Investment projections – style over substance?

Fund manager adviser briefings and roadshows are always in part about them selling their wares, albeit with a degree of subtlety. Still, they can also be informative and thought provoking. Sometimes, however, the subtlety is non-existent and the content leaves much to be desired.

So it was at a recent large manager presentation covering, among a few other things, the outlook for investment returns.

First we were told the returns would be lower than in the 1980s and 1990s. This was based on three basic variables: dividend yield at three per cent per annum; historical earnings growth of 5.5 to six per cent per annum; and an assumption of no change in the market price to earning (PE) ratio. Given these conditions, returns from Australian shares going forward were forecast at 8.5 to nine per cent annually for the next 10 years.

Fine so far, although I would question the assumption of no downward re-rating of the market PE ratio, given that it is at still near record levels of around 20.

This was followed with a slide showing that international equities were projected to return 9.5 to 10.5 per cent each year over the next 10 years. There was no explanation of how this figure was determined, nor was there any analysis similar to that conducted for Australian shares.

If such a simple analysis was undertaken using the same variables, the results would differ from that stated by the manager. This is because there is a lower starting dividend yield on international equities, which is around 1.5 per cent, but a similar level of earnings growth at 5.5 to six per cent on an annual basis for both.

Still assuming no downward re-rating of the PE from a higher ratio of around 25 to 30, the return you come up with is around seven to 7.5 per cent each year or three per cent lower than the fund manager’s projection in the presentation.

Furthermore, from this higher PE one could argue that some downward re-rating was even more likely than with Australian shares. In addition, there is the possible negative impact of an upward movement in the Australian dollar if, over the next 10 years, it was assumed to move closer towards its purchasing power parity value.

We were given another scenario involving higher inflation of three per cent per annum. By the way, if three per cent is high inflation, the 70s and early 80s must have been hyperinflation!

This ‘high’ inflation scenario did assume some PE contraction, which subtracted 1.5 per cent each year from returns, bringing a PE of 20 down to just over 17 over 10 years.

However, this was partly offset by 0.5 per cent higher earnings growth expected in this ‘high inflation’ environment. Under this outcome, the return for equities is one per cent lower at 7.5 to eight per cent per annum.

Using the mid points for the returns for the first Australian shares estimate at 8.75 per cent per annum, international equities at 10 per cent per annum and 5.5 per cent for fixed interest (which seems reasonable), we were told that a balanced fund was projected to return 8.5 per cent per annum.

Of course, these figures are all pre-investment management and other fees and transaction costs that might take off two to three per cent each year, resulting in a return of 5.5 to 6.5 per cent per annum for investors. Fees were not discussed in the presentation.

Nevertheless, the gross 8.5 per cent figure was viewed as being well below what many advisers and investors expect going forward. What could investors and advisers do to counter this depressing picture?

This fund manager had a simple answer. All investors had to do was hire a good, active fund manager, such as themselves, and this would boost returns significantly. They suggested that three per cent outperformance of the index in Australian and overseas equities each year could easily be achieved by such a manager.

This was despite the fact that this manager already managed almost $15 billion in Australian equities and that large mainstream active international funds had generally struggled to outperform the index over most time frames.

How was this outperformance possible? The key, we were told, was the increased volatility of individual stocks in the market today. Double the possible bets and you automatically double your return — right? Voila! An extra three per cent return for equity investments.

There is no doubt that individual stock volatility has increased but such volatility is itself at least partly the result of some active fund managers attempting to pre-empt their competitors and heavily focusing on short-term momentum and returns. To suggest that large brand name active managers can easily capture the benefits of this volatility and produce consistent added value of three per cent per each year over the next 10 years requires a huge leap of faith.

Nevertheless under this ‘three per cent added value in equities scenario’ a balanced fund was now projected to return 10.5 per cent each year over the next 10 years, not 8.5 per cent. Everybody was happy. No need to re-work your asset allocation, no need to consider alternative assets, no need to consider smaller or boutique managers. This good, large active manager would deliver the extra three per cent per annum over the next 10 years with ease it seemed.

The key themes of the presentation were then summarised. Firstly, lower returns mean saving more into fund manager products. Secondly, we were told that the key asset allocation implication from the presentation was a “higher overseas weighting”. Where had this come from? The only support for this view in the whole presentation was the previously unjustified higher return projections for international equities. A higher overseas weighting makes sense because we say so, the fund manager seemed to be suggesting.

It is no surprise that this is a manager who had built its reputation on Australian shares and grown rapidly in this asset class to a point where size is likely to constrain returns in the future. A cynic might argue that pushing the international case with the aim of easing the pressure on their Australian equities capability is very sensible from a business perspective. However, planners and investors should be more concerned in the investment perspective.

The adviser briefing was titled ‘a recipe for success’. Perhaps this referred to the quality of the breakfast, which seemed to be enjoyed by the hundreds present. Maybe it referred to successfully meeting the fund manager’s business objectives. Perhaps it just referred to making planners more comfortable and successful in writing more business.

In any case, as a recipe for investment success it lacked some basic ingredients and might go off rather quickly.

Perhaps most of the planners were satisfied with what they heard. However, I suspect a few were a bit curious and had some questions. Unfortunately, the opportunity to ask questions never came. After a quick advertisement for some new products, the show was over.

No one knows the future with any precision, but simple analysis can point to some overriding trends. One is that returns from mainstream asset classes in this decade will almost certainly be significantly lower then the last 20 years and that consistent active excess returns will not be easy to achieve, particularly for larger fund managers.

To skip over such realities with glib statements and questionable numbers and to build expectations among advisers that high returns are easily achievable risks, building complacency that is likely to lead to disappointment and disillusionment amongst investors. It also inhibits advisers and investors from taking more serious measures to adapt to a more difficult investment environment.

Of course, it would be naïve to expect adviser roadshows to always be the fountain of investment knowledge or for fund managers to shy away from promoting their own products.

However, to do this through flawed or oversimplified arguments that are skewed towards the manager’s business objectives could be seen as irresponsible. Some fund managers may think they can treat financial planners as product salesmen who unquestioningly accept their every word. The smarter ones, however, will eventually ask the right questions whether they are given the opportunity at the time or not.