Peter Westaway: Why all investors should prepare for lower returns (2/2)

Posted by Robin Powell on August 4, 2018

We’ve had a big response to Part 1 of our interview with Vanguard Europe’s chief economist, Peter Westaway. In Part 2, Peter explains why he’s sceptical about the value of tactical asset allocation, why calling a top in the market is so difficult, and why, in his view, all investors can expect to receive lower returns in the future.


Peter, what are your views on market timing, and whether asset allocation should be static or dynamic?

In the same way that it’s very difficult to know which stocks are going to outperform versus those that aren’t, it kind of applies to sectors or even to regions. It would be lovely if we knew in advance when the UK market is going to outperform the US and vice versa and switch between them. But even if you can predict what’s going to happen in the economy, that doesn’t necessarily map straight through to markets.

So it’s very difficult to know how to time the market. What the empirical evidence shows, is that more strategies than not underperform when they try to do it. It’s simple, static portfolios that tend over the long run to do just as well or better than those portfolios which on the face of it sound much better, that are more nimble and move in and out.

Very often that’s the criticism that gets made of some of the funds that we at Vanguard run — our simple LifeStrategy range, for example, which has a static allocation — that they aren’t nimble. But if you look at the evidence — there’s probably more evidence for this in our US funds, but it applies to our UK fund too — typically the simple static allocation outperforms all of the more nimble competitors.

Notwithstanding your point that the economy and the markets are not the same thing, there are such things as economic cycles, and there are economists who claim to be able to spot whereabouts in the cycle we are. What do you make of that?

A lot of this hinges on whether or not where we are in the cycle is already reflected in existing market prices. Because if it’s completely obvious where we are in the cycle and that’s already reflected in the configuration of bond and equity prices, then there’s nothing particular to be exploited. So again, it’s not just about knowing that China grows faster than the UK, it’s needing to know that this month the GDP data is going to come out more strongly than everyone’s expecting and then that will cause the markets to surge, and that’s a much higher bar than knowing where we are in the cycle.

So, generally speaking, the claims of tactical asset allocators are overstated. It’s not impossible — there are some good ones out there — but knowing which ones they are and whether they’re going to be able to sustain their performance throughout the cycle is again a higher bar than many give it credit for.

The bull run is now in its tenth year. On average there’s a crash about every four years, so by law of averages we should have had two in that time. What do you say to those who are calling a market top?

The difficulty is, people have been calling the market top for a couple of years and no doubt got out of the market and lost out on the ongoing returns we’ve had. In the bond market, for instance, investors that have been saying for the last few years that it’s just a matter of time before interest rates go up and the bond market crashes. Year after year we’ve heard that prediction and we’ve just seen bond yields grinding further down rather than up.

So we should beware of statements about the inevitability of what is going to happen next, which at the time can seem quite compelling but looking back can seem rather foolish. Knowing exactly when to call the turning point is difficult.

There are a lot of points in economic history where, in retrospect, it was obvious that a crash was going to come. For example, we can look at the stock market in 1999 at the peak of the tech bubble. Clearly, looking back, the valuations were ridiculously stretched and that couldn’t go on. But that tells you as much as anything about the dangers of skewing your portfolio towards tech stocks in the expectation that they would carry on rising.

It was very interesting at that time. Vanguard was being criticised in the US for not offering more tech-related products and people asked why we weren’t doing it. Vanguard actually stayed away and were thanked after the event for not encouraging investors into that. It’s not that these things aren’t explicable after the event, but being able to call it is not at all easy.

Many commentators, including Vanguard’s founder Jack Bogle, have warned that investors should expect lower returns in the future. Are they right?

There are good economic reasons as to why we should think returns will be lower in the future. Yes, of course, interest rates and returns are low at the moment because central banks are holding rates low, but in the end I think we’re going to see lower returns further into the future because global GDP growth is much lower than it has been in recent history, demographics are causing population growth to slow, and productivity growth since the financial crisis has tended to come out lower. So there are a number of factors.

Over the long run there is a very strong relationship between the real rate of return on financial assets — if you like, the safe rate of interest that you might get from an interest rate — and global growth. Of course, when you invest in an equity, you are getting a return that is partly determined by the safe rate of interest but also by the equity risk premium, the additional return you get for investing in equities. But the benchmark of all returns across all assets is determined by this lower return on assets, and so we’re in a lower-return environment for the foreseeable future.

That is important because it means that investors have to work out how to come to terms with that. If they’re investing for their retirement, for example, either they can save more to deliver the same income in retirement, or they have to put up with lower income in retirement. The third thing they can do, which many are doing or being encouraged to do, is to shift their portfolios towards higher-yielding, riskier assets. It might work out fine for them, but I think it’s really dangerous to assume that this is an absolute panacea, because getting those higher returns is a riskier enterprise. So people need to be comfortable with the amount of risk they’re taking in order to meet their long-term objectives, and if they’re going to start taking on more risk they need to be conscious of that.

Young adults are less well-off financially than their parents, so it’s especially hard for them to save more than they already are doing. But there’s a huge advantage in starting early, isn’t there?

I should start by saying that not only does the low-return environment mean that people need to save more, but typically people didn’t save enough even in the old world when returns were higher. So a lot of people end up getting less income in retirement than they were expecting.

Why is it important for people to start saving as early as possible? It’s really down to the beautiful power of compound interest. The longer you have your money working for you and being invested, the more chance it has to generate the long-run positive expected returns we can get from equity and bond markets. Of course, saving early means you’ve got to postpone spending that you’d otherwise like to do, and for some people that’s very difficult. But, as a discipline, getting that habit of saving early and accumulating is very important. I think it may have been Einstein that said compound interest is the eighth wonder of the world, and it really is.

Of course Vanguard makes a big thing about the need for investors to control their costs. Can you explain, in simple terms, the effect of fees and charges on the eventual returns that investors can expect to receive?

It’s really important to understand this. Investors typically have to pay 100 basis points, or 1%, for a typical active fund, compared to, say, 20 basis point for a passive fund. You might, think, “What’s the difference? 50 basis points or 80 basis points — that’s nothing”. But you should think about that in the context of an overall return, a gross return that might only be 4% or 5% on average for a balanced portfolio of equities and bonds. So rather than thinking that it’s 1/100th of the total capital that you’re paying, you’re suddenly losing a fifth of the total return and in some cases more than that — perhaps half of the overall return. When that accumulates through time, you can find a situation where say you end up with two-thirds or a half of what you could have had, over a long time period, simply because of that pernicious effect of costs building up and eating into your overall returns. It’s about compound interest. The more you keep, the more you get to gain.

Ultimately, of course, it’s all about the value you receive as an investor after all your costs have been factored in, isn’t it?

We would say exactly, it is completely about value. What an active manager is trying to demonstrate is that even though there is a cost of x — for example, 150 basis points — they can deliver for you, say, 250 basis points. So they’re going to give you additional return that will start to accumulate for you over the future.

There may be some active managers that may be able to do that, but the problem is, on average, most of the returns of those active managers aren’t 150 basis points, but more likely 100 or 50, once you’ve taken those costs into account. So that’s the problem.

We’ve done some research that shows that before you’ve taken cost into account, there are actually some active managers that are able to outperform the market. But then, of course, what happens is that because of the effect of those costs, which subtract from the overall returns, you end up underperforming an index fund or the underlying benchmark.


Did you miss Part 1 of Peter’s interview? Here it is:

Peter Westaway: A PhD in economics won’t make you a better investor


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Robin Powell

Robin is a journalist and campaigner for positive change in global investing. He runs Regis Media, a niche provider of content marketing for financial advice firms with an evidence-based investment philosophy. He also works as a consultant to other disruptive firms in the investing sector.


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