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Best-performing asset classes

Photo of Tim Cook By Tim Cook

min read

The Russell Investments/ASX Long-Term Investing Report 2015 recently provided a 10- and 20-year analysis of global asset classes, including Australian residential property.

As is the nature of such a long-term assessment, the broad underlying themes do not always change from year to year - and longer periods can mask shorter-term volatility. At first glance, long-term returns across various asset classes look similar. But taking a closer look is worthwhile.  

The 20-year performance
Investing for the long term is not just about looking to the horizon nor spotting the next minor blemish in the road. You need eyes on the near, mid and long distance.

Riskier assets typically provide higher returns with greater volatility over the long term. As such, shares and property provided the highest returns to Australian investors over the 20 years to 31 December 2014.

However, over the last 20 years, the return on lower-risk assets, i.e. bonds (international and Australian bonds returned 8.6 per cent and 7.6 per cent a year respectively), were almost equally positive.

International and Australian bonds had much lower annual volatility -- roughly 5 per cent compared with shares’ 18 per cent.

So why not just buy bonds?
The last 20 years have seen a dramatic and continuous fall in yields, providing capital appreciation on top of regular income. Rates are now at or coming off historic lows so similar returns cannot be expected. Indeed, as rates rise, we expect bond returns to be somewhat subdued over the coming years.

Should long-term investors only invest in property and shares?
The annual volatility of property and shares is higher than for other asset classes. When investing in these asset classes, investors should be prepared for potential returns of as low as minus 40 per cent in a year eg Australian and international equities during the Global Financial Crisis.

I am more worried about multi-year periods than single years. So I should be okay, right?
The average economist considers a market cycle to be around seven years. Exhibit 1 below shows the last 21 years (dating back to 1994) and splits them into three seven-year economic cycles. You can see the difference in asset-class returns over extended periods. These periods also segment into the Tech Boom, Tech Crash and Recovery, and Global Financial Crisis and Recovery.

Exhibit 1: 21 years of returns split into three market cycles (1994-2014)

Source: Russell Investments.
AFI = Australian Fixed Income. AEQ = Australian Equities. IEQ = international equities. (H) = hedged. A-REITs = Australian Real Estate Investment Trusts. G-REITs = Global Real Estate Investment Trusts.

Period 1 - 1994-2000: Tech Boom
The late 90s (1994-2000) proved a good period across all asset classes covered. Excluding cash, the worst-performing asset class was Australian fixed income with a return of more than 8 per cent a year for a seven-year period. That compounds to an increase of over 70 per cent.

The best-performing asset class was unhedged international equity (affected by currency movements), which returned a total of nearly 200 per cent (or 16.8 per cent a year).

Period 2 - 2001-2008: Tech Crash and Recovery
Over the next seven years (2001-2008) however, the same investment in unhedged international equity gave investors a marginally negative minus 0.7 per cent return.

The star performer was Australian equities, returning just over 15 per cent a year, totalling 167 per cent for the period. Australian real estate investment trusts (A-REITS) also perfomed notably from 2001-2008, returning over 14 per cent a year.

Period 3 - 2008-2014: Global Financial Crisis and Recovery
However, looking to the final period of 2008-2014, we see that A-REITS performed worst, providing on average minus 2 per cent a year. The period obviously included the GFC, so returns are more subdued across all “risk” asset classes. That said, the difference between the period return for the highest- and lowest-performing asset class was still 90 per cent (international hedged bonds 76.4 per cent and A-REITS minus 13.6 per cent).

Looking to the top-returning asset class in the previous period, a similar pattern of divergence emerges. Australian shares went from providing over 15 per cent a year from 2001-2007, to less than 2 per cent a year from 2008-2014.

Four lessons from investment cycles

1. Annualised returns over 20 years can hide extended periods of poor returns
Australian shares, though the top-performing liquid asset class over the past 20 years, were the only asset class to underperform cash over the last seven.

2. The top-performing asset class in one period can be the worst-performing asset class in the next
Examples include international equities (unhedged) moving from Period 1 to Period 2, as well as Australian equities (including A-REITS) from Period 2 to Period 3.

3. All performance analysis is period (or point-to-point) dependent
While almost any performance numbers can be disputed as time-period dependent, the conclusions of volatile returns between periods cannot be disputed. Indeed, considering five-year buckets, we can find consecutive periods returning 205 per cent, but then losing 22 per cent over the next five years (unhedged international equities 1995-1999 and 2000-2004 respectively).

4. The performance you receive at the outset is very important
One could argue that “over 20 years, I will be okay”. But especially for investors managing post-retirement portfolios (i.e. when you are drawing an income), the order of returns becomes more important. Imagine you started with $100 and planned to spend $5 a year over 10 years.

If the period started with five years of positive returns (205 per cent) and ended with five years of negative returns (totalling minus 22 per cent), you would end up with $184. But if the scenario was flipped and the negative period occurred first, you would end up with $128 -- 30 per cent less.

How should I invest to avoid disappointment over the short and long term?
When we put the returns from the three diversified portfolios considered in the Russell Investments/ASX Long-term Investing Report 2015 alongside the period returns, we see a huge dampening of annual and period volatility. The diversified portfolios produce annual returns that compare well to specific asset classes (period and total return and volatility are illustrated in the chart below).

Diversification will reduce the risk of negative returns and can also reduce the effect of sequencing risk (getting the wrong return at the wrong time) through the combination of uncorrelated asset classes (asset prices that do not move in the same direction) that act as a dampener to absolute volatility.

Thus, diversification can increase the probability of your portfolio providing sufficient returns.

Exhibit 2, below, illustrates the lower variability between period returns provided by a diversified fund compared with the individual equity asset classes.

The range of period returns for Australian equities (1.9 to 15 per cent) is much broader than those for the Balanced portfolio (5.2 to minus 10.1 per cent) despite the total period returns being comparable (8.7 versus 8.2 percent).

(Editor’s note: This analysis suggests owning a balanced portfolio that is diversified across asset classes can provide comparable returns to Australian shares in the long-term, at lower risk).

Exhibit 2: returns and volatility across asset classes over three periods

Source: Russell Investments

By diversifying, will I miss out on the upside?
Yes, but diversification can also help you manage the risk of hitting big potential downsides. Numerous studies illustrate that investors who chase returns, erode value or jump ship with poor timing miss recoveries and lock in losses.

Simple consideration of a fixed asset allocation versus selecting last year’s top asset class will illustrate that the average person may not be the best at making tactical asset-allocation decisions if unduly swayed by past returns.

About the author

Tim Cook is a senior consultant at Russell Investments

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