Elroy Dimson is a Finance Professor at Cambridge University, Professor Emeritus at the London Business School, Chairman of the FTSE Advisory Board and Chairman of the Strategy Council of the Norwegian Government Pension Fund. With his co-authors, he is the world’s leading authority on the history of financial markets. His Global Investment Returns Yearbook, produced annually with Paul Marsh and Mike Staunton, gathers data across major asset classes for 25 countries (including Australia) over 114 years, and is often quoted as the definitive source of market information.
I met Elroy Dimson at the 2014 Research Affiliates Advisory Panel at Laguna Beach, California.
When Elroy Dimson presents a paper or consults to clients in New York, he tries to be back home in London the same or the next day, often without needing a hotel room. Some of his meetings with the Norwegian Pension Fund are held at Heathrow or Oslo Airport. He is acutely aware that his highest profile work, the Yearbook, is taking up more of his time each year. Dimson is one of those people who needs 25 hours in every day.
Real return expectations
The obvious question for someone who analyses thousands of data points across 25 countries each year is what should an investor learn from reading the Yearbook. For example, it reports that US equities have never delivered negative real returns in any 20 year period. Does this mean a long term investor with a 30 to 40 year horizon should be invested almost all in equities?
Dimson does not encourage this view. He agrees that if you look at the statistics since 1900, the minimum holding period to be confident of a non-negative real return for US equities is 17 years. But the average for European countries is between 40 and 50 years, and he advises not to extrapolate from the past US experience, as the US may not be superior to most other countries in the future. Looking forward, with real bond rates around zero and an equity risk premium of maybe 3 to 3.5% and a 60/40 asset allocation, the overall return will be 2% real before fees. This is well under the expectations of most people.
He says expectations of returns have come down, and now many ‘thinking people’ believe a 3 to 4% real return is a more sustainable level for equities. By ‘thinking people’ he means consultants and asset managers who are honest with their clients, not worried that the client will think the consultant is failing to help achieve return objectives. Or that the next consultant or manager pitching 30 minutes later will be more optimistic and win the business.
Most investors need to accept and manage with these lower returns. Some endowments are supported by gifts, so maybe it matters less for a higher education institution or a charity funded by a flag day, but others who have to exist on what they earn need to manage it very carefully.
Asset allocation and rebalancing
Dimson has strong views on so-called tactical asset allocation. He says there is no evidence that market timing works. But he is in favour of countercyclical investing, in other words, buying when the mass of investors need to sell. When equity markets have declined, for example, insurance companies are faced with solvency margin implications, which means they can't do their ordinary insurance business. If they don't have the right balance sheet, they are forced to sell their risky assets. It makes sense for longer term, long horizon, low liability funds to move in the other direction.
The most difficult part of a rebalancing, such as buying stocks when markets are still falling, is going against what most others are doing. Dimson says it's very important when buying on weakness and selling on strength to have a long term strategy that stops knee-jerking. He quotes a British insurance company which during a heavy market fall announced a strategy of buying cheap. They were loading up on equities as prices fell, but then had to reverse their actions to maintain their solvency margin. Likewise, family offices, institutional investors or sovereign wealth funds must be able to maintain the strategy, because the worst of all is to knee-jerk and end up in a big mess. The Norwegians don't fall into that trap because they have a disciplined approach to strategy.
The truth in the numbers
Dimson is most often referenced for his long term data work, but the Yearbook has become more than simply an accurate source of financial markets numbers:
“Occasionally we do venture into expressing strong opinions, but quite often, we try to let the data speak for itself. We don't make such strong statements as people who make a living from forecasting. Most frequently, we are listening to what we think are current concerns. We have to form a judgement by about September each year on what will be the hottest issue in February the following year, and then we do the research. We try to capture what many people believe, and we can then let the data confirm or reject the story.
“When it became clear that expected returns were lower, we wrote extensively about that. We also analysed historical data to see if equities might save you from low interest rates. History reveals that income oriented equity strategies have had a long-term total return that has been superior to growth oriented strategies. There, we were a bit more forceful.
“Some market beliefs are not well-founded. The work we did earlier this year on emerging markets addressed the belief that emerging markets outperform, but there’s no compelling evidence one way or the other. Some investors who follow our work closely have ended up having much the same percentage in emerging markets, Europe, North America, and the rest of the world.
“We’ve also looked at country rotation strategies. People have said if you’re invested internationally, you should avoid countries with weak currencies. You don’t want gains on a national stock market to be offset by weak currencies. But we find you get a higher long-term reward from the equity markets of countries that have experienced prior currency weakness.
“Some believed if you buy countries with strong economic growth, you’d be rewarded. We thought this was implausible, and our evidence is clear. If you buy the common stocks of countries that have low economic growth, the subsequent performance is on average better. The extra risk is rewarded.”
Financial markets commonly feed on urban myths and generalisations, but Dimson finds truth in the numbers. He likes nothing more than testing a market perception that has gained credibility, using long-term data to evaluate it – and quite often, to shoot it down. And then he’s off to track down someone who has the data on the 26th country to add to the investment return series, or to tweak the accuracy of last year’s numbers. It’s a project which will never end.