Falling ERP to drive investor creativity: Russell

An ongoing deterioration in the equity risk premium (ERP) will require retail investors to “temper investment return expectations and adopt a more creative stance to eke out portfolio performance”, according to a visiting Russell Investment Group portfolio strategist.

US-based Stephen Wood said the ERP (the difference between equity returns and the risk free government bond return) was now at “its lowest level in 30 years and in reality the lowest level since the 1920s”.

Russell also expects this deterioration to continue, Wood said, forecasting a “five-year ERP of 3.0 per cent, representing a fall from 5.8 per cent over the past 40 years and 7.5 per cent over the past 60 years”.

“To top it all off, fixed income returns have also dropped by 3 per cent over the last 20 years.”

He said the ERP trend is not well understood by retail investors yet has major implications for the most basic investment decisions, including how to allocate money between property, equities and more defensive assets.

“Investors globally tend to overestimate potential portfolio returns, as well as their capacity to recover from investment mistakes, such as investing in assets at the peak of the cycle.”

He recommended that investors “look beyond mainstream investment such as traditional fixed income and long-only equities and seek out innovative approaches to capture excess returns”.

Russell had developed a number of investment strategies as a response to the falling ERP, he said, including the new Russell Select Holding Strategy.

Wood said this strategy aims to boost returns by investing in a “best ideas” portfolio of stocks given the highest weighting by individual fund manager in the Russell Australian Shares Fund.

Other Russell strategies aim to boost returns via access to emerging markets and private equity, increased leverage (hedge funds) and improved cost management via efficient implementation.