Chapter Seven
When the Good Times No Longer Roll
What Happens If Future Returns Are Lower?
REMEMBER THE UNFAILING principle described in Chapter 2: in the long run it is the reality of business—the dividend yields and earnings growth of corporations—that drives the returns generated by the stock market. However, I must warn you that during the past 25 years—the period examined in the three preceding chapters—the 12.5 percent nominal annual return provided by the U.S. stock market included a speculative return of nearly 3 percent per year, far above the business reality.
Recall that the century-plus nominal investment return earned by stocks was 9.5 percent, consisting of an average dividend yield of 4.5 percent and average annual earnings growth of 5.0 percent. A mere 0.1 percent per year—what I described as speculative return—was added by the rise in the price/earnings ratio from 15 times at the beginning of the period to 18 times at its end, bringing the total annual return to 9.6 percent.
16Paradoxically, the investment return earned by stocks over the past 25 years was hardly extraordinary. A dividend yield averaging 3.4 percent plus annual earnings growth of 6.4 percent brought it to 9.8 percent, almost precisely equal to the historical norm of 9.5 percent. But, illustrating the difficulty of forecasting changes in the amount that investors are willing to pay for each dollar of corporate earnings, the speculative return was anything but normal.
Common sense tells us that we’re facing an era of subdued returns in the stock market.
As investor confidence rose, so did the price/earnings (P/E) ratio rise—from 9 times to 18 times, an amazing 100 percent increase, adding fully 2.7 percentage points per year—almost 30 percent—to the solid 9.8 percent fundamental return. (Early in 2000, the P/E ratio had actually risen to an astonishing 32 times, only to plummet to 18 times as the new economy bubble burst.) Result: speculative return was responsible for more than 20 percent of the market’s 12.5 percent annual return during this period. Since it is unrealistic to expect the P/E ratio to double in the coming decade, a similar 12.5 percent return is unlikely to recur. Common sense tells us that we’re facing an era of subdued returns in the stock market (
Exhibit 7.1).
Why? First, because today’s dividend yield on stocks is not 4.5 percent (the historical rate), but slightly below 2 percent. Thus we can expect a dead-weight loss of 2.5 percentage points per year in the contribution of dividend income to investment return. Let’s assume that corporate earnings will continue (as, over time, they usually have) to grow at about the pace of our economy’s expected nominal growth rate of 5 or 6 percent per year over the coming decade. If that’s correct, then the most likely investment return on stocks would be in the range of 7 to 8 percent. I’ll be optimistic and project an annual investment return (a bit nervously!) averaging 8 percent.
Second, the present price/earnings multiple on stocks looks to be about 18 times based on the trailing 12-month reported earnings of the S&P 500 (16 times if we use projected operating earnings, which exclude write-offs for discontinued business activities). If it remains at that level a decade hence, speculative return would neither add to nor detract from that possible 8 percent investment return. My guess (it is little more than that) is that the P/E might ease down to, say, 16 times, reducing the market’s return by about 1 percentage point a year, to an annual rate of 7 percent. You don’t have to agree with me. If you think it will leap to 25 times, add 3 percentage points, bringing the total return on stocks to 11 percent. If you think it will drop to 12 times, subtract 4 percentage points; reducing the total return on stocks to 4 percent.
If rational expectations suggest future annual returns of about 7 percent on stocks, what does this imply for returns on equity funds?
Now assume that 7 percent is a rational expectation for future stock market returns. To calculate the return for the average actively managed equity mutual fund in such an environment, simply remember the humble arithmetic of fund investing: nominal market return, minus investment costs, minus taxes (reduced to reflect lower capital gains realization), minus an assumed inflation rate of 2.3 percent (the rate the financial markets are now expecting over the coming decade) equals just 1.4 percent per year (
Exhibit 7.2). I simply didn’t have the courage to make another deduction to reflect the impact of the counterproductive timing and adverse fund selection that will likely continue to bedevil the typical fund shareholder. It may seem absurd to project such a low return for the typical equity fund investor. But the numbers are there. Again, feel free to disagree and to project the future using your own rational expectations.
In summary, the future outlook for stock returns is far below the long-term real return on U.S. stocks of about 6.5 percent annually. My projection of a future real return of 4.7 percent (before costs and taxes) is conservative largely because today’s dividend yield of 2 percent is below the long-term norm of 4.5 percent, partially offset by my optimistic projection of real earnings growth of 2.5 percent per year versus the 1.5 percent long-term norm. The real long-term rate of per share earnings growth of U.S. corporations has been no more than that humble figure. As suggested earlier, some experts put the figure at only 1 percent on an earnings per share basis.
EXHIBIT 7.2 Index Fund versus Managed Fund: Projected Profit on Initial Investment of $10,000, 2006-2016
In any event, in a likely future environment of lower returns on equities, the low-cost, tax-efficient index fund would provide even higher real returns relative to actively managed equity funds than the enormous advantage it has achieved over the past quarter century. Yes, a real 10-year gain of $5,100 on a $10,000 investment in the index fund is nothing to write home about. But what’s to be said about the mere $1,500 profit that could well be what the typical managed equity fund delivers?
Unless the fund industry begins to change, the typical actively managed fund appears to be a singularly unfortunate investment choice.
The fact is that lower returns harshly magnify the relentless arithmetic of excessive mutual fund costs, even ignoring all those unnecessary taxes. Why? While costs of 2.5 percentage points would consume “only” 16 percent of a 15 percent return and “only” 25 percent of a 10 percent return, such costs would consume nearly 40 percent of a 7 percent nominal return and (I hope you’re sitting down) nearly 60 percent of the 4.5 real return on stocks that rational expectations suggest. Unless the fund industry begins to change—by reducing management fees, operating expenses, sales charges, and portfolio turnover, with its attendant costs—the typical actively managed fund appears to be a singularly unfortunate choice for investors.
The 1.2 percent expected annual real return that the average equity fund might deliver is unacceptable. What can equity fund investors do to avoid being trapped by these relentless rules of arithmetic, so devastating when applied to future returns that are likely to be well below long-term norms? There are at least five options for improving on it: (1) Select winning funds on the basis of their long-term past records. (2) Select winning funds on the basis of their recent short-term performance. (3) Get some professional advice in selecting funds that are likely to outpace the market. (4) Select funds with rock-bottom costs, minimal portfolio turnover, and no sales loads. Or (5) Select a low-cost index fund that simply holds the stock market portfolio.
In Chapters 8 through 12, we’ll examine each of these options.
Don’t Take My Word for It
Financial advisers seem to agree with my appraisal of future returns. In the latter part of 2006, in a speech before these professionals at their Chicago convention, I polled the audience. The clear consensus: stock returns of 6.5 percent over the coming decade.
Investment bankers are of a similar mind. When Henry McVey, market strategist for Morgan Stanley, polled the chief financial officers of the 100 largest corporations in the United States, they expected a future return on stocks of 6.6 percent. (One wonders how these executives can justify their implicit assumption that the stocks in their companies’ pension plans will return 11 percent per year.)
Other highly regarded investment strategists also share my general view that we are facing a new era of subdued investment returns. Gary P. Brinson, CFA, former president of UBS Investment Management, is one whose assessment about future returns echoes my own. “Today’s investment market fundamentals and financial variables clearly suggest that future real returns from a mixed portfolio of stocks, bonds, and other assets (such as real estate) are unlikely to be greater than 4.5 to 5.0 percent. With an inflation assumption of 2.5 percent, nominal returns greater than 7.0 to 7.5 percent for these portfolios are unrealistic. What cannot be explained is why people are willing to pay the considerable fees (involved). Perhaps they are paying for historical returns, for hope, or out of desperation... “For the markets in total, the amount of value added, or alpha, must sum to zero. One person’s positive alpha is someone else’s negative alpha. Collectively, for the institutional, mutual fund, and private banking arenas, the aggregate alpha return will be zero or negative after transaction costs. Aggregate fees for the active managers should thus be, at most, the fees associated with-passive management. Yet, these fees are several times larger than fees that would be associated with passive management. This illogical conundrum will ultimately have to end.”
Or consider these words by Richard M. Ennis, CFA, Ennis Knupp + Associates, and editor of the Financial Analysts Journal: “Today, with interest rates near 4 percent and stocks yielding less than 2 percent, few among us expect double-digit investment returns for any extended period in the near future. Yet, we live with a legacy of that era: historically high fee structures brought on by trillions upon trillions of dollars seeking growth during the boom and shelter in its aftermath. Second, facing the dual challenge of market efficiency and high costs, investors will continue to shift assets from active to passive management. And third, some of active management’s true believers will shift assets from expensive products to more reasonably priced products. Impetus for this move will be the growing realization that high fees sap the performance potential of even skillful managers.”
