” Below are some key points you can use when having the all important portfolio construction and performance conversation with your clients.

Diversification is critical for any successful portfolio

To see an asset class outperform one month versus others and then underperform the next really demonstrates the value of having an investment mix that is made up of a combination of asset classes. Diversification is a core discipline of investing as it uses the power of compounding to reduce the severity of negative returns which is important for any successful portfolio. It’s also important to understand and articulate what success looks like. What investors seek is a portfolio that generates diverse ‘real’ returns (i.e. returns above inflation) that will be highly likely to generate an ‘acceptable’ return even if several sleeves in the portfolio perform poorly.

There are risks concentrating on one particular asset class

In line with diversification, the lack of return correlation is powerful for portfolio construction, because when one sector is being sold off a well constructed portfolio will be supported by another sector, thus mitigating the potential damage a more concentrated portfolio would suffer. For example, in 2002 Australian equities returned -8.8%, international equities were worse returning -27.4%, yet Australian Fixed Interest returned 8.8% and International Fixed Interest returned 11.6%. Equally in 1999 Australian Fixed Interest returned -1.2%, International Fixed Interest returned 0.3% versus Australian equities which returned 16.1% and International Equities returning 17.2%.

Maintain a modest exposure to higher volatility asset classes

Looking at the respective return profiles, the higher volatility asset classes like Small Caps can be both outstanding contributors and detractors to the portfolio. For that reason whilst the high return potential can be appealing, keeping allocations as modest sleeves in the portfolio will provide some exposure to take advantage of outperformance, while also keeping a lid on the risk. For example, after returning -14.6% in 2000 and a further -9.1% in 2002, the asset class recovered strongly to deliver over 15% per year for the next five years straight. Risk appetite is a critical factor in any decision to invest but maintaining a high level of risk awareness when it comes to high volatility asset classes like this is paramount.

Cash and Fixed Interest are safe options but won’t necessarily meet return objectives

Cash is rightly considered a safe investment option, but the fact is in 2013 it returned 2.8% which in real return terms is not going to meet many return objectives and it is not likely to deliver much more with the Australian cash rate currently at record low levels. Fixed Interest is also facing headwinds to generate strong returns. However, it does offer defensive characteristics by balancing negative periods of equity returns so it can be appealing to anxious investors. It’s important to understand the pros and cons to investing in these asset classes.

Last year’s winner is not always next year’s winner

Last year’s winning asset class is infrequently the top performing asset class the following year. Only Small Caps, Listed Property and International Shares are able to claim that accolade. So beware of chasing last year’s winner – make sure you have a well-diversified portfolio that is structured to meet your needs, not based on the previous year’s best performing asset classes.

What the last 20 years really tells us

Sharing these insights from the last 20 years of performance is not meant to give you the secrets to build successful portfolios in the future. Rather they give you some interesting facts to share with your clients to really reinforce the benefit of understanding the bigger performance picture and demonstrate some core investing principles – the benefit of having a long-term view to investing; the benefit (and security) of having a well-diversified portfolio; and the risks of investing based on past performance.

Important information: The content of this publication are the opinions of the writer and is intended as general information only which does not take into account the personal investment objectives, financial situation or needs of any person. It is dated March 2014, is given in good faith and is derived from sources believed to be accurate as at this date, which may be subject to change. It should not be considered to be a comprehensive statement on any matter and should not be relied on as such. Neither Zurich Australia Limited ABN 92 000 010 195 AFSL 232510, nor Zurich Investment Management Limited ABN 56 063 278 400 AFSL 232511 of 5 Blue Street North Sydney NSW 2060, nor any of its related entities, employees or directors (Zurich) give any warranty of reliability or accuracy nor accept any responsibility arising in any way including by reason of negligence for errors and omissions. Zurich recommends investors seek advice from appropriately qualified financial advisers. Zurich and its related entities receive remuneration such as fees, charges and premiums for the financial products which they issue. Details of these payments can be found in the relevant fund Product Disclosure Statement. No part of this document may be reproduced without prior written permission from Zurich. ESCL-008505-2014
Past performance is not reliable indicator of future performance.

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