The Equity Risk Premium (ERP) is a key component of every risk and return model in finance and reflects the price which investors place on equity risk. The ERP will impact decisions as diverse as how superannuation funds invest their assets, to the price at which regulated monopolies can charge for their products. David Carruthers reports.
Given the importance of the ERP to all actuaries, the sixth annual survey of the profession was undertaken in November 2016. The survey results highlighted an average equity risk premium expectation of 5¼% for the Australian market. As shown in Graph 1, this represents an increase over the average of 4.9% in the 2015 survey. The range of results this year was slightly higher than last year, with the “optimists” predicting an ERP around 7%, with the “pessimists” close to 4%.
Whilst the average ERP expectation rose over the year, the majority of respondents (64%) to this year’s survey indicated that their expectation had not changed over the year – the difference in results due to different individuals taking the two surveys. Almost 25% of respondents this year said that their expectation had decreased over the year, while the remainder (14%) had raised their ERP from the previous year.
Investing in Australian shares provides many investors with franking credits, the value of which will vary depending on the tax rate of the investor. The above results for the Australian ERP included an allowance, on average, on 1% for these tax credits – although results varied from 0% to 2%. Without this allowance, the Australian ERP would have been 4.3%.
The ERP for global developed market shares was generally slightly higher than for the Australian market. On average, respondents assumed that these markets would produce around 20bps more return than Australian shares (after removing the allowance for franking credits). However, the majority of those surveyed (47%) assumed no premium for investing globally, as shown in Graph 2.
Emerging markets, which are typically viewed as more risky, were expected to produce a commensurately greater return to offset this higher risk. On average, the survey showed a 1.6% premium for investing in emerging markets over developed market shares. However, almost 20% of respondents expected a premium of 3% or more.
Most people (52%) use a variety of methods for determining the equity risk premium, with forward looking measures (26%) more prevalent than historical data (17%).
The ERP survey was undertaken in the days following the US election. The Trump election saw the Australian stock market rise by almost 3% in November (and more than 4% in December). Australian 10 year bond yields also rallied, rising by around 40bps in each of September and October.
With this backdrop, we asked what the effect of a rise in either interest rates or inflation would have on the ERP estimate.
As the above results show, two-thirds of respondents do not expect an increase in interest rates to affect their estimate of the ERP. The remaining third would decrease their ERP estimate if rates rise.
The results for an increase in inflation are more mixed. Again, most expect an increase in inflation to have no effect on the ERP. However, a similar number expect their ERP estimate to increase/decrease if inflation rises. As one respondent noted, it may be depend on the cause of the rise of inflation.
The importance of the ERP was highlighted in the responses as to how it is used. Over two-thirds of respondents (68%) used the ERP in asset allocation/portfolio construction decisions. The ERP is also used in the valuation of assets (36% for unlisted assets and 14% for listed assets). In addition, 17% of respondents indicated that the ERP was used in the valuation of liabilities.
About the survey: This year’s survey took place from the 23rd November to the 12th December 2016. A total of 24 people completed the survey. As such the results of the survey should not necessarily be taken as an indication of the results of the full profession. Investment was the most populous practice area (41%), followed by Superannuation (32%), Life (23%) and General Insurance (14%). Almost three-quarters of respondents had over 20 years’ experience.
In line with previous years, we defined the ERP as ‘the expected excess of the return of the market portfolio of equities over the long-term sovereign bond rate’. As such, the Australian ERP is defined as the expected return on the Australian share market (the S&P ASX 200 Accumulation index is a reasonable proxy) less the 10-year Australian government bond yield.
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