What If the Risk/Return Theory Was Wrong?

Investors were not better rewarded for taking risk over the past decade and until the economic waves die down, this could well continue.

(July 31, 2012) — The adage of risk leading to return has been blown out of the water by research conducted by investment consultant Redington.

Data from the United Kingdom-based firm has shown that fixed-income outperformed a range of equities on an annualised basis between June 1999 – June 2012.

Crucially, the measure showing how well compensated an investor is for taking risk indicated that previous thoughts on the matter may be out of kilter.

“The Sharpe Ratio is used to show how well the return from an asset compensates an investor for the risk taken – the higher the number the better. Credit assets have shown much higher ratios than equities and commodities across all time periods, with the latter both showing negative ratios at certain points,” the Redington report said.

The risk-free rate used to measure risk in this instance is three-month Libor, which stood at 4%.

Over the 13-year period, the MSCI World index returned 2.7% on an annualised basis with a negative Sharpe Ratio of 0.08. The MSCI Emerging Markets index fared a little better, making a 9.6% return with a slightly better Sharpe Ratio – a positive 0.23.

Over a one and five-year period, both sets of equities made losses and bought investors double-digit volatility for their trouble, Redington said.

However, non-government debt issued in the United Kingdom made an annualised 6% return with a Sharpe Ratio of 0.41, while relatively risk-free sovereign issued 15-year gilts made an annualised 6.7% with a Sharpe Ratio of 0.35. For global bonds the figures were similar. Redington’s data showed global non-government bonds returned an annualised 6.6% with a Sharpe Ratio of 0.34, and 11% over a five-year period with a Sharpe Ratio of 0.88.

Should this phenomenon continue, many investors – and their consultants – may have to reassess their approach to risk.

The Redington report continued: “For long-term investors, the actual performance of equity since 1999 has been far below returns expected from the asset class. The debt-versus-equity question grows ever more puzzling to answer – can bonds continue to show higher returns with lower risk even at these high prices/low yields, or will the next decade break from the last?”

The report cited actions by global central banks affecting each asset class.

“Since the Great Financial Crisis began in 2008, equity markets have been buoyed by each new monetary policy boost and the promise of cheap lending by central banks for the foreseeable future. Bond prices have also been buoyed by central bank actions, in addition to support from falling inflation rates, regulatory changes, a search for yield and the need for liability-matching assets by pension funds and insurers.”

Redington concluded that until the current period of uncertainty was over – and the end, for the moment, is not in view – investors should be wary of claims that higher risk would lead to higher returns.

“A number of economic hurdles need to be cleared before a lasting recovery is in place and it could take a number of years before an end to the GFC is declared officially. With monetary bazookas being central bankers’ weapon of choice and fiscal austerity being used by politicians, it may turn out that credit assets continue to post positive returns while equities grapple with what the debt crisis and its solutions mean for longer-term stock valuations.”

To access the full report, click here.