Perhaps the simplest way to get exposure to Australian equities is to buy an Exchange Traded Fund (ETF), such as STW from State Street that is a mimic of the S&P/ASX 200. Alternatively, there are index-tracking managed funds such as those provided by Vanguard Fees are very low on these products compared to an actively managed fund that seeks to outperform the benchmark index. So what return should an investor expect?
The long run
In any given year, it is very hard to predict the return on the index. However, over longer periods, the task gets a bit easier. Since data on the ASX 200 only goes back to 1992, I have analysed data on the All Ordinaries in Table 1 back to 1962. The All Ordinaries comprises the ASX 200 plus about 300 smaller capitalised stocks listed on the same exchange. In the left hand panel of Table 1, I have averaged the capital gains (that is excluding dividends) in periods all ending in December 2013 but with differing lengths of data.
Table 1: Average historical growth rates on the All Ordinaries
Source: Wren research
Starting with the latest five-year period, the average capital gain was 8.1% per annum. That figure is higher than in many five-year periods because it so happens the market was near the bottom of the cycle in December 2013 and near a five-year high in December 2013. Adding previous blocks of five years of data, makes the average fall to around 5% per annum until the 1983-1988 period is included. Prior to that period, the average jumps back up. So which average should be used as a guide?
In devising my own investment strategies, I use 5% as a rough base for a long-run return and supplement my 12-month-ahead view with my broker-based forecasts that I have discussed on this site and I post my forecasts [1]on a weekly basis.
Dividends supplement the capital gains on the index. The dividend stream (in dollars) is typically smoother than the price index so that the ratio – or dividend yield – is more variable than the income stream. A reasonable historical average yield is around 4.5% pa.
Franking credits do change over time but 70% – 80% is a rough guide many use for predicting what are known as grossed-up dividends (that is, grossed up for franking credits) on the ASX 200. So my conservative (70% franking) estimate for a grossed-up yield for the index is 4.5% x (1 + 0.7 x 3/7) = 4.5% x 1.3 = 5.85%. For my personal calculations, I use 5% capital gains and 6% (grossed-up) yield – or 11% total return – as my guide for long-run expectations.
Don’t forget inflation
Investors should always adjust expectations for tax and inflation. For zero-tax payers, only inflation needs to be considered. Inflation was rampant in the 1970s and 1980s but has been contained by Reserve Bank (RBA) intervention since then. If the RBA continues to be as successful, a forecast of 2.5% or 3% per annum is a reasonable annual rate of inflation going forward. The inflation rate only needs to be subtracted from the capital gain as the yield is itself a percentage of the stock price. So, for a zero-tax universe I use what is called a ‘real’ (or inflation-adjusted) capital-gains forecast of 2.5% per annum and a yield of 6% per annum making a total (grossed up) return of 8.5% per annum. While inflation at 2.5% might seem small enough to ignore, it does mount up over time and so it should be accounted for.
For investors no longer contributing to super but drawing down 6% or less in a pension, the capital might not need to be touched and it might grow at around the real rate of 2.5% per annum. More importantly, not needing to draw down capital during bear markets is really important as any part which is drawn down cannot ‘bounce back’ if the market subsequently bounces back.
My new portfolio
I am in the process of creating a new yield-type portfolio for myself that seeks to make capital gains as well as produce a high yield. My current forecast from that prototype model is 6% yield (or 8% grossed up) with the prospects of a capital gain for the next 12 months of 9%. Of course, my gains’ forecast could well be off track – particularly if there is another big global macro event such as those experienced in the last few years – but I believe there is a good chance of getting a grossed-up yield near 8%. If I draw down only 5% and a bear market strikes, I can reinvest that excess 3% at possibly a market low or I can keep it in cash to supplement the next year’s pension drawdown.
Since it is my opinion that I think the market will be soft in the April – June quarter, I am not in a rush to rebalance and possibly make a mistake. It is my savings that are at stake.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
Also in the Switzer Super Report:
- Tony Featherstone: SSR takeover targets – Reckon, iiNet and NIB Holdings [2]
- Super Report Subscriber: SMSF – A hobby not a chore [3]
- Staff Reporter: Buy, Sell, Hold – what the brokers say [4]
- Tony Negline: Segregation anxiety – how to split assets [5]
- Questions of the Week: Time for a cleanout and off-market transfers [6]