The Ebbs and Flows of Returns

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To further enhance our perspective on long-term expected returns and the effect of ebbing and flowing short-term returns, let’s start by looking at index returns prior to the global financial crisis:

It’s reasonable to describe annual returns over nine decades as the “expected returns” for the asset classes. More conservative investors might discount these to 9%, 11%, and 13% (before inflation). But for the sake of this illustration, it’s the relative, not absolute, numbers that really matter. We can also assume these are the expected returns for non-US developed markets as well. Since the MSCI international index data starts in 1970, we’ll have to adjust our time frame to include those markets:

Looks like our assumptions are reasonable, although the numbers are higher than expected.

Should we expect returns to “correct” to their long-term expected returns eventually? We think so, and that’s what has happened (next chart). It’s always the timing that’s unknown.

Of course, this includes the brutal July 2007 to February 2009 decline (which I won’t show, out of mercy). What are the results for the full period?

Hmm. Twelve years of ups and downs, and actual returns align with expected returns once again. So, what should we expect of returns going forward? How does 9% for the markets and 11% and 13% for large value  and small value stocks, respectively, sound—for US and on-US stocks?

As market returns ebb and flow more or less randomly in the short term—rendering market timing a destructively foolish behavior—the best strategy is to diversify among asset classes that are relatively uncorrelated and contribute positively to long-term returns, own asset class funds with a long history of structural integrity and consistency to more fully capture those returns, and rebalance to your targets when necessary.

Investors should understand this:

When one asset class dominates for a period of time—as US large growth stocks have recently—asset class funds that are structured and optimized to offer the greatest exposure to other asset classes over the long term will perform worse in the short term than “peer” funds that are not as well structured and optimized.

This is a basic truth that drives our fund selection for client portfolios and fuels our discipline.

Shifting to funds that have performed better in the short run but will underperform when the tide turns (and over the long run) is just another form of performance-destroying market timing. Unfortunately, frustration, impatience, and a misunderstanding of the importance of superior and consistent fund structure often drive this kind of destructive investor behavior. Clients who know this appreciate our rebalancing into lagging asset class funds, even though at times it can feel very uncomfortable.

Simply stated, firms like Equius have the responsibility to maximize your investment experience over your investing time horizon by selecting the best funds for the job and staying with them through cycles like these.

The global developed markets offer a choice: you can be patient with their short-term randomness and be confident the long-term expected returns will prevail, or you can jump around and virtually guarantee to reduce your portfolio returns by a significant degree in the process.


All returns shown are annualized.

Descriptions of Indexes
S&P 500 index: The S&P 500® is widely regarded as the best single gauge of large-cap U.S. equities. There is over USD 9.9 trillion indexed or benchmarked to the index, with indexed assets comprising approximately USD 3.4 trillion of this total. The index includes 500 leading companies and covers approximately 80% of available market capitalization. © 2019 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved.

US Large Value index: June 1927 – December 1974: Dimensional US Large Cap Value Index Composition: A subset of the US Large Cap Index. The subset is defined as companies whose relative price is in the bottom 25% of the US Large Cap Index after the exclusion of utilities, companies lacking financial data, and companies with negative relative price. The Eligible Market is composed of securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market. Exclusions: Non-US companies, REITs, UITs, and Investment Companies Source: CRSP and Compustat. January 1975 – Present: Dimensional US Large Cap Value Index Composition: Consists of companies with market capitalizations above the 1000th largest company of the Eligible market whose relative price is in the bottom 30% of large companies after the exclusion of utilities, companies lacking financial data, and companies with negative relative price. The Index emphasizes securities with higher profitability, lower relative price, and lower market capitalization. Profitability is defined as operating income before depreciation and amortization minus interest expense divided by book equity.

US Small Value index: June 1927 – December 1974: Dimensional US Small Cap Value Index Composition: A subset of the US Small Cap Index. The subset is defined as companies whose relative price is in the bottom 25% of the US Small Cap Index after the exclusion of utilities, companies lacking financial data, and companies with negative relative price. The Eligible Market is composed of securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market. Exclusions: Non-US companies, REITs, UITs, and Investment Companies Source: CRSP and Compustat. January 1975 – Present: Dimensional US Small Cap Value Index Composition: A subset of the US Small Cap Index. The subset is defined as companies whose relative price is in the bottom 35% of the US Small Cap Index after the exclusion of utilities, companies lacking financial data, and companies with negative relative price.

MSCI EAFE index: The MSCI EAFE Index is designed to represent the performance of large and mid-cap securities across 21 developed markets, including countries in Europe, Australasia and the Far East, excluding the U.S. and Canada. The Index is available for a number of regions, market segments/sizes and covers approximately 85% of the free float-adjusted market capitalization in each of the 21 countries. © 2019 MSCI Inc. All rights reserved.

MSCI Canada index: The MSCI Canada Index is designed to measure the performance of the large and mid cap segments of the Canada market. With 90 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in Canada. © 2019 MSCI Inc. All rights reserved.

MSCI Europe index: The MSCI Europe Index captures large and mid cap representation across 15 Developed Markets (DM) countries in Europe*. With 443 constituents, the index covers approximately 85% of the free float-adjusted market capitalization across the European Developed Markets equity universe. © 2019 MSCI Inc. All rights reserved.

MSCI Pacific index: The MSCI Pacific Index captures large and mid cap representation across 5 Developed Markets (DM) countries in the Pacific region. With 470 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country. © 2019 MSCI Inc. All rights reserved.

Equius Partners is a Registered Investment Advisor. Please consider the investment objectives, risks, and charges and expenses of any mutual fund and read the prospectus carefully before investing. Indexes are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio.

Past performance is not a guarantee of future results. This information is provided for educational purposes only and should not be considered investment advice or a solicitation to buy or sell securities. There is no guarantee an investing strategy will be successful. Investing involves risks, including possible loss of principal. Diversification does not eliminate the risk of market loss.

© 2019 Equius Partners, Inc.

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