Anthony Asher and David Carruthers help manage expectations with the 2015 Equity Risk Premium Survey. Find out what the results mean for you.
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.
Given the importance of the ERP to all actuaries, the fifth annual survey of the profession was undertaken in December 2015. The survey results highlighted an average equity risk premium expectation of 4.9% for the Australian market. As shown in Graph 1, this represents an increase over the average of 4.4% in the 2014 survey (4.8%, 4.6% and 4.7% in the 2013/2012/2011 surveys). The range of results this year was similar to last year, with the “optimists” predicting an ERP around 6%, with the “pessimists” close to 2.5%.
Whilst the average ERP expectation rose over the year, the majority of respondents (52%) 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 35% 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. It is interesting to note however that the change in the average is roughly tracking the dividend yield on the ASX, which is perhaps something of an anchor point.
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, of 1% for these tax credits – although results varied from 0% to 1.5%. Without this allowance, the Australian ERP would have been 3.8%.
The ERP for international shares was generally slightly higher than for the Australian market. On average, respondents assumed that global markets would produce around 40bps more return than Australian shares (after removing the allowance for franking credits). However, the majority of those surveyed (46%) 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 international shares. However, over 20% of respondents expected a premium of 3% or more.
Most people (52%) used a variety of methods for determining the equity risk premium, with forward looking measures (21%) more prevalent than historical data (17%) for the rest. The methodology for determining the ERP ranged from detailed modelling to “gut feel based on 40 years’ experience”. Gut feel has a bad name in some quarters (See Juha m Alho (1992) Estimating the Strength of Expert Judgement: The Case of US Mortality Forecasts) but only time will tell which method proves to be most accurate.
The importance of the ERP was highlighted in the responses as to how it is used. Almost two-thirds of respondents (66%) used the ERP in asset allocation/portfolio construction decisions. As such, it is unsurprising that 60% of people indicated that over estimating the ERP would result in excessive exposure to equities – and 79% indicated that under estimating the ERP would lead to an inadequate investment in equities.
The ERP is also used in the valuation of assets (28% for unlisted assets and 24% for listed assets). Rejection of projects which were actually profitable was highlighted by a quarter of the survey responses as an impact of over estimating the ERP. Under estimating the ERP could result in excessive investment in longer term projects (11% of responses).
On this score, a speech by Phillip Lowe of the RBA last year highlights what may be a major obstacle to economic growth in the years ahead. He produced the graph below, noting that the hurdle rates of return that firms use for new investments are “quite sticky and that they are not very responsive to movements in interest rates”:
Investment in new long term projects (think particularly renewable energy and infrastructure), will be severely curtailed if shareholders are expecting returns of 6% real and managers are not investing in projects with an expectation of return of twice that. Actuaries in the UK have been concerned about this issue for some time. (See Lewin C.G., A. Carne, N. F. C. De Rivaz, R. E. G. Hall, K. J. Mckelvey and A. D. Wilkie, (1995) ‘Capital Projects’. British Actuarial Journal 1.2 pp. 155-249)
In addition, 17% of respondents indicated that the ERP was used in the valuation of liabilities. Over estimating the ERP in this circumstance could result in the underfunding of superannuation or other liabilities (43% of responses). Under estimating the ERP could result in excessive caution in determining defined benefit contribution rates (21% of responses).
About the survey: This year’s survey took place from the 9th to the 19th December 2015. As with last year, 29 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 (42%), followed by Superannuation (31%), Life (23%) and General Insurance (15%). More than half 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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