Equities and Fixed Interest Performance under the spotlight

Equities, often also referred to as shares or stocks, could be considered the ying to fixed interest's yang. Where fixed interest is generally included in a portfolio as a defensive asset with the intent of reducing volatility of returns, equities are included in a portfolio as a growth asset, with the aim of producing returns. While the asset classes do not always abide by these roles, traditionally this is the reason for their allocation in an investor's portfolio.

The following two charts display the monthly rolling annualised returns for domestic bonds and domestic equities.

Monthly Rolling Annual Returns for Australian Fixed Interest as at 31/05/1993 – 30/06/2008 Source: Bloomberg

Monthly Rolling Annual Returns for Australian Equities as at 31/05/1993 – 30/06/2008 Source: Bloomberg

Scanning the charts, two differences are immediately obvious. First, fixed interest returns have peaked at around 20 per cent compared to equities, which reached 40 per cent. Second, there are a lot more periods of negative return with equities than with fixed interest. In fact, there are only 13 observations of negative returns produced by an investment in fixed interest compared to 48 observations of negative returns produced by an investment in equities, in this time frame. Further those negative equity returns were in the order of 15 to 20 per cent whereas the negative fixed interest returns were generally less than 5 per cent.

We may also look at global returns to understand how an allocation to both fixed interest and equities can help to smooth returns. Over the past 15 years, Global Equities have returned 5.07 per cent p.a. Global Bonds have returned 7.69 per cent p.a.

Risk, briefly mentioned earlier, needs closer examination. If you invested in global equities the risk exposure, measured by standard deviation of returns, is 15.14 per cent, over the last 15 years. However, if you invested in global fixed interest the risk you would incur over the same time is 3.58 per cent. This means the variability in annual returns is much greater in equities than fixed interest, or in other words, equity returns can swing from positive one year to negative the next with much greater frequency than returns generated by fixed interest investment.

The chart below shows the returns for global equities and global fixed interest over a number of different periods. If we use the returns over a one year period as an example, we can see that the global equities produced a negative return of -8.96 per cent. Therefore if an investor had invested $100 in global equities at the start of the year they would have $91.04 at the end of the year. If, however, they have invested some of the $100 in global fixed interest they would have at least partially offset this loss as fixed interest returned 7.07 per cent for the year.

as at 30 September 2009

But this is only one of the return streams from equities and fixed interest, the other potential return paid to the investor from owning shares and bonds is income. Traditionally, investors held bonds for income. A bond is a loan; as such an investor can expect to receive a steady stream of interest payments for the life of the loan (assuming the issuer of the loan is not in default). The predictability of the payments has always been a central attraction for institutional investors such as superannuation funds, since they can use the income to meet similarly predictable liabilities. Reinvesting the interest paid in bonds can increase capital over time due to the effect of compounding.

While shares might also provide income through dividend payments, they tend to be much smaller than bond coupon payments, and companies make dividend payments at their discretion. Bond issuers are obligated to make known coupon payments on a predictable and regular basis.

For investors seeking regular income, and certainty of return from their capital, fixed income provides a more assured alternative where security is a key issue. Equities tend to provide a higher level of overall return over the longer term, but without the certainty of regular income.