Bond ETFs vs equity ETFs

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Australian investors are increasingly spoilt for choice when it comes to seeking plain vanilla equity or bond market exposure through exchange-traded funds, or ETFs.

All the major ETF providers – StateStreet, Vanguard and iShares – have listed ETFs that track either the top 200 or 300 stocks by market capitalisation. And Vanguard, iShares and Russell also have a range of fixed income ETFs on the market (Read more on broad-based ETFs and bond ETFs).

Investors now have a cheap and easy way to manage their core asset allocation between these two major investment classes. The only question now is what weights to attach to them.

In this regard, a word of caution: given the recent poor performance of equity markets relative to bonds, there’s been some commentary of late that the usual preference for the former in a growth portfolios is wrongheaded. Maybe safer bonds are better after all?

Comparing the two

Not helping the equity case is this startling fact: bonds have beaten equities not just in the past year or so, but over the past two decades.

Indeed, in the 22 years between December 1989 and December 2011, the annual compound return from the UBS benchmark Australian composite bond index has been 8.9%. And in exchange for this return, investors have had to endure a standard deviation in annual returns of 7.1%. In other words, investors had a two-thirds chance of getting a return each year between 1.8% and 16%.

In the equity market, the MSCI Australian equity index produced a compound annual return of 8.5% over the same period. Yet this time, investors had to endure a standard deviation in annual returns of 18.6% – or 2.5 times larger. Investors had roughly a two-third chance of getting an annual equity return between minus 10.1% and 27.1%.

So does this mean the old adage that equities produce the best long-run returns is bunkum? Not necessarily.

The past two decades have seen profound structural and cyclical changes in the economy that helped keep equity returns down, but most importantly, temporarily boosted the returns from bonds.

Will inflation rise?

The single greatest change over the past two decades has been a structural decline in the rate of inflation – and by consequence the level of interest rates. As bonds pay out a fixed dollar coupon each year, declining market interest rates boost their capital value – providing investors an added capital gain over and above that of their yield return in the year in which interest rates decline.

Cyclically, the recent global financial crisis has also caused central banks in Europe, Japan and the United States to slash their official policy rates to very low levels and print cash to buy bonds. These actions have driven down long-term bond yields to unusually low (and likely unsustainable) levels. The US 10-year bond yield, for example, is hovering around 2%.

As a result, the GFC has given the return on bonds an added cyclical boost in the past few years.

A change is coming

But as and when the global economy recovers, interest rates should rise to more normal levels – producing capital losses for bonds holders. And the return on bonds will be even worse if the huge private and public debt overhang in the developed world encourages central banks to tolerate higher inflation – which could start to unwind the structural decline in interest rates bond holders have enjoyed over the past two decades.

The most likely long-term return for Australian bonds is probably closer to 5.5-6%. And over the next three to five years, annual returns (factoring in capital losses) could be considerably less.

The pain of the GFC meanwhile has left equity markets reasonably cheap, and likely poised for above average returns over the next few years. The price-to-earnings ratio for the Australian MSCI equity index, for example, ended last month at 13.5 – compared with a 22-year average of 17.5. Prices could rise by 30% relative to current earnings just to get the PE ratio back to average – which equates to an added 5.5% annual return if achieved over, say, five years.

On top of this, equity investors should benefit from a trend rise in earnings over time (around 6% on average per year) plus a dividend yield of around 3.5 to 4%.

All up, perhaps a more relevant investment adage to keep in mind is that past returns are not necessarily a good indicator of future performance. Indeed, bonds returns are likely to remain relatively less volatile, but they’re unlikely to keep beating equity returns in the next few years. The pendulum is due to swing the other way.

Important information: 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. Any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek professional advice.

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