The 1990s can be seen as the golden era of investment management. The rising tide of stock prices lifted all boats — even the silliest skiffs. Goals were easily met. Clients were happy. Advisor fees seemed modest.
But what if I told you that the party of the 1990s was a fool’s paradise? What if the outsize returns of the ‘90s were a necessary precursor to a new era of more modest asset returns in the 21st Century? And what if the salad days don’t return? What if the era of low returns is here to stay?
Researchers in financial economics have been gathering data that suggests we are in fact entering a new low-return environment for both safe and risky investments. The data is convincing and, if true, the impact on the investment advising profession will be enormous.
What are asset returns? It’s surprising that professionals trained in the economic sciences don’t stop to think about financial assets as normal economic goods subject to the forces of supply and demand. In reality, there is a finite supply of financial instruments. And when demand goes up, so does price.
What happens to returns on these assets when prices rise? They go up as well — until they don’t. Then they go down. Consider this fact pointed out by Harvard finance professors Robin Greenwood and David Scharfstein.
Between 1980 and 2007, the market value of stocks grew from 50% of U.S. gross domestic product to 141% of GDP. This would be great news, if companies in 2007 were three times more profitable than they were in 1980. Unfortunately, it wasn’t an increase in profits that drove the increase in stock values. It was an increase in prices. Investors were willing to pay 266% more per dollar of earnings in 2007 than they were willing to pay in 1980.
The implications are sobering. Stocks rose in the 1990s, because investors were willing to pay more per dollar of earnings (which can be either paid back in dividends or reinvested for growth). Investors received fantastic returns in the late 1990s, since the demand for stocks shifted outward. And when demand for stocks goes up, expected returns on stocks (after prices have risen) goes down.
Another interesting implication of the rise in stock values between 1980 and 2007 is that nearly all of the revenue growth in investment management that occurred during this time can be attributed to higher stock prices.
This is worth repeating. For those who charge a percentage of assets under management, your revenues have tripled between 1980 and 2007 because the price of stocks went up. But if your clients only received returns on the dividends paid from profits in these public companies, their returns would not have tripled. They wouldn’t have gone up at all. They are paying three times as much for each dollar of stock earnings. And you, the advisor, are receiving three times as much revenue from the client for each dollar of corporate earnings.
Of course, stocks aren’t the only financial asset that has become more expensive as demand for financial assets rose during the past three decades. Bonds are also significantly more expensive. Consider that as late as Jan 1, 1990, clients would need to invest $122 to receive $10 in bond income from 10-year Treasuries.
Today, an investor needs $641 to buy $10 of bond income. That means a client working with an advisor charging 1% would pay 12.2 cents for each dollar of bond income. Today’s client pays an advisor 64.1 cents for each dollar of bond income.
In 1980, a client paid $88.50 to receive $10 in stock earnings. Today, a client must pay $270 to get $10 in profits. That amounts to 8.85 cents for each dollar of earnings in 1980 and 27 cents for each dollar of earnings in late 2016. And that doesn’t include any fund or transaction expenses on the assets themselves.
If two-thirds of a client’s growth in safe assets and one-quarter of growth in risky assets are eaten up in asset management fees, then advisors face significantly greater pressure to justify their value beyond producing investment returns. This may be less important if returns rise again, but the research on future returns isn’t reassuring.
More Bad News for Future Returns
Why are investors willing to pay more for each dollar of stock earnings and bond income? What is the evidence that demand for financial assets is rising?
First, let’s consider the source of stock prices. The traditional model explains the price today depends on the risk-free rate plus the risk premium. What is the risk-free rate today? A 3-month T-bill’s yield hovered between 5 and 10 basis points (0.05% to 0.10%) between 2011 and 2015. The historical average between 1934 and 2015 was 3.6%. So the expected return on stocks is already starting 3.5% behind the historical average.
Now, let’s move to the so-called equity risk premium. The equity premium is the amount of extra return needed to compensate investors for holding an asset with a payout that could be uncertain. Most of us look to history to determine how much extra return investors hold for accepting risk.
The size of the risk premium depends on which period of history you examine. In a 2002 article titled “The Equity Premium,” by Nobel prize-winning economist Eugene Fama and Ken French, they estimated the expected risk premium from dividend and earnings growth and found that stock prices rose more than would be expected during the latter half of the 20th century.
Why? “The high return for 1951 to 2000 seems to be the result of low expected future returns,” they said. Stock prices rose more quickly than dividends or earnings, because investors didn’t require such a high rate of return from stock investments.
Why don’t investors require the same premium in order to hold risky assets? Fama and French attribute this to a combination of factors including much wider stock market participation by both individuals and institutions (one in seven Americans owned stock in 1980 compared to half of Americans by 2000) and the emergence of mutual funds that allowed investors to hold well-diversified portfolios at a low cost.
We can also add a big reduction in the cost of buying stocks after the May Day deregulation of the brokerage industry in 1975 and a decline in capital-gains tax rates. In an article published in 2008, co-authors from New York University and Wharton attribute the recent rise in stock prices to an increase in global macroeconomic stability. Who can doubt that an investor in 2016 should feel more comfortable buying risky assets than an investor in 1930 or 1940?