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Crystal clear

Before I conclude my recent series of articles looking at expected returns from the main asset classes, I would like to develop a little further the projections for equities on which my last article mostly concentrated.

I noted that the average dividend yield on the FTSE 100 index is 3.15 per cent with an average dividend cover of 2.3, indicating an earnings’ yield of 7.245 per cent a year, that is, 3.15 per cent multiplied by 2.3.

I then noted the differences between these figures and those for the FTSE 250 index, which represents medium-sized companies, and the FTSE Small Cap index, repre-senting smaller companies.

Before bringing together all the asset classes in a comparison of expected returns, it is perhaps worth mentioning two other equity indices which I suggest are also highly relevant to fund selection – the FTSE 350 Higher Yield index and the FTSE 350 Lower Yield index.

The main FTSE 350 index covers the biggest 350 companies listed on the stockmarket as measured by their market capitalisation. At the time of writing, the average dividend yield on this index is 3.05 per cent with an average dividend cover of 2.25. This is slightly lower than for the FTSE 100 index, reflecting the fact that the combined stockmarket value of the top 100 companies far exceeds the value of all the other companies added together.

The FTSE 350 Higher Yield index represents those companies within the FTSE 350 index which pay an above-average dividend while the FTSE 350 Lower Yield index represents those companies paying a below-average dividend. The figures for these two indices are as shown in the table below.

On the face of it, looking solely at earnings’ yield, higher-yielding shares might be considered better prospective value than their lower-yielding counterparts. The former offer a higher immediate and imminent cashflow while the latter should offer higher growth prospects by reinvesting a greater proportion of their profits. But these statistics do not tell the whole story.

For example, there is a body of opinion which suggests that companies paying a lower dividend, and thereby retaining a bigger proportion of profits to fuel further growth, are demonstrating a higher level of confidence in their ability to make profits work harder for shareholders than if they were paid out as dividends.

Looking at how these statistics affect fund selection, they clearly indicate that a typical high-yielding equity fund should be projecting income returns between 3.5 and 4 per cent while a typical growth fund could be expected to have a dividend yield between 2 and 2.5 per cent. This is not terribly relevant for investment bonds where income is reinvested within the fund to fuel capital growth but very important, I suggest, for fund selection within pension schemes, especially self-invested personal pensions.

Let us now bring our projections of the different asset classes together in the table on the right.

Although I have discussed in previous articles most of the issues relating to these statistics, a little reminder and updating of some of the more important points is worthwhile.

The cash index is self-explanatory and closely reflects the rates of interest payable on high-yielding bank and building society savings accounts. This projection is therefore easy to justify to clients, unlike the commercial property fund projection.

At the time of writing, the Investment Property Databank index shows an income yield for the previous month of 0.5 per cent with capital growth of 1.5 per cent. This equates to a total return from commercial property of 2 per cent over the month.

If this performance were to be repeated in future months, it would indicate an annual rate of return in excess of 25 per cent. I doubt that anyone could seriously suggest that this rate of return could be sustainable over the next few years. However, the same index showed an income yield of 1.4 per cent over the previous three months, with capital growth of 3.7 per cent. This equates to a total quarterly return of 5.1 per cent, which indicates a total annual return in excess of 20 per cent.

Even this indicator surely cannot be sustainable over future years although it could easily be reasoned that the fact that each monthly and quarterly indicator over the past few years has shown consistent returns could suggest continued high returns over the next few months at least. In any event, the 0.5 per cent income yield is quite attractive in its own rights, even ignoring the prospects for capital growth. I have therefore toned down the expected annual return from these investments to a mere 17 per cent.

In truth, one could hardly dare to suggest that even this projection is likely to be achievable in the medium to long term. Financial advisers have to take a pragmatic approach to projected total returns from property, which I believe should be somewhere in excess of the ongoing rental yield of 6 per cent a year. For my money, I cannot suggest a number lower than 8.5 per cent, being the rental yield added to the rate of inflation, which indirectly drives increasing rental yields over the longer period.

I would suggest that this average rental yield compares favourably not only with the total redemption yield on gilts but also with the redemption yield on high-grade corporate bonds. Even lower-grade corporate bonds, yielding in excess of 6 per cent, might be seen by some planners to offer inferior returns and potential to commercial property.

As regards the statistics for gilts and corporate bonds, you will note that I have not differentiated between income yield and capital growth. Quite simply, this is because some of these fixed-interest investments have low yields with high capital growth to redemption while others have much higher yields with capital losses to redemption.

Finally, with regard to equities, I have discussed these statistics in my latest couple of articles, so I will content myself with reiterating the fact that the objective indicators of total returns take no account of the possibility or probability of profit growth, which, quite apart from explaining the low indication of total returns from smaller companies, should also surely indicate that the total returns from bigger companies might be expected to grow in the future by at least the rate of inflation.

In my next article, I will finally bring together all these issues in a selection of model portfolios with combined projected growth rates and volatility ratios.


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