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In a class of its own

I would like to close this series of articles with a discussion about the outlook for returns from equities. Projecting future returns from equities requires much greater subjectivity than the other major asset classes. However, this does not mean that there are no objective methods of estimating returns.

One method is to consider dividend yield and dividend cover. Looking at the FTSE All Share index, the average dividend yield is 3.11 per cent at the time of writing. However, the dividend cover on this index is 1.72, meaning that if companies were to pay out all their profits as dividends rather than retaining some of the profit to fund further growth, the dividend yield would be 5.35 per cent (3.11 x 1.72). Thus, unless it is expected that corporate profits are likely to fall over the foreseeable future, one would not expect total investment returns from equities (dividend yield plus growth in the value of the companies) of less than 5.35 per cent.

One might also suggest that corporate profits should rise at least in line with price inflation as, if those companies were to continue to sell the same volume of goods or services from year to year while maintaining the same level of costs and prices, then profits should go up. Adding in an expectation of future price inflation of, say, 2.75 per cent, one might arrive at a conclusion that future returns from equities are likely to be 8.1 per cent (5.35 per cent + 2.75 per cent).

Indeed, there could be an argument to further increase this expectation if one believes that company profits over the longer term should increase by a rate greater than price inflation by continuing to strive for greater productivity.

Although objective reasoning for expected returns from many of the asset classes can be supported by evidence available from the Financial Times or the IPD index for commercial property, the kind of reasoning I have used above for equities cannot be so specifically justified to arrive at a confident expectation of future returns. Equities are much more volatile than the other major asset classes.

Nonetheless, I would quite strongly suggest that some sort of methodology is desirable in arriving at a suggested likely rate of investment return from equities in order to give investors some sort of benchmark against which actual returns can be measured.

At this stage, I would like to summarise the main issues from this series of articles as regards expected rates of investment return from each of the major asset classes and conclude with a few quick words about managed funds.

Starting with equities, I would suggest that a fair projection would be somewhere between 8 and 9 per cent total annual returns using the reasoning noted above.

For commercial property funds, noting the presence of cash, a projection of 9 per cent annually using the IPD index monthly statistics would seem reasonable.

In the fixed-interest market, redemption yields on mediumand long-dated gilts are running at around 4.7 per cent while high-grade corporate bonds are yielding around 5 per cent on average.

Redemption yields and, therefore, projected returns from lower-investment-grade corporate bonds are averaging around 6 per cent while higher-yield corporate bonds (sub-investment grade) have redemption yields from 7 per cent upwards.

Index-linked gilts should generally be expected to provide similar returns to fixed-rate bonds, at a little under 5 per cent, for the reasons noted in my earlier article. Finally, money-market rates are between 3.7 per cent over shorter terms and 4.5 per cent over longer terms up to a year.

From these observations, it is possible for a financial adviser to give clients a much more accurate projection of likely future returns from their portfolio than using the standard projections of 4, 6 and 8 per cent. I am aware that these standard projections must be provided to clients but would strongly suggest that, at the very least, advisers should provide guidance as to which of these three rates is most likely to prove correct.

It might be appropriate and profitable to provide clients with a more complex projection for a portfolio in a format similar to that which I have produced below.

I accept that some advisers might consider calculations and presentations of this nature to be more complex than they or some of their clients might find appropriate but few would deny that such as a strategy gives a highly professional projection of likely future returns from a portfolio.

Finally, such calculations might be appropriate to project future investment returns from managed funds. These funds hold various combinations of asset classes and projections can therefore be arrived at by proportionately allocating the suggested projections for each asset class. In this way, differentiation becomes obvious between managed funds which are heavily weighted towards cash and fixed interest and those with heavier weightings in equities or property.

The issue of changing projections for different asset classes may be one to which I will return as and when significant changes occur. My next series of articles will start to look at ways in which various regulatory and legal reviews can greatly assist advisers in many areas of financial services.


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