Chapter 14: Relationship between returns on asset classes

Question 1

Why are returns a key consideration in development of an investment portfolio?

Answer 1

• Returns offered by particular asset or asset class are always key consideration in development of an investment portfolio – since investment objectives will normally make some reference to expected returns
• Important to bear in mind that returns that actually are received on any investment or asset class are in practice unlikely to exactly equal expected returns

Question 2

How is the required return on any asset class written and discuss the required return further.

Answer 2

Required return

• Return that investors require on any asset class can be written as:

Required return = required risk-free real rate of return + expected inflation + risk premium

• Makes sense if we consider that investors will require:

 That value of their investments do not decrease in real terms

 Additional compensation for giving up use of cash that they invest over period of investment

• Risk premium reflects compensation required for risk that is incurred by undertaking the investment
• Terms on right-hand side represent market averages as investors are considered as a class here
• Individual investors will have differing views on each component on RHS, upon which they will base decisions to buy/ sell particular securities or asset classes
• Interaction of overall market demand with supply is what determines market price
• Assumed that market defines risk-free in real rather than nominal terms
• Risk-free real rate of return can be taken as real yield on an index-linked government bond of appropriate term
• Risk premium on particular asset class will depend on characteristics of asset and investors’ preferences which are largely driven by their liabilities
• Higher return required from riskier asset classes
• Risk premium in equation may cover any adverse feature of one investment relative to another for which investors require compensation

Question 3

How is the expected return on any asset class written and what is the expected return?

Answer 3

Expected return

• Expected return = initial income yield + expected capital growth
• Expected return is what investor expects to achieve on asset, given that:

 Price paid for asset

 Price for which investor expects to sell/redeem the asset

 Expected income while asset is held

Question 4

How does the require return compare with the expected return?

Answer 4

Required vs expected return

• If assets are fairly priced then required and expected returns will be equal
• CAPM expresses this – where expected returns are expressed as return on risk-free asset plus risk premium dependent on systematic risk of asset
• CAPM determined the expected required return, i.e. suggests that expected return on any asset is:

 Equal to risk-free rate of interest + additional risk premium to reflect its systematic or market risk

 Linearly related to its systematic risk

Question 5

How is the required and the expected returns used to determine whether an asset seems cheap?

Answer 5

Determining whether an asset seems cheap

• Required and expected return can be used to determine whether particular asset classes appear good value to particular investor
• If for an investor, the expected return exceeds the required return, then the asset appears cheap

Question 6

Analyse the expected return of equities.

Answer 6

Equities

• Economic growth i.e. GDP growth, comes from land, labour and capital
• Over long term, equity dividend growth might be expected to be close to growth in GDP, assuming that share of GDP taken by capital remains constant
• Equities would thus be expected to give real return close to growth in real GDP + equity yield
• Short-term fluctuations are significant and actual returns achieved by investors will depend on exact timing of deals as well as their tax position
• There is dilution effect due to need for companies to raise new equity capital from time to time if dividend yields are high
• This arises through new issues of shares in existing companies
• Dilution effect also depends on extent to which economic growth is generated by start-up companies
• If earning of unquoted companies grow more quickly than those of quoted companies, then share of profits attributable to quoted companies must decline

Question 7

Analyse the expected return of conventional bonds.

Answer 7

Conventional bonds

• For fixed-interest stocks there is no income growth
• Initial yield and capital value change for bond held to redemption combine to give fixed nominal total return i.e. gross redemption yield
• The analysis of total returns compared with inflation:

 When inflation is higher than expected, real returns from fixed-interest stocks are lower than expected and poor compared with equities

 In periods when yields are rising, real returns from fixed-interest stocks are poor

 And vice-versa

• When nominal yields are rising, bond prices will be falling
• Thus, investor who bought bond and sold it at reduced price will achieve poor nominal return

Question 8

Analyse the expected return of index-linked bonds.

Answer 8

Index-linked bonds

• Real return on index-linked bonds known at outset if held to redemption
• Real yield often taken as benchmark required real yield for the analysis of expected returns on equities
• If equities are fairly priced in market then expected return on equities should equal that on long-dated index-linked government bonds + risk premium
• Index-linked bonds will not afford complete inflation protection if coupon and redemption payments are related to appropriate price index with time lag
• Time lag exists so that nominal amount of next payment is always known
• If index-linked bonds are sold before redemption then actual real return will depend on price for which bonds are sold
• This will be influence by normal supply and demand issues

Question 9

Analyse the expected return of cash.

Answer 9

Cash

• Returns on cash may be expected to exceed inflation except when inflation is rising rapidly and under-estimated by investors
• Short-term real interest rates can be kept very high or very low by government for significant periods

Question 10

For which investors will the growth of earnings be of interest?

Answer 10

Earnings

• The growth in earnings over time is of interest to investors with liabilities that are earnings-related
• For example:

 Defined benefit pension schemes – benefits are related to final or average salary of employee

 General insurers – who may face earnings-related claims