Description
The purpose of this paper is to determine whether self-managed superannuation fund
(SMSF) trustees earn: the equity risk premium or any premium to the riskless rate of interest.
Accounting Research Journal
Can self-managed superannuation fund trustees earn the equity risk premium?
Peter J . Phillips Michael Baczynski J ohn Teale
Article information:
To cite this document:
Peter J . Phillips Michael Baczynski J ohn Teale, (2009),"Can self-managed superannuation fund trustees
earn the equity risk premium?", Accounting Research J ournal, Vol. 22 Iss 1 pp. 27 - 45
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Can self-managed superannuation
fund trustees earn the equity
risk premium?
Peter J. Phillips
School of Accounting, Economics and Finance,
University of Southern Queensland, Toowoomba, Australia
Michael Baczynski
University of Southern Queensland, Toowoomba, Australia, and
John Teale
University of Sunshine Coast, Sunshine Coast, Australia
Abstract
Purpose – The purpose of this paper is to determine whether self-managed superannuation fund
(SMSF) trustees earn: the equity risk premium or any premium to the riskless rate of interest.
Design/methodology/approach – Using a sample of 100 SMSFs, the average annual returns since
inception of the funds in the sample are compared with: the average annual equity risk premium since
that time and the average yield of Commonwealth Government Securities since that time.
Findings – The investigation reveals: the SMSFs in the sample do not earn the equity risk premium
and the SMSFs in the sample did not earn a premium to riskless rate of interest. This leads to the
conclusion that the SMSFs have borne risk without commensurate reward.
Research limitations/implications – The trustees’ rationale for making particular investment
decisions and the consistency of the portfolio structures with the risk pro?les of the trustees are two
areas that may be fruitfully explored in future research.
Practical implications – For SMSF trustees, a simple portfolio that divides assets between
(unmanaged) index funds and risk-free securities on the basis of trustees’ risk aversion may generate
better results than the existing portfolios. For policy makers, the relatively poor performance of SMSFs
implies that the superannuation system as currently structured may not be generating returns that
will maximize retirement incomes.
Originality/value – The paper provides the ?rst comparison of SMSF returns with the equity risk
premium and the riskless rate of interest measured at appropriate horizons.
Keywords Pension funds, Trustees, Financial risk, Interest rates
Paper type Research paper
Over the long term, equities (or shares) have generated returns of approximately
6 percent in excess of the returns generated by bonds. This is the equity risk premium.
Even if future equity returns cannot match those that have been generated historically,
there is still a strong case to be made for substantial investments in equities. This is
particularly the case for investment vehicles that should have long time horizons, such
as self-managed superannuation funds (SMSFs). Investment vehicles with such
long-time horizons can bear the short-term ?uctuations exhibited by the share market
and potentially generate substantial returns in excess of the risk-free rate over the long
term. Of course, this depends on the portfolios constructed by the trustees of SMSFs.
Poor portfolio construction, including under-diversi?cation or high allocations to cash
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1030-9616.htm
The equity
risk premium
27
Accounting Research Journal
Vol. 22 No. 1, 2009
pp. 27-45
qEmerald Group Publishing Limited
1030-9616
DOI 10.1108/10309610910975315
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assets, will signi?cantly reduce a portfolio’s ability to generate returns that match or
exceed the equity premium experienced by the broader share market averages. The
high-equity risk premium is an enticement for investment in shares. Whether SMSF
trustees have been able to earn the equity premium in the period since their funds were
incepted is examined in this paper.
The equity risk premium – which, in many Western nations, has averaged
approximately 6 percent above the riskless rate of interest – has de?ed explanation by
?nancial economists. In a now-classic article, Mehra and Prescott (1985) reported that
the extant models of asset pricing could not explain the magnitude of the difference
between the return on shares and the return on bonds. Mehra and Prescott (1985)
presented an analysis that revealed that the standard assumptions underlying the
application of the consumption-based capital asset pricing model (C-CAPM), with
plausible estimates for the relative risk-aversion parameter, are consistent with an
equity premium of just 0.35 percent. The equity premium that has characterised US
stock returns for over a century is almost 2,000 percent greater than what ?nancial
economists would have expected on the basis of the theoretical asset pricing models.
The inability of the most sophisticated asset pricing models to explain the historical
equity risk premium is one of the great puzzles of modern ?nancial economics.
The challenge that the equity premium presents to economic theorists would hardly
be foremost in the thoughts of most trustees of SMSFs but the magnitude of the equity
premium is very important for them just the same. For the average SMSF with assets
of approximately $800,000 (Australian Taxation Of?ce, 2008), the (real) 7.5 percent
per annum average Australian share market return would lead to a terminal value of
almost $5,000,000 over 25 years for a fully invested portfolio[1]. Even if the equity
premium were to fall by half, the average SMSF that is fully invested in Australian
equities would have a terminal value of almost $2,500,000. Whilst these terminal values
would be less for a portfolio with partial allocations to cash or ?xed interest securities,
the overall portfolio returns for a diversi?ed portfolio (with risky and low-risk assets)
would still be bolstered by the investment of some of the portfolio in equity securities
and would no doubt compare very favourably to a terminal value for a portfolio
fully invested in bonds over the same period. Whilst most SMSF portfolios will not
be fully invested in equities, the magnitude of the historical equity premium is a strong
incentive for at least some allocation to equities[2].
In addition, there continues to be a signi?cant public policy question surrounding
the ability for SMSFs to perform well. As highlighted elsewhere (Phillips et al., 2009),
the current retirement framework has only operated over a narrow and relatively
homogeneous period of the economic cycle, punctuated by the global market downturn
of 2007-2008. The development of superannuation schemes in Australia, and more
speci?cally the ability to self-manage those arrangements, has played out against a
backdrop of historic levels of return. However, if policy decisions relating to the
fairness of superannuation arrangements were made with more optimistic levels of
return in mind, then there is the potential that the amount set aside to fund safety-net
retirement incomes is under-endowed. Already, there have been reports of an increase
in the number of self-funded retirees seeking aged pension support due to the collapse
in value of their assets, and it is currently unknown, whether in the midst of other ?scal
pressures, the federal government has suf?cient reserve within their current scheme to
adequately account for increases in demand for pension payments.
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From a portfolio management perspective, the problem with recommending that
SMSF trustees attempt to take advantage of the high premium available on equity
investments vis-a` -vis investments in cash or bonds is that simply investing in equities
in a random or ad hoc manner will not guarantee a return that matches that generated
by the broader market averages. In fact, there is a possibility that poorly managed
portfolios may do considerably worse than the market averages and fail to earn the
equity premium (Siegel, 1999). Furthermore, policy makers who consider such returns
as actually being captured by any category of superannuation funds (including
SMSFs) will almost certainly be over-estimating the premium above the riskless rate of
interest that is being generated by these investment vehicles. That being said, SMSFs
(or any portfolios with allocations to equity securities) should earn some premium
above the riskless rate of interest. Just how much is actually being earned is an
important question, the answer to which promises to shed much needed light on the
nature and operation of the SMSF industry in Australia. In this paper, this question is
analysed by considering the annual returns since inception of a sample of 100 SMSFs.
The remainder of this paper is organised as follows. In Section I, the nature of the
equity premium puzzle is described and some of the relevant literature is brie?y
reviewed. Since this topic has been the subject of more than 300 scholarly articles
(Siegel, 2005), only a brief description is required. In Section II, the data collected for
this investigation is described. In Section III, Australia’s equity premium is calculated
over various overlapping periods since 1987 in order to facilitate the comparison of
the average annual returns generated by the SMSFs since their inception with the
average annual equity premium. In Section IV, the average annual returns generated
by the SMSFs since inception are compared with the average annual Australian equity
risk premium observed in corresponding periods. In Section V, the average annual
returns of the SMSFs are compared with the riskless rate of interest in order to
determine whether the SMSFs earned any premium above the risk-free rate. Section VI
concludes the paper.
I. The equity premium puzzle
In order to provide contextual completeness for this investigation, it is worthwhile
presenting a brief overview of the equity premium puzzle, the solution of which has
occupied ?nancial economists for almost a quarter-century. Within the context of
the standard form of the CAPM ðEðR
i
Þ ¼ r
f
þb
i
ðEðR
M
Þ 2r
f
ÞÞ, the investor’s utility
is assumed to depend only upon his or her expected future wealth and the expected
standard deviation of the possible divergence of actual wealth from that which
was expected (Sharpe, 1964, p. 428). Since wealth depends on investment returns, it is
possible to assume that in assessing an investment, the individual will base his or her
assessment on the expected return and expected standard deviation of returns (Sharpe,
1964, p. 428). The individual is assumed to favour additional expected returns and
dislike additional standard deviation of actual returns from expected returns (risk).
Formally, the individual’s utility is a function of expected returns and the standard
deviation of returns:
U ¼ f ðE
R
; s
R
Þ ð1Þ
where U is the investor’s total utility, E
R
is the expected return of an investment
ðdU=dE
R
. 0Þ and s
R
is the standard deviation of the possible divergence of actual
The equity
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returns from expected returns ðdU=ds
R
, 0Þ (Sharpe, 1964, p. 428). Geometrically, the
indifference curves that derive from this particular con?guration of the individual’s
utility are concave-upwards in the expected return-risk plane. One possible
speci?cation of the utility function for this type of individual is a quadratic function
for expected returns expressed as follows:
U ¼ ð1 þ bÞE
R
þ bE
2
R
2cs
2
R
ð2Þ
where E
R
and s
2
R
denote expected return and variance of return, respectively, b is a
parameter that adheres to the restriction – 1 , b , 0 when investors are risk averse
and c is a parameter that adheres to the restriction 0 , c , 1 (Tobin, 1958, p. 76).
Alternatively, it is also possible, as Elton et al. (2003) have shown, to write a quadratic
function directly for wealth:
UðWÞ ¼ W 2bW
2
ð3Þ
Underlying this theoretical work is the theory of risk aversion. Pratt’s (1964) work,
produced independently of Kenneth Arrow’s similar efforts, sets down the pure theory
of risk aversion. Indeed, the Arrow-Pratt measures of absolute and relative risk
aversion hold a place of some prominence in the literature:
R
A
ðWÞ ¼ 2
U
00
ðWÞ
U
0
ðWÞ
ð4Þ
R
R
ðWÞ ¼ 2W
U
00
ðWÞ
U
0
ðWÞ
ð5Þ
In equations (4) and (5), R
A
ðWÞ is the Arrow-Pratt measure of absolute risk aversion
and R
R
ðWÞ is the Arrow-Pratt measure of relative risk aversion. These measures have
a very desirable property. The numerical estimates of equations (4) and (5) do not
depend upon the units in which the utility is measured. This is a signi?cant advance
over the na? ¨ve measure of risk aversion computed simply by taking the second
derivative of the utility of wealth function, U
00
ðWÞ:
Whilst the derivation of these risk aversion measures represented a signi?cant
contribution to theoretical ?nancial economics, both the utility function in equation (3)
and in the numerators and denominators of equations (4) and (5) are not correctly
speci?ed (Siegel, 2005). Wealth is only a proxy for consumption and it is consumption
that is of the utmost concern to the individuals whose behaviour is modelled by the
equations of ?nancial economics. Once consumption was input into the utility
functions, the consumption based C-CAPM are developed. The C-CAPM of Breeden
(1979), Lucas (1978) and Grossman and Shiller (1982) is analogous to the standard
CAPM in many respects. The similarities are plain and the basic expression is
straightforward:
R
it
¼ a
i
þb
i
C
t
þ e
it
ð6Þ
Breeden’s continuous time asset pricing model is one in which asset betas are
measured relative to the aggregate real consumption rate, C
t
, rather than relative to the
market’s returns. In this context, Marshall and Parekh (1999) explain that the
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theoretical equity premium that ?nancial economists would expect to observe if the
C-CAPM were “true” is:
EP
0
;
2cov m
t
; r
e
t
À Á
Eðm
t
Þ
ð7Þ
where m
t
is the C-CAPM stochastic discount factor (SDF) or asset pricing kernel and r
e
t
is the excess return on equities (over the riskless rate of interest). Mehra and Prescott
(1985) showed that the covariance between the SDF and r
e
t
is very low. Equation (7)
therefore predicts an equity premium that is very low and, indeed, far lower than that
which has been observed empirically in most Western countries during the twentieth
century. Only when the coef?cient for risk aversion is allowed to be approximately
50 times greater than the highest plausible estimates of around 1.50 can the empirically
observed equity premium be reconciled with the C-CAPM. The inability of asset
pricing models to explain the magnitude of the equity premium is the source of the
equity premium puzzle.
Exactly, why the asset pricing models failed has been the subject of much
conjecture. Cochrane (2001, p. 24) offers a number of possible explanations:
.
people are far more risk averse than scholars have thought them to be;
.
the stock returns over the last half century were the result of good luck rather
than equilibrium compensation for risk; or
.
there is something “deeply wrong” with the theoretical models that have been
produced, including the utility function that has been deployed and the
utilisation of aggregate consumption data.
Of course, there are many more explanations extant in the literature, including the ?rst
solution proposed by Rietz (1988) and Barro (2006) that purports to solve the puzzle by
taking into account infrequently occurring disastrous events. According to Rietz
(1988), a large “crash” in output of 25-50 percent occurring with a probability of 1.4-0.4
percent per year generates ex ante equity risk premiums roughly consistent with the
observed equity premium (although the required risk aversion coef?cients are still a
little high). Unfortunately, despite its apparent promise, Rietz’s work and all
subsequent investigations have failed to resolve the equity premium puzzle to the
satisfaction of ?nancial economists.
Cochrane’s (2001) second explanation (above) may eventually prove correct. If so,
the equity premium that we can expect in the future will be much lower than that
which we have experienced over the last century. However, Siegel (2005, p. 70) adds:
The equity premium is a critical number in ?nancial economics. It determines
asset allocations, projections of retirement and endowment wealth, and the cost of capital
to companies. Economists are still searching for a simple model that can justify the premium
in the face of the much lower volatility of the aggregate economic data. Although there are
good reasons why the future equity risk premium should be lower than it has been
historically, projected compound equity returns of 2-3 percent over bonds will still give ample
reward for investors willing to tolerate the short-term risks of stocks.
With approximately $300 billion in assets under management, SMSFs account for about
one-quarter of Australia’s superannuation savings. Even if the equity premium falls by
half, the rewards for long-term investment in Australian equities may be substantial.
The equity
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Compound equity returns of 2-3 percent per annumabove the riskless rate of interest may
alleviate some of the possible shortfalls that are anticipated in Australia’s retirement
savings stream and provide a higher standard of living in retirement for those investors
who can earn the equity premium over the long term.
In this context, the present investigation has two main parts. First, we determine the
magnitude of the returns generated by each of the SMSFs in the sample. The purpose of
this is to highlight the difference in absolute magnitude between the returns earned by
the SMSFs and the “head-line” equity premium ?gures that are widely quoted and
discussed. Second, unless portfolios are completely risk free – as characterised by
b
j
¼ 0 – they should exhibit a positive premium to the riskless rate of interest. The
failure of SMSFs to generate any premium to the riskless rate of interest has signi?cant
implications. As mentioned in the introductory section of this paper, the ability of
investors to earn the equity premium on either part or all of their portfolios may be
impaired by poor portfolio management. Excess volatility of returns that results from
inadequate diversi?cation, for example, will generate a terminal value for the portfolio
that is lower than a less volatile portfolio even if the arithmetic mean annual returns are
the same. Whilst investments in equities have generated high returns above the riskless
rate of interest, the possibility remains that investors are unable to replicate the equity
premium on either their overall portfolios or the equity component of their portfolios.
There is also the possibility that investors are unable to earn any risk premium at all.
II. Data
In Australia, provisions of approximately $1 billion each week are made for retirement
through the nation’s superannuation system. The present mandatory superannuation
savings system has a relatively short history. The requirement for employers to
contribute a minimum percentage of gross income on behalf of employees to a
superannuation fund was introduced in the early 1990s, in a bid to widen the coverage
of superannuation to more working Australians. Additional contributions may be
made voluntarily. Whilst contributions to superannuation are compulsory for all wage
earners, individuals are generally free to choose the type of superannuation fund where
their savings will be invested. A popular choice is simply to invest in “retail”
superannuation funds which are available to all members of the public. That is, an
individual does not need to be employed in a particular industry to become a member
of a retail fund. However, numerous other options are available.
A choice that has been growing in popularity is “self-managed” superannuation.
A self-managed superannuation fund is a fund with fewer than ?ve members and may
comprise a group of individuals, a couple or a family. All members must also be
trustees of the self-managed superannuation fund and as such are responsible for
managing the fund’s investment portfolio, subject to various government regulations,
including the Superannuation Industry (Supervision) Act 1993. The compulsory and
voluntary contributions made to the SMSF and are managed by the trustees for the
“sole purpose” of providing for their retirement. It is against the law, for instance, to
utilise the funds in the SMSF for other than retirement purposes, such as purchase a
new car, a painting to hang in one’s house or a holiday apartment. The amount of
assets invested in SMSFs is $326 billion, which represents approximately 29 percent of
Australia’s total superannuation assets (APRA, 2008). There are now more than
400,000 SMSFs.
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For this investigation, a sample of 100 SMSF portfolio microstructures was
gathered. The data were obtained from a ?nancial services ?rm operating in one of
Australia’s capital cities. The funds in the sample were drawn more or less at random
from the total number of SMSFs administered by the ?nancial services ?rm. Bearing in
mind that each SMSF represents the retirement savings of a small group of people up
to a maximum of four members, the portfolios are quite large. The average size of
each of the 100 portfolios in the sample was $796,611 as at June 30, 2007. The largest
portfolios have a value of just over $4 million whilst the smallest portfolios have a value
of just under $200,000. Most of the SMSFs were formed over the last ?ve to 15 years
but a few of the funds were established more than 20 years ago. There is nothing
unique or special about the SMSFs in the sample that would lead to a conclusion that
the SMSFs are not representative of the broader population of self-managed
superannuation funds in Australia. Whilst the trustees of the SMSF portfolios may
have bene?ted from ?nancial advice in choosing investments and constructing their
portfolios, ultimately the trustees remain responsible for their SMSF.
The SMSF portfolios contained in the sample are reasonably large portfolios
containing an asset mix of cash, ?xed interest securities, managed funds and domestic
and overseas shares. For the most part, the equity investments are con?ned to
domestic Australian companies and fund managers. Some of the funds contain real
assets such as art and real estate. The average asset allocations of each of the 100
portfolios are shown in Figure 1.
It is clear from Figure 1 that the SMSFs in the sample are heavily weighted towards
cash, (Australian) shares and managed investments. The interesting feature is the high
allocation to managed investments. One rationale for initiating a SMSF is to obtain
more control over the investment strategy and execution and avoid the fees associated
with managed investments products. In light of this, the allocation of more than
one-?fth of the portfolios (on average) to managed investments is quite curious.
However, it is possible that the SMSF trustees use these investment vehicles to access
markets that are not easily targeted with direct investments.
The high allocations to cash and ?xed interest securities would appear to suggest
that the trustees are reasonably risk averse – approximately, 20 percent of the overall
Figure 1.
SMSF average
asset allocations
45%
Note: Sample of 100 portfolios
40%
35%
30%
25%
20%
15%
10%
5%
0%
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The equity
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33
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portfolios are allocated to these asset classes. However, a conservative investment
strategy would not normally have an allocation of 50 percent of the overall portfolio to
equity securities and, in most cases, the SMSFs in the sample are characterised by such
an allocation. Figure 2 shows the allocations to listed Australian shares of all SMSFs in
the sample.
The portfolios exhibit a dichotomythat is dif?cult toreconcile withthe asset allocations
associated with standard investment strategies. Rather than a consistently applied
strategy, the SMSF trustees simply split their portfolios into either cash or Australian
shares. The result is a portfolio that is neither consistently conservative nor consistently
aggressive (to any degree). Whilst this problem may be traced to poor portfolio
management, it is more likely that poorly constructed investment strategy documents are
the source of this dichotomous (and ad hoc) portfolio construction. Permissible
asset allocations must be set very wide. This permits a level of ?exibility but will, in the
absence of disciplined portfolio management, result in unstructured portfolios.
In light of these compositions of the SMSF portfolios, it would be surprising if the
SMSFs in the sample are able generate returns that match or exceed the premium
above the riskless rate of interest exhibited by the broader market averages. As Siegel
(1999) has suggested, problems with portfolio construction may lead to returns that fall
short of those experienced by the share market in general. However, whilst Siegel
(1999) suggests that poorly diversi?ed portfolios with a lower expected return than the
market combined with transactions costs will prevent investors from matching the
equity premium, the magnitude of the differential between the equity premium and
what investors actually earn is only able to be determined by an investigation of
individual portfolios. The SMSF portfolio data obtained for this investigation provide a
unique opportunity to determine whether a group of investors has been able to earn the
equity premium and, perhaps more importantly, whether they have been able to earn
Figure 2.
SMSF allocations to listed
Australian shares
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
0 10 20 30 40 50 60 70 80 90 100
Note: All 100 portfolios
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any premium to the risk-free rate at all. In the following section, the average annual
returns since inception of the SMSFs in the sample are compared with the average
annual equity premiums over the same time periods.
III. The equity risk premium in Australia
The equity risk premium is measured by determining the difference between the rate of
return on stocks and the riskless rate of interest. In practice, the yield on either short- or
long-term government securities is deployed as a proxy for the risk-free rate of return.
Because both equity returns and bond yields are reported in nominal terms, this
approach avoids the necessity of adjusting the ?gures for in?ation (Brailsford et al.,
2008). Like most Western countries, Australian shares returned a large equity risk
premium throughout the twentieth century. With real rates of return on government
bonds averaging a little over 1 percent per annum and real rates of return on
government bills averaging a little less than 1 percent per annum, Australia’s
7.5 percent per annum real stock returns generated an equity risk premium of
approximately 6 percent each year during the period 1900-2003 (Siegel, 2005, p. 64).
The equity premium ?gure of approximately 6 percent appears to be quite stable
across a number of different empirical studies. Siegel’s (2005) estimate of 6 percent for
the Australian equity premium is con?rmed by Brailsford et al. (2008) who found that
Australian shares returned a premium of 6.20 percent per annum over bonds for the
period 1883-2005 and 6.30 percent over bonds for the period 1958-2005. Given that
there are a number of estimation problems that can affect the result of the analysis, this
is also close to Of?cer’s (1989) result of 7.90 percent for the period 1883-1987 and
Dimson et al. (2002) result of 7.50 percent over the period 1900-2000. However, Jorion
and Goetzmann (1999) computed a considerably lower value – just 1.58 percent – for
the real return generated by Australian equities over the course of the twentieth
century. The estimation of the equity premium can be quite contentious and this
should be borne in mind when calculating the premium or discussing results.
Whilst debate continues on a number of issues surrounding the measurement of the
equity premium, it is clear that the long run average Australian equity risk premium of
6 percent per annum conceals the extraordinary volatility that the equity risk premium
has exhibited from year to year over the past two decades. Since 1987, the Australian
equity risk premium has averaged 4 percent per annum. This is much lower than the
historical average but the time series has been far from stable. On the contrary, the
equity premium has exhibited 14 percent annual standard deviation during the 20 year
period-2007. The equity premium in Australia over the last two decades has ranged
from a low of 231 percent during 1990 to a high of approximately 28 percent in 1993.
Interestingly, the equity premium has exhibited a tendency to retreat substantially and
register negative annual values following periods where it has reached high points of
20 percent or more in any given year.
The data collected from the sample of SMSFs allowed us to compute the average
annual return generated by the funds since their inception. Since the SMSFs have
different inception dates at various points in time over the past two decades, it is
necessary to compute the equity risk premium in Australia over various time horizons
in order to facilitate the comparison of the average annual returns of the SMSFs for the
period since their inception with the equity risk premium generated by Australian
stocks over the corresponding periods. This was accomplished using returns data
The equity
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generated from the Australian Stock Exchange’s All Ordinaries Accumulation (Total
Return) Index in conjunction with the average yield on ten year Australian
Commonwealth Government bonds. The average annual risk premium over the
ten year bond yield that has been generated by Australian equities was calculated
over a number of different (overlapping) horizons for the period 1987-2006. The results
are displayed in Table I.
The average annual equity risk premium during this 20-year period was 2 percent
lower than the longer term equity risk premium revealed by Siegel’s (2005) calculations
and approximately 2.3 percent lower than Brailsford et al.’s (2008) long-term
calculations. The longer term premiums computed by Siegel (2005) and Brailsford et al.
(2008) were 6 and 6.3 percent per annum above the risk-free rate, respectively. In the
past two decades, the average annual premium on equities over the bond yield has
been a lower 4 percent. However, it must be noted that the 20 year average from 1987 to
2006 is diminished by approximately one-half by the large negative equity risk
premiums experienced during 1987, 1990 and 1992. These periods of negative equity
risk premiums correspond, of course, to the years in which Australia experienced the
1987 stock market crash and the dif?cult economic times of the early 1990s. Having
computed the equity risk premium at these time horizons, it is possible to determine
whether the SMSF portfolios have earned the equity risk premium over the period
since their inception.
IV. SMSF returns vis-a` -vis the equity risk premium
The ?rst step in the analysis is to determine the magnitude of the premium above the
riskless rate of interest earned by the SMSF portfolios vis-a` -vis the equity premium
%
1987-2006 3.98
1988-2006 4.55
1989-2006 4.47
1990-2006 4.52
1991-2006 6.75
1992-2006 5.88
1993-2006 7.11
1994-2006 5.48
1995-2006 7.36
1996-2006 7.08
1997-2006 7.22
1998-2006 7.43
1999-2006 7.94
2000-2006 7.29
2001-2006 8.67
2002-2006 9.38
2003-2006 15.20
2004-2006 16.95
2005-2006 15.86
2006 17.27
Note: Various periods 1987-2006
Table I.
Average annual
Australian equity risk
premium
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generated by the broader Australian stock market averages. This number is important
for both ?nancial economists and policy makers to know because the equity premium
on Australian stocks in aggregate – something of a “headline ?gure” – may be
somewhat different from the premium above the riskless rate of interest that is
generated by individual SMSF portfolios. Since the SMSF portfolios tend to allocate
funds between cash and Australian shares (at least for the most part), the SMSF
portfolio expected returns may be represented as follows:
EðR
P
Þ ¼ x
1
ðr
f
Þ þ x
2
ðEðR
M
ÞÞ ð8Þ
where x
1
is the percentage of investable funds allocated to the risk-free security, r
f
and
x
2
is the percentage of investable funds allocated to the Australian share market.
The share market has an expected return of EðR
M
Þ. The equity premium generated by
the share market will be equal to EðR
M
Þ 2r
f
. At the very least, therefore, the SMSFs
should be expected to earn a premium above the riskless rate of interest given that the
portfolios, for the most part, contain at least some risky assets. Whilst the question of
any premium to the riskless rate of interest is left to a later section, close inspection of
each individual SMSF reveals that most of the funds have generated positive returns
since their inception.
As shown in Figure 3, the SMSFs in the sample have, in general, generated positive
returns average annual returns. Only eight of 100 funds in the sample have generated
negative returns since inception; that is, they have a lower portfolio value than they
started with. Given that the trustees of SMSFs are likely to be relatively
unsophisticated investors and probably are not skilled in the technical aspects of
portfolio management and investment selection, the fact that the majority of the
portfolios have generated positive average annual returns since inception is
encouraging. However, the question of interest to this investigation is the magnitude
of the returns above the riskless rate of interest. This question is addressed by:
.
comparing the returns of the SMSF portfolios with the equity risk premium
generated by the broader Australian stock market averages measured at the
appropriate horizon; and
Figure 3.
SMSF average annual
returns since inception
(n ¼ 100)
30%
25%
20%
15%
10%
5%
0%
–5%
–10%
0 10 20 30 40 50 60 70 80 90 100
The equity
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comparing the returns of the equity portions – rather than the whole portfolios
(of the SMSF portfolios), with the equity risk premium measured at the
appropriate horizon.
The purpose of comparing the whole-of-portfolio returns of the SMSFs with the equity
risk premium generated by the broader Australian stock market averages (measured at
the appropriate horizon) is to determine the magnitude of the SMSF portfolio returns,
relative to the premium above the riskless rate of interest that characterised Australian
stocks over comparative time horizons. Figure 4 shows that the sample of SMSFs has,
on average, not generated returns that match or exceed the equity risk premium.
Indeed, the SMSFs have generated returns that fall short of Australia’s equity risk
premium by an average of 6 percent per annum[3]. However, a small number of the
SMSFs generated an average annual return equal to or in excess of the equity risk
premium.
This ?nding should not be interpreted as a severe indictment of SMSF performance.
Rather, the ?nding should be considered as an indication of the performance of SMSFs
vis-a` -vis the “headline ?gures” that denote the performance of the stock markets in
aggregate. It is inappropriate, for instance, for ?nancial economists, policy makers and
regulators to undertake policy analysis and evaluation and the development of regulatory
frameworks without relevant information concerning the performance of individual
SMSFportfolios, relative to broader market averages. The equity risk premiumgenerated
by Australian stocks in aggregate may over-shadow the returns that characterise
individual portfolios. Our ?nding highlights that the premium above the riskless rate of
interest generated by Australian stocks in aggregate is not a performance statistic that
re?ects the premium above the riskless rate of interest generated by SMSFs, at least not
within the context of the sample of SMSFs considered here.
Figure 4.
Annual SMSF return
minus the equity risk
premium (n ¼ 100)
10%
5%
0%
–5%
–10%
–15%
–20%
–25%
0 10 20 30 40 50 60 70 80 90 100
Notes: This figure shows the average annual SMSF return minus the average annual risk
premium measured over the period since each SMSF's inception. Positive values are
recorded for SMSFs that earn a return in excess of the equity risk premium. The fact that
most observations lay below the horizontal axis indicates that most of the SMSFs did not
earn returns that matched or exceeded the equity risk premium
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The second step in the analysis is to determine whether the SMSFs have generated
returns on the equity components of the portfolios that match or exceed the premium to
the riskless rate of interest generated by Australian stocks in aggregate. Since the
portfolios have large allocations to cash and ?xed interest securities, the returns
generated by the equity components of the SMSF portfolios will tend to be the main
engine that drives the returns on the overall portfolios. It is, therefore, important to
know just how the returns on this critical component of the portfolios compare with the
premium to the riskless rate interest generated by Australian stocks. When the returns
generated on the equity components of the funds are compared with the equity
premium measured over the appropriate horizon, as shown in Figure 5, it is revealed
that 29 percent of the SMSFs in the sample generated returns on the equity components
of their portfolios that match or exceed the Australian equity premium. On average, the
equity components of the SMSFs generated returns that fall short of the equity
premium generated by Australian equities by just 3 percent. This compares favourably
to the 6 percent shortfall detected when considering the overall portfolios.
The engine that drives the returns of the SMSF portfolios – the equity components
of the portfolios – does not appear to be malfunctioning. On the contrary, the premium
above the riskless rate of interest that this “growth engine” generates is sometimes
much higher than that generated by the Australian stock market in aggregate.
However, it is important to recognise that the equity components of individual
portfolios do not necessarily generate returns that match the premium above the
riskless rate of interest that is generated by the broader Australian stock market
averages. Again, the headline ?gure is shown to be a misleading indicator of the
performance that likely typi?es individual portfolios. For example, when forecasting
SMSF members’ retirement incomes, it is important to understand that the returns on
Figure 5.
SMSF Equity component
returns minus the
Australian equity
premium (n ¼ 100)
20%
15%
10%
5%
0%
–5%
–10%
–15%
–20%
–25%
–30%
–35%
0 10 20 30 40 50 60 70 80 90 100
Notes: This figure shows each SMSF's average annual equity component return minus
the Australian equity risk premium measured over the corresponding period since the
inception of the SMSF. This part of the analysis was only undertaken on the first part of
the sample. The computational burden of undertaking the analysis on all of the SMSFs
was too great given the number of data points involved
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the overall portfolios are unlikely to match the much-discussed equity risk premium on
Australian stocks in aggregate, and although the equity components of SMSF
portfolios apparently perform well, they do not perform so well as to drive the entire
portfolios’ returns towards those that characterise the stock market in aggregate.
V. Did the SMSF’s earn any equity premium?
Whilst it is important to determine the magnitude of SMSFs’ premium to the riskless
rate of interest vis-a` -vis the premium generated by Australian stocks in aggregate, few
unexpected conclusions may be drawn regarding the actual performance and
management of SMSFs. Relatively, of course, the performance is not good. Even on a
risk-adjusted basis, the performance is unlikely to compare favourably with the
unmanaged stock market indices (Phillips et al., 2007, 2009). Given that the portfolios
are not fully invested in Australian equities, the premium generated by the broader
Australian stock market averages is not expected to be matched by SMSFs. However,
given that the SMSFs have, on average, some allocation to Australian equity securities
(and other risky assets) it is expected that they will generate at least some premium to
the riskless rate of interest. Failure to do so would be evidence of poor portfolio
management and evidence that SMSF trustees’ investment decisions detract value
from the portfolios.
Having established that the SMSFs have not, on average, matched the observed
equity premium on Australian stocks, it is logical to also investigate whether the
SMSFs earned any return in excess of the riskless rate of interest. As mentioned in the
previous section, because the SMSFs contain some risky assets it should be expected
that they have earned at least some premium above the riskless rate of interest.
Whether or not the SMSFs in the sample have earned any risk premium at all is easily
determined. By comparing the average annual return generated by each SMSF with the
average interest rate on Australian Commonwealth Government ten-year bonds
measured over the relevant time horizon, it is a straightforward matter to determine the
magnitude of the premium to the riskless rate of interest that these portfolios have
generated. For completeness, both the returns on the overall portfolios and the returns
on the equity components of the portfolios are compared with the relevant riskless rate
of interest.
Figure 6 shows that in comparing the average annual returns generated on the
overall portfolios with the average interest rate on Australian Commonwealth
Government ten-year bonds during corresponding periods, most of the SMSFs did not
earn a premium to the riskless rate of interest. Rather, on average, the SMSF portfolios
earned returns that fell short of the riskless rate of interest by 2 percent per annum, and
only 13 percent of the SMSFs earned returns in excess of the riskless rate of interest.
This result is signi?cant in that it indicates inferior security selection by the SMSF
trustees in that their selections result in negative value. The inability of the SMSF
portfolios to, on average, earn a risk premium is surprising given that almost all of
the portfolios contain at least some risky assets. This result is probably explained by
poor portfolio management (Phillips et al., 2007) and the absence of an adequately
documented investment strategy to guide the construction and management of the
SMSFs’ investment portfolios.
As shown in Figure 7, when the average annual returns since the inception of each
SMSF that have been generated on the equity components of the 100 portfolios in the
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sample are compared with the riskless rate of interest, the results are more favourable.
A much larger number of portfolios earned a premium to the riskless interest rate when
the equity components of the portfolios are considered in isolation, and, on average, the
SMSFs earned a small premium above the riskless rate of interest on the equity
components of the portfolios. This premium was much lower than that which has been
Figure 6.
SMSF returns minus the
riskless rate of interest
(n ¼ 100)
20%
15%
10%
5%
0%
–5%
–10%
0 10 20 30 40 50 60 70 80 90 100
Notes: This figure shows the average annual SMSF returns minus the average riskless
rate of interest that prevailed during the corresponding period since the inception of the
SMSF. Positive values indicate average annual returns on the overall portfolios in excess
of the riskless rate of interest. This analysis was undertaken on all of the SMSFs in the
sample
Figure 7.
SMSF Equity component
returns minus the riskless
interest rate (n ¼ 100)
20%
15%
10%
5%
0%
–5%
–10%
–15%
–20%
0 10 20 30 40 50 60 70 80 90 100
Notes: This figure shows the average annual returns generated by the equity components
of each SMSF portfolio minus the average riskless rate of interest that prevailed during
the corresponding period since the inception of the SMSF. Positive values indicate average
annual returns on the equity components of the portfolios in excess of the riskless rate of
interest. This analysis was undertaken on the SMSFs in the first part of the sample
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experienced by the broader Australian share market. On average, the equity portions
of the SMSF portfolios earned a premium to the riskless rate of interest of 1 percent per
annum during the lifetime of the portfolios. Although the signi?cance of this ?nding
can only be con?rmed through further empirical analysis, it is interesting to note that
the average equity premium earned by the SMSFs on the equity portions of the
portfolios found here is, coincidentally or otherwise, much closer to Mehra and Prescott
(1985) estimate of 0.35 percent than the equity premium generated on Australian
shares in aggregate.
On balance, risky SMSF portfolios would be expected to generate returns above the
riskless rate of interest, and the failure of the sample funds to do so indicates that far
from being superior security selectors, SMSF trustees are making choices that detract
from the performance of their portfolios. A purely risk-free portfolio containing
Australian Government securities would, in the majority of cases, generate returns in
excess of those generated by the risky SMSFs. On a risk-adjusted basis, these SMSF
trustees are overseeing and are responsible for a real diminution in the value of their
retirement assets. All the costs involved with setting up and running these funds have
hardly been worth the effort. Finding that the SMSFs have not generated returns in
excess of the riskless rate of interest leads to the conclusion that the risks borne by
SMSF trustees have not delivered the expected returns.
VI. Discussion and conclusions
The analysis presented in this paper generated three main results:
(1) the sample of SMSFs generated a much lower premium to the riskless rate of
interest than the aggregate Australian share market;
(2) even when considered in isolation, the equity portions of the portfolios earned
only a very small premium to the riskless rate of interest; and importantly
(3) the SMSF portfolios did not earn a premium to the riskless rate of interest, even
though the portfolios contain risky assets.
This latter result has implications for policymakers and is indicative of poor portfolio
management. The ?ndings show that although most of the portfolios generated
positive returns since inception, the returns are far below those generated by the
Australian share market, and below the yield of Australian Commonwealth
Government ten-year bonds. In retrospect, higher returns could have been generated
by simply allocating some portion of each portfolio to a managed bond fund or cash
management trust and an index fund that mirrors the Australian share market in a
proportion consistent with trustees’ risk preferences.
Constructing an investment portfolio for SMSFs, like most portfolios, is a complex
task. In essence, the portfolios are combinations of securities with risk and return
characteristics that must be carefully managed in order to generate returns that are
commensurate with the risk being borne. When returns are not commensurate with
risks being borne, the dif?cult exercise of forming and managing a portfolio has, it
might be said, hardly been worthwhile. This is particularly the case when a much more
straightforward approach would have generated higher returns. It is one of the main
results of modern ?nance theory that investors should simply divide their portfolios
between the risk-free asset and the market portfolio. In light of the returns generated
by the sample SMSF portfolios examined in this study, this simple approach appears
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all the more attractive. Simply allocate a portion to the riskless security and a portion
of the portfolio to a fund that mirrors the Australian share market. For most of the last
three decades, such an approach would have generated returns far in excess of those
that were generated by the SMSFs.
Since the SMSFs contain risky assets, at least some premium to the riskless rate of
interest should be expected. Poor diversi?cation could be one possible reason for the
failure of the funds to generate returns in excess of the riskless rate of interest.
However, the portfolios of the SMSF sample appear to comprise suf?ciently different
securities to be considered as adequately diversi?ed. It is more likely that poor
portfolio construction – poor security selection and perhaps over-diversi?cation,
especially in managed investments – is the source of the low returns. This is dif?cult
to rectify without ?rst considering the appropriateness of the fund’s investment
strategy. The fact that such wide-ranging allocations such as 20 percent cash and
40 percent shares are permissible under the investment policy statements suggests a
problem with the construction of the plan which the managers (in this case trustees)
follow in their day-to-day management of the SMSFs. Investigation of this issue would
form the basis for an interesting research program, focussing on trustees’ rationale that
informs their portfolio construction and management decisions. Furthermore, it would
be instructive to know more about the knowledge set of SMSF managers and the
amount of time they spend engaged in SMSF-related activities.
In bringing this paper to a close, it is worthwhile returning to the discussion on the
equity risk premium. Asset pricing continues to present numerous challenges. Even
though the “classical” period of asset pricing theory has long since receded, the
reconciliation of the theoretical work undertaken during the 1970s and 1980s with
“stylised facts” may yet take a generation or more of solid endeavour on the part of
?nancial economists (Campbell, 2000). The premium of aggregate stock returns above
the riskless rate of interest is dif?cult to reconcile with the C-CAPM unless one is
willing to accept an implausibly high value for the risk-aversion parameter. However,
as Siegel (1999) conjectured, there is a very strong possibility that investors may not
actually earn the equity premium on their portfolios. The results of this investigation,
though not based on a suf?ciently large sample to permit the generalisation of the
?ndings to all investors, provide some support for this conjecture.
The results generated during this investigation are somewhat concerning but they
are by no means surprising or perplexing. SMSF portfolios have been shown to be
poorly constructed (Phillips et al., 2007). Portfolio management, relying on Markowitz
diversi?cation and portfolio programming, is a complex task and may be beyond the
capabilities of unsophisticated investors. Even if this were not the case, it is not
unreasonable to suggest that very few SMSF trustees would have been educated on the
mechanics of portfolio management. Whilst na? ¨ve diversi?cation is possible and may
have been attempted by most investors, this method of portfolio construction may not
be effective if it ignores the correlation structure of the returns on the securities in the
portfolio. The low-excess returns generated by the SMSFs are probably due to poor
portfolio management, including low diversi?cation, the inclusion of too many
managed investments in the portfolios and high weightings in low return-low risk
assets such as cash in bank accounts.
The high-historical equity premium provides encouragement to investors seeking to
build their wealth over the long term. However, the recommendation that SMSFs be
The equity
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43
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heavily invested in Australian shares must be considered in light of the actual ability
of SMSF trustees to manage a portfolio in such a manner as to extract some or the
entire available premium. The failure of the risky SMSFs to generate returns in excess
of the riskless rate of interest is evidence that SMSF trustees do not possess the ability
to select securities that generate returns in excess of the returns that would have been
expected given the risks involved. Rather than attempt to implement any active
portfolio management strategy, SMSF investors seeking to bene?t from any premium
that may characterise Australian shares in the future are likely to perform better than
the average SMSF trustee by taking a very simple approach and dividing their assets
between the risk-free security and the market portfolio (an index fund). Those who are
uncomfortable with such an approach might consider whether the right choice for them
is to start-up a SMSFs.
Notes
1. Of course, the terminal value could be less even if the average return is 7.5 percent
per annum. Increased volatility will decrease the terminal value.
2. The average SMSF invests 36 percent of the overall portfolio in Australian shares (ATO,
2008).
3. Whilst the SMSF returns may be partially or wholly after tax, allowing for taxation effects
does not change the conclusions presented in this section (or other sections) of this paper.
Allowing for taxation would reduce the shortfall from 6 to 5.1 percent.
References
APRA (2008), Quarterly Superannuation Performance, Australian Prudential Regulation
Authority, Canberra, December.
ATO (2008), Self Managed Superannuation Fund Statistical Report, Australian Taxation Of?ce,
Canberra.
Barro, R.J. (2006), “Rare disasters and asset markets in the twentieth century”, Quarterly Journal
of Economics, Vol. 121, pp. 823-66.
Brailsford, T., Handley, J.C. and Maheswaran, K. (2008), “Re-examination of the historical equity
risk premium in Australia”, Accounting and Finance, Vol. 48 No. 1, pp. 73-97.
Breeden, D.T. (1979), “An intertemporal asset pricing model with stochastic consumption and
investment opportunities”, Journal of Financial Economics, Vol. 7, pp. 265-96.
Campbell, J. (2000), “Asset pricing at the millennium”, Journal of Finance, Vol. 55 No. 4,
pp. 1515-67.
Cochrane, J.H. (2001), Asset Pricing, Princeton University Press, Princeton, NJ.
Dimson, E., Marsh, P.R. and Staunton, M. (2002), Triumph of the Optimists: 101 Years of Global
Investment Returns, Princeton University Press, Princeton, NJ.
Elton, E., Gruber, M.J., Brown, S.J. and Goetzmann, W.N. (2003), Modern Portfolio Theory and
Investment Analysis, 6th ed., Wiley, New York, NY.
Grossman, S.J. and Shiller, R.J. (1982), “Consumption correlatedness and risk measurement in
economies with non-traded assets and heterogenous information”, Journal of Financial
Economics, Vol. 10, pp. 195-210.
Jorion, P. and Goetzmann, W.N. (1999), “Global stock markets in the twentieth century”, Journal
of Finance, Vol. LIV No. 3, pp. 953-80.
Lucas, R.E. Jr (1978), “Asset prices in an exchange economy”, Econometrica, Vol. 46, pp. 1929-46.
ARJ
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Marshall, D.A. and Parekh, N.G. (1999), “Can costs of consumption adjustment explain asset
pricing puzzles”, Journal of Finance, Vol. 65 No. 2, pp. 623-54.
Mehra, R. and Prescott, E. (1985), “The equity premium: a puzzle”, Journal of Monetary
Economics, Vol. 15 No. 2, pp. 145-61.
Of?cer, R.R. (1989), “Rates of return to shares, bond yields and in?ation rates: an historical
perspective”, in Ball, R., Brown, P., Finn, F. and Of?cer, R.R. (Eds), Share Markets and
Portfolio Theory, 2nd ed., Queensland University Press, Brisbane.
Phillips, P.J., Baczynski, M. and Teale, J. (2009), “Self managed superannuation funds and the
bear market of 2007 to 2008”, Australasian Accounting, Business and Finance Journal,
Vol. 3 No. 1, pp. 38-56.
Phillips, P.J., Cathcart, A. and Teale, J. (2007), “The diversi?cation and performance of self
managed superannuation funds”, Australian Economic Review, Vol. 4 No. 4, pp. 339-52.
Pratt, J.W. (1964), “Risk aversion in the small and in the large”, Econometrica, Vol. 32 Nos 1/2,
pp. 122-36.
Rietz, T.A. (1988), “The equity risk premium: a solution”, Journal of Monetary Economics, Vol. 22,
pp. 117-31.
Sharpe, W. (1964), “Capital asset prices: a theory of market equilibrium under conditions of risk”,
Journal of Finance, Vol. XIX No. 3, pp. 425-42.
Siegel, J.J. (1999), “The shrinking equity premium”, Journal of Portfolio Management, Vol. 26
No. 1, pp. 10-17.
Siegel, J.J. (2005), “Perspectives on the equity risk premium”, Financial Analyst’s Journal, Vol. 61
No. 6, pp. 61-73.
Tobin, J. (1958), “Liquidity preference as behaviour towards risk”, Review of Economic Studies,
No. 67, pp. 65-86.
Further reading
Blume, M. and Friend, I. (1975), “The asset structure of individual portfolios and some
implications for utility functions”, Journal of Finance, Vol. 30 No. 2, pp. 585-603.
Cass, D. and Stiglitz, J. (1972), “Risk aversion and wealth effects on portfolios with many assets”,
Review of Economic Studies, July, pp. 331-54.
Friend, I. and Blume, M. (1975), “The demand for risky assets”, American Economic Review,
Vol. 65 No. 5, pp. 900-22.
Corresponding author
Peter J. Phillips can be contacted at: [email protected]
The equity
risk premium
45
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This article has been cited by:
1. Peter J. Phillips. 2011. Will Self-Managed Superannuation Fund Investors Survive?. Australian Economic
Review 44:10.1111/aere.2011.44.issue-1, 51-63. [CrossRef]
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doc_348557439.pdf
The purpose of this paper is to determine whether self-managed superannuation fund
(SMSF) trustees earn: the equity risk premium or any premium to the riskless rate of interest.
Accounting Research Journal
Can self-managed superannuation fund trustees earn the equity risk premium?
Peter J . Phillips Michael Baczynski J ohn Teale
Article information:
To cite this document:
Peter J . Phillips Michael Baczynski J ohn Teale, (2009),"Can self-managed superannuation fund trustees
earn the equity risk premium?", Accounting Research J ournal, Vol. 22 Iss 1 pp. 27 - 45
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Can self-managed superannuation
fund trustees earn the equity
risk premium?
Peter J. Phillips
School of Accounting, Economics and Finance,
University of Southern Queensland, Toowoomba, Australia
Michael Baczynski
University of Southern Queensland, Toowoomba, Australia, and
John Teale
University of Sunshine Coast, Sunshine Coast, Australia
Abstract
Purpose – The purpose of this paper is to determine whether self-managed superannuation fund
(SMSF) trustees earn: the equity risk premium or any premium to the riskless rate of interest.
Design/methodology/approach – Using a sample of 100 SMSFs, the average annual returns since
inception of the funds in the sample are compared with: the average annual equity risk premium since
that time and the average yield of Commonwealth Government Securities since that time.
Findings – The investigation reveals: the SMSFs in the sample do not earn the equity risk premium
and the SMSFs in the sample did not earn a premium to riskless rate of interest. This leads to the
conclusion that the SMSFs have borne risk without commensurate reward.
Research limitations/implications – The trustees’ rationale for making particular investment
decisions and the consistency of the portfolio structures with the risk pro?les of the trustees are two
areas that may be fruitfully explored in future research.
Practical implications – For SMSF trustees, a simple portfolio that divides assets between
(unmanaged) index funds and risk-free securities on the basis of trustees’ risk aversion may generate
better results than the existing portfolios. For policy makers, the relatively poor performance of SMSFs
implies that the superannuation system as currently structured may not be generating returns that
will maximize retirement incomes.
Originality/value – The paper provides the ?rst comparison of SMSF returns with the equity risk
premium and the riskless rate of interest measured at appropriate horizons.
Keywords Pension funds, Trustees, Financial risk, Interest rates
Paper type Research paper
Over the long term, equities (or shares) have generated returns of approximately
6 percent in excess of the returns generated by bonds. This is the equity risk premium.
Even if future equity returns cannot match those that have been generated historically,
there is still a strong case to be made for substantial investments in equities. This is
particularly the case for investment vehicles that should have long time horizons, such
as self-managed superannuation funds (SMSFs). Investment vehicles with such
long-time horizons can bear the short-term ?uctuations exhibited by the share market
and potentially generate substantial returns in excess of the risk-free rate over the long
term. Of course, this depends on the portfolios constructed by the trustees of SMSFs.
Poor portfolio construction, including under-diversi?cation or high allocations to cash
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1030-9616.htm
The equity
risk premium
27
Accounting Research Journal
Vol. 22 No. 1, 2009
pp. 27-45
qEmerald Group Publishing Limited
1030-9616
DOI 10.1108/10309610910975315
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assets, will signi?cantly reduce a portfolio’s ability to generate returns that match or
exceed the equity premium experienced by the broader share market averages. The
high-equity risk premium is an enticement for investment in shares. Whether SMSF
trustees have been able to earn the equity premium in the period since their funds were
incepted is examined in this paper.
The equity risk premium – which, in many Western nations, has averaged
approximately 6 percent above the riskless rate of interest – has de?ed explanation by
?nancial economists. In a now-classic article, Mehra and Prescott (1985) reported that
the extant models of asset pricing could not explain the magnitude of the difference
between the return on shares and the return on bonds. Mehra and Prescott (1985)
presented an analysis that revealed that the standard assumptions underlying the
application of the consumption-based capital asset pricing model (C-CAPM), with
plausible estimates for the relative risk-aversion parameter, are consistent with an
equity premium of just 0.35 percent. The equity premium that has characterised US
stock returns for over a century is almost 2,000 percent greater than what ?nancial
economists would have expected on the basis of the theoretical asset pricing models.
The inability of the most sophisticated asset pricing models to explain the historical
equity risk premium is one of the great puzzles of modern ?nancial economics.
The challenge that the equity premium presents to economic theorists would hardly
be foremost in the thoughts of most trustees of SMSFs but the magnitude of the equity
premium is very important for them just the same. For the average SMSF with assets
of approximately $800,000 (Australian Taxation Of?ce, 2008), the (real) 7.5 percent
per annum average Australian share market return would lead to a terminal value of
almost $5,000,000 over 25 years for a fully invested portfolio[1]. Even if the equity
premium were to fall by half, the average SMSF that is fully invested in Australian
equities would have a terminal value of almost $2,500,000. Whilst these terminal values
would be less for a portfolio with partial allocations to cash or ?xed interest securities,
the overall portfolio returns for a diversi?ed portfolio (with risky and low-risk assets)
would still be bolstered by the investment of some of the portfolio in equity securities
and would no doubt compare very favourably to a terminal value for a portfolio
fully invested in bonds over the same period. Whilst most SMSF portfolios will not
be fully invested in equities, the magnitude of the historical equity premium is a strong
incentive for at least some allocation to equities[2].
In addition, there continues to be a signi?cant public policy question surrounding
the ability for SMSFs to perform well. As highlighted elsewhere (Phillips et al., 2009),
the current retirement framework has only operated over a narrow and relatively
homogeneous period of the economic cycle, punctuated by the global market downturn
of 2007-2008. The development of superannuation schemes in Australia, and more
speci?cally the ability to self-manage those arrangements, has played out against a
backdrop of historic levels of return. However, if policy decisions relating to the
fairness of superannuation arrangements were made with more optimistic levels of
return in mind, then there is the potential that the amount set aside to fund safety-net
retirement incomes is under-endowed. Already, there have been reports of an increase
in the number of self-funded retirees seeking aged pension support due to the collapse
in value of their assets, and it is currently unknown, whether in the midst of other ?scal
pressures, the federal government has suf?cient reserve within their current scheme to
adequately account for increases in demand for pension payments.
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From a portfolio management perspective, the problem with recommending that
SMSF trustees attempt to take advantage of the high premium available on equity
investments vis-a` -vis investments in cash or bonds is that simply investing in equities
in a random or ad hoc manner will not guarantee a return that matches that generated
by the broader market averages. In fact, there is a possibility that poorly managed
portfolios may do considerably worse than the market averages and fail to earn the
equity premium (Siegel, 1999). Furthermore, policy makers who consider such returns
as actually being captured by any category of superannuation funds (including
SMSFs) will almost certainly be over-estimating the premium above the riskless rate of
interest that is being generated by these investment vehicles. That being said, SMSFs
(or any portfolios with allocations to equity securities) should earn some premium
above the riskless rate of interest. Just how much is actually being earned is an
important question, the answer to which promises to shed much needed light on the
nature and operation of the SMSF industry in Australia. In this paper, this question is
analysed by considering the annual returns since inception of a sample of 100 SMSFs.
The remainder of this paper is organised as follows. In Section I, the nature of the
equity premium puzzle is described and some of the relevant literature is brie?y
reviewed. Since this topic has been the subject of more than 300 scholarly articles
(Siegel, 2005), only a brief description is required. In Section II, the data collected for
this investigation is described. In Section III, Australia’s equity premium is calculated
over various overlapping periods since 1987 in order to facilitate the comparison of
the average annual returns generated by the SMSFs since their inception with the
average annual equity premium. In Section IV, the average annual returns generated
by the SMSFs since inception are compared with the average annual Australian equity
risk premium observed in corresponding periods. In Section V, the average annual
returns of the SMSFs are compared with the riskless rate of interest in order to
determine whether the SMSFs earned any premium above the risk-free rate. Section VI
concludes the paper.
I. The equity premium puzzle
In order to provide contextual completeness for this investigation, it is worthwhile
presenting a brief overview of the equity premium puzzle, the solution of which has
occupied ?nancial economists for almost a quarter-century. Within the context of
the standard form of the CAPM ðEðR
i
Þ ¼ r
f
þb
i
ðEðR
M
Þ 2r
f
ÞÞ, the investor’s utility
is assumed to depend only upon his or her expected future wealth and the expected
standard deviation of the possible divergence of actual wealth from that which
was expected (Sharpe, 1964, p. 428). Since wealth depends on investment returns, it is
possible to assume that in assessing an investment, the individual will base his or her
assessment on the expected return and expected standard deviation of returns (Sharpe,
1964, p. 428). The individual is assumed to favour additional expected returns and
dislike additional standard deviation of actual returns from expected returns (risk).
Formally, the individual’s utility is a function of expected returns and the standard
deviation of returns:
U ¼ f ðE
R
; s
R
Þ ð1Þ
where U is the investor’s total utility, E
R
is the expected return of an investment
ðdU=dE
R
. 0Þ and s
R
is the standard deviation of the possible divergence of actual
The equity
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returns from expected returns ðdU=ds
R
, 0Þ (Sharpe, 1964, p. 428). Geometrically, the
indifference curves that derive from this particular con?guration of the individual’s
utility are concave-upwards in the expected return-risk plane. One possible
speci?cation of the utility function for this type of individual is a quadratic function
for expected returns expressed as follows:
U ¼ ð1 þ bÞE
R
þ bE
2
R
2cs
2
R
ð2Þ
where E
R
and s
2
R
denote expected return and variance of return, respectively, b is a
parameter that adheres to the restriction – 1 , b , 0 when investors are risk averse
and c is a parameter that adheres to the restriction 0 , c , 1 (Tobin, 1958, p. 76).
Alternatively, it is also possible, as Elton et al. (2003) have shown, to write a quadratic
function directly for wealth:
UðWÞ ¼ W 2bW
2
ð3Þ
Underlying this theoretical work is the theory of risk aversion. Pratt’s (1964) work,
produced independently of Kenneth Arrow’s similar efforts, sets down the pure theory
of risk aversion. Indeed, the Arrow-Pratt measures of absolute and relative risk
aversion hold a place of some prominence in the literature:
R
A
ðWÞ ¼ 2
U
00
ðWÞ
U
0
ðWÞ
ð4Þ
R
R
ðWÞ ¼ 2W
U
00
ðWÞ
U
0
ðWÞ
ð5Þ
In equations (4) and (5), R
A
ðWÞ is the Arrow-Pratt measure of absolute risk aversion
and R
R
ðWÞ is the Arrow-Pratt measure of relative risk aversion. These measures have
a very desirable property. The numerical estimates of equations (4) and (5) do not
depend upon the units in which the utility is measured. This is a signi?cant advance
over the na? ¨ve measure of risk aversion computed simply by taking the second
derivative of the utility of wealth function, U
00
ðWÞ:
Whilst the derivation of these risk aversion measures represented a signi?cant
contribution to theoretical ?nancial economics, both the utility function in equation (3)
and in the numerators and denominators of equations (4) and (5) are not correctly
speci?ed (Siegel, 2005). Wealth is only a proxy for consumption and it is consumption
that is of the utmost concern to the individuals whose behaviour is modelled by the
equations of ?nancial economics. Once consumption was input into the utility
functions, the consumption based C-CAPM are developed. The C-CAPM of Breeden
(1979), Lucas (1978) and Grossman and Shiller (1982) is analogous to the standard
CAPM in many respects. The similarities are plain and the basic expression is
straightforward:
R
it
¼ a
i
þb
i
C
t
þ e
it
ð6Þ
Breeden’s continuous time asset pricing model is one in which asset betas are
measured relative to the aggregate real consumption rate, C
t
, rather than relative to the
market’s returns. In this context, Marshall and Parekh (1999) explain that the
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theoretical equity premium that ?nancial economists would expect to observe if the
C-CAPM were “true” is:
EP
0
;
2cov m
t
; r
e
t
À Á
Eðm
t
Þ
ð7Þ
where m
t
is the C-CAPM stochastic discount factor (SDF) or asset pricing kernel and r
e
t
is the excess return on equities (over the riskless rate of interest). Mehra and Prescott
(1985) showed that the covariance between the SDF and r
e
t
is very low. Equation (7)
therefore predicts an equity premium that is very low and, indeed, far lower than that
which has been observed empirically in most Western countries during the twentieth
century. Only when the coef?cient for risk aversion is allowed to be approximately
50 times greater than the highest plausible estimates of around 1.50 can the empirically
observed equity premium be reconciled with the C-CAPM. The inability of asset
pricing models to explain the magnitude of the equity premium is the source of the
equity premium puzzle.
Exactly, why the asset pricing models failed has been the subject of much
conjecture. Cochrane (2001, p. 24) offers a number of possible explanations:
.
people are far more risk averse than scholars have thought them to be;
.
the stock returns over the last half century were the result of good luck rather
than equilibrium compensation for risk; or
.
there is something “deeply wrong” with the theoretical models that have been
produced, including the utility function that has been deployed and the
utilisation of aggregate consumption data.
Of course, there are many more explanations extant in the literature, including the ?rst
solution proposed by Rietz (1988) and Barro (2006) that purports to solve the puzzle by
taking into account infrequently occurring disastrous events. According to Rietz
(1988), a large “crash” in output of 25-50 percent occurring with a probability of 1.4-0.4
percent per year generates ex ante equity risk premiums roughly consistent with the
observed equity premium (although the required risk aversion coef?cients are still a
little high). Unfortunately, despite its apparent promise, Rietz’s work and all
subsequent investigations have failed to resolve the equity premium puzzle to the
satisfaction of ?nancial economists.
Cochrane’s (2001) second explanation (above) may eventually prove correct. If so,
the equity premium that we can expect in the future will be much lower than that
which we have experienced over the last century. However, Siegel (2005, p. 70) adds:
The equity premium is a critical number in ?nancial economics. It determines
asset allocations, projections of retirement and endowment wealth, and the cost of capital
to companies. Economists are still searching for a simple model that can justify the premium
in the face of the much lower volatility of the aggregate economic data. Although there are
good reasons why the future equity risk premium should be lower than it has been
historically, projected compound equity returns of 2-3 percent over bonds will still give ample
reward for investors willing to tolerate the short-term risks of stocks.
With approximately $300 billion in assets under management, SMSFs account for about
one-quarter of Australia’s superannuation savings. Even if the equity premium falls by
half, the rewards for long-term investment in Australian equities may be substantial.
The equity
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Compound equity returns of 2-3 percent per annumabove the riskless rate of interest may
alleviate some of the possible shortfalls that are anticipated in Australia’s retirement
savings stream and provide a higher standard of living in retirement for those investors
who can earn the equity premium over the long term.
In this context, the present investigation has two main parts. First, we determine the
magnitude of the returns generated by each of the SMSFs in the sample. The purpose of
this is to highlight the difference in absolute magnitude between the returns earned by
the SMSFs and the “head-line” equity premium ?gures that are widely quoted and
discussed. Second, unless portfolios are completely risk free – as characterised by
b
j
¼ 0 – they should exhibit a positive premium to the riskless rate of interest. The
failure of SMSFs to generate any premium to the riskless rate of interest has signi?cant
implications. As mentioned in the introductory section of this paper, the ability of
investors to earn the equity premium on either part or all of their portfolios may be
impaired by poor portfolio management. Excess volatility of returns that results from
inadequate diversi?cation, for example, will generate a terminal value for the portfolio
that is lower than a less volatile portfolio even if the arithmetic mean annual returns are
the same. Whilst investments in equities have generated high returns above the riskless
rate of interest, the possibility remains that investors are unable to replicate the equity
premium on either their overall portfolios or the equity component of their portfolios.
There is also the possibility that investors are unable to earn any risk premium at all.
II. Data
In Australia, provisions of approximately $1 billion each week are made for retirement
through the nation’s superannuation system. The present mandatory superannuation
savings system has a relatively short history. The requirement for employers to
contribute a minimum percentage of gross income on behalf of employees to a
superannuation fund was introduced in the early 1990s, in a bid to widen the coverage
of superannuation to more working Australians. Additional contributions may be
made voluntarily. Whilst contributions to superannuation are compulsory for all wage
earners, individuals are generally free to choose the type of superannuation fund where
their savings will be invested. A popular choice is simply to invest in “retail”
superannuation funds which are available to all members of the public. That is, an
individual does not need to be employed in a particular industry to become a member
of a retail fund. However, numerous other options are available.
A choice that has been growing in popularity is “self-managed” superannuation.
A self-managed superannuation fund is a fund with fewer than ?ve members and may
comprise a group of individuals, a couple or a family. All members must also be
trustees of the self-managed superannuation fund and as such are responsible for
managing the fund’s investment portfolio, subject to various government regulations,
including the Superannuation Industry (Supervision) Act 1993. The compulsory and
voluntary contributions made to the SMSF and are managed by the trustees for the
“sole purpose” of providing for their retirement. It is against the law, for instance, to
utilise the funds in the SMSF for other than retirement purposes, such as purchase a
new car, a painting to hang in one’s house or a holiday apartment. The amount of
assets invested in SMSFs is $326 billion, which represents approximately 29 percent of
Australia’s total superannuation assets (APRA, 2008). There are now more than
400,000 SMSFs.
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For this investigation, a sample of 100 SMSF portfolio microstructures was
gathered. The data were obtained from a ?nancial services ?rm operating in one of
Australia’s capital cities. The funds in the sample were drawn more or less at random
from the total number of SMSFs administered by the ?nancial services ?rm. Bearing in
mind that each SMSF represents the retirement savings of a small group of people up
to a maximum of four members, the portfolios are quite large. The average size of
each of the 100 portfolios in the sample was $796,611 as at June 30, 2007. The largest
portfolios have a value of just over $4 million whilst the smallest portfolios have a value
of just under $200,000. Most of the SMSFs were formed over the last ?ve to 15 years
but a few of the funds were established more than 20 years ago. There is nothing
unique or special about the SMSFs in the sample that would lead to a conclusion that
the SMSFs are not representative of the broader population of self-managed
superannuation funds in Australia. Whilst the trustees of the SMSF portfolios may
have bene?ted from ?nancial advice in choosing investments and constructing their
portfolios, ultimately the trustees remain responsible for their SMSF.
The SMSF portfolios contained in the sample are reasonably large portfolios
containing an asset mix of cash, ?xed interest securities, managed funds and domestic
and overseas shares. For the most part, the equity investments are con?ned to
domestic Australian companies and fund managers. Some of the funds contain real
assets such as art and real estate. The average asset allocations of each of the 100
portfolios are shown in Figure 1.
It is clear from Figure 1 that the SMSFs in the sample are heavily weighted towards
cash, (Australian) shares and managed investments. The interesting feature is the high
allocation to managed investments. One rationale for initiating a SMSF is to obtain
more control over the investment strategy and execution and avoid the fees associated
with managed investments products. In light of this, the allocation of more than
one-?fth of the portfolios (on average) to managed investments is quite curious.
However, it is possible that the SMSF trustees use these investment vehicles to access
markets that are not easily targeted with direct investments.
The high allocations to cash and ?xed interest securities would appear to suggest
that the trustees are reasonably risk averse – approximately, 20 percent of the overall
Figure 1.
SMSF average
asset allocations
45%
Note: Sample of 100 portfolios
40%
35%
30%
25%
20%
15%
10%
5%
0%
C
a
s
h
F
i
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s
t
L
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t
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s
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a
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(
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a
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a
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R
e
a
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a
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e
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portfolios are allocated to these asset classes. However, a conservative investment
strategy would not normally have an allocation of 50 percent of the overall portfolio to
equity securities and, in most cases, the SMSFs in the sample are characterised by such
an allocation. Figure 2 shows the allocations to listed Australian shares of all SMSFs in
the sample.
The portfolios exhibit a dichotomythat is dif?cult toreconcile withthe asset allocations
associated with standard investment strategies. Rather than a consistently applied
strategy, the SMSF trustees simply split their portfolios into either cash or Australian
shares. The result is a portfolio that is neither consistently conservative nor consistently
aggressive (to any degree). Whilst this problem may be traced to poor portfolio
management, it is more likely that poorly constructed investment strategy documents are
the source of this dichotomous (and ad hoc) portfolio construction. Permissible
asset allocations must be set very wide. This permits a level of ?exibility but will, in the
absence of disciplined portfolio management, result in unstructured portfolios.
In light of these compositions of the SMSF portfolios, it would be surprising if the
SMSFs in the sample are able generate returns that match or exceed the premium
above the riskless rate of interest exhibited by the broader market averages. As Siegel
(1999) has suggested, problems with portfolio construction may lead to returns that fall
short of those experienced by the share market in general. However, whilst Siegel
(1999) suggests that poorly diversi?ed portfolios with a lower expected return than the
market combined with transactions costs will prevent investors from matching the
equity premium, the magnitude of the differential between the equity premium and
what investors actually earn is only able to be determined by an investigation of
individual portfolios. The SMSF portfolio data obtained for this investigation provide a
unique opportunity to determine whether a group of investors has been able to earn the
equity premium and, perhaps more importantly, whether they have been able to earn
Figure 2.
SMSF allocations to listed
Australian shares
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
0 10 20 30 40 50 60 70 80 90 100
Note: All 100 portfolios
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any premium to the risk-free rate at all. In the following section, the average annual
returns since inception of the SMSFs in the sample are compared with the average
annual equity premiums over the same time periods.
III. The equity risk premium in Australia
The equity risk premium is measured by determining the difference between the rate of
return on stocks and the riskless rate of interest. In practice, the yield on either short- or
long-term government securities is deployed as a proxy for the risk-free rate of return.
Because both equity returns and bond yields are reported in nominal terms, this
approach avoids the necessity of adjusting the ?gures for in?ation (Brailsford et al.,
2008). Like most Western countries, Australian shares returned a large equity risk
premium throughout the twentieth century. With real rates of return on government
bonds averaging a little over 1 percent per annum and real rates of return on
government bills averaging a little less than 1 percent per annum, Australia’s
7.5 percent per annum real stock returns generated an equity risk premium of
approximately 6 percent each year during the period 1900-2003 (Siegel, 2005, p. 64).
The equity premium ?gure of approximately 6 percent appears to be quite stable
across a number of different empirical studies. Siegel’s (2005) estimate of 6 percent for
the Australian equity premium is con?rmed by Brailsford et al. (2008) who found that
Australian shares returned a premium of 6.20 percent per annum over bonds for the
period 1883-2005 and 6.30 percent over bonds for the period 1958-2005. Given that
there are a number of estimation problems that can affect the result of the analysis, this
is also close to Of?cer’s (1989) result of 7.90 percent for the period 1883-1987 and
Dimson et al. (2002) result of 7.50 percent over the period 1900-2000. However, Jorion
and Goetzmann (1999) computed a considerably lower value – just 1.58 percent – for
the real return generated by Australian equities over the course of the twentieth
century. The estimation of the equity premium can be quite contentious and this
should be borne in mind when calculating the premium or discussing results.
Whilst debate continues on a number of issues surrounding the measurement of the
equity premium, it is clear that the long run average Australian equity risk premium of
6 percent per annum conceals the extraordinary volatility that the equity risk premium
has exhibited from year to year over the past two decades. Since 1987, the Australian
equity risk premium has averaged 4 percent per annum. This is much lower than the
historical average but the time series has been far from stable. On the contrary, the
equity premium has exhibited 14 percent annual standard deviation during the 20 year
period-2007. The equity premium in Australia over the last two decades has ranged
from a low of 231 percent during 1990 to a high of approximately 28 percent in 1993.
Interestingly, the equity premium has exhibited a tendency to retreat substantially and
register negative annual values following periods where it has reached high points of
20 percent or more in any given year.
The data collected from the sample of SMSFs allowed us to compute the average
annual return generated by the funds since their inception. Since the SMSFs have
different inception dates at various points in time over the past two decades, it is
necessary to compute the equity risk premium in Australia over various time horizons
in order to facilitate the comparison of the average annual returns of the SMSFs for the
period since their inception with the equity risk premium generated by Australian
stocks over the corresponding periods. This was accomplished using returns data
The equity
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generated from the Australian Stock Exchange’s All Ordinaries Accumulation (Total
Return) Index in conjunction with the average yield on ten year Australian
Commonwealth Government bonds. The average annual risk premium over the
ten year bond yield that has been generated by Australian equities was calculated
over a number of different (overlapping) horizons for the period 1987-2006. The results
are displayed in Table I.
The average annual equity risk premium during this 20-year period was 2 percent
lower than the longer term equity risk premium revealed by Siegel’s (2005) calculations
and approximately 2.3 percent lower than Brailsford et al.’s (2008) long-term
calculations. The longer term premiums computed by Siegel (2005) and Brailsford et al.
(2008) were 6 and 6.3 percent per annum above the risk-free rate, respectively. In the
past two decades, the average annual premium on equities over the bond yield has
been a lower 4 percent. However, it must be noted that the 20 year average from 1987 to
2006 is diminished by approximately one-half by the large negative equity risk
premiums experienced during 1987, 1990 and 1992. These periods of negative equity
risk premiums correspond, of course, to the years in which Australia experienced the
1987 stock market crash and the dif?cult economic times of the early 1990s. Having
computed the equity risk premium at these time horizons, it is possible to determine
whether the SMSF portfolios have earned the equity risk premium over the period
since their inception.
IV. SMSF returns vis-a` -vis the equity risk premium
The ?rst step in the analysis is to determine the magnitude of the premium above the
riskless rate of interest earned by the SMSF portfolios vis-a` -vis the equity premium
%
1987-2006 3.98
1988-2006 4.55
1989-2006 4.47
1990-2006 4.52
1991-2006 6.75
1992-2006 5.88
1993-2006 7.11
1994-2006 5.48
1995-2006 7.36
1996-2006 7.08
1997-2006 7.22
1998-2006 7.43
1999-2006 7.94
2000-2006 7.29
2001-2006 8.67
2002-2006 9.38
2003-2006 15.20
2004-2006 16.95
2005-2006 15.86
2006 17.27
Note: Various periods 1987-2006
Table I.
Average annual
Australian equity risk
premium
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generated by the broader Australian stock market averages. This number is important
for both ?nancial economists and policy makers to know because the equity premium
on Australian stocks in aggregate – something of a “headline ?gure” – may be
somewhat different from the premium above the riskless rate of interest that is
generated by individual SMSF portfolios. Since the SMSF portfolios tend to allocate
funds between cash and Australian shares (at least for the most part), the SMSF
portfolio expected returns may be represented as follows:
EðR
P
Þ ¼ x
1
ðr
f
Þ þ x
2
ðEðR
M
ÞÞ ð8Þ
where x
1
is the percentage of investable funds allocated to the risk-free security, r
f
and
x
2
is the percentage of investable funds allocated to the Australian share market.
The share market has an expected return of EðR
M
Þ. The equity premium generated by
the share market will be equal to EðR
M
Þ 2r
f
. At the very least, therefore, the SMSFs
should be expected to earn a premium above the riskless rate of interest given that the
portfolios, for the most part, contain at least some risky assets. Whilst the question of
any premium to the riskless rate of interest is left to a later section, close inspection of
each individual SMSF reveals that most of the funds have generated positive returns
since their inception.
As shown in Figure 3, the SMSFs in the sample have, in general, generated positive
returns average annual returns. Only eight of 100 funds in the sample have generated
negative returns since inception; that is, they have a lower portfolio value than they
started with. Given that the trustees of SMSFs are likely to be relatively
unsophisticated investors and probably are not skilled in the technical aspects of
portfolio management and investment selection, the fact that the majority of the
portfolios have generated positive average annual returns since inception is
encouraging. However, the question of interest to this investigation is the magnitude
of the returns above the riskless rate of interest. This question is addressed by:
.
comparing the returns of the SMSF portfolios with the equity risk premium
generated by the broader Australian stock market averages measured at the
appropriate horizon; and
Figure 3.
SMSF average annual
returns since inception
(n ¼ 100)
30%
25%
20%
15%
10%
5%
0%
–5%
–10%
0 10 20 30 40 50 60 70 80 90 100
The equity
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comparing the returns of the equity portions – rather than the whole portfolios
(of the SMSF portfolios), with the equity risk premium measured at the
appropriate horizon.
The purpose of comparing the whole-of-portfolio returns of the SMSFs with the equity
risk premium generated by the broader Australian stock market averages (measured at
the appropriate horizon) is to determine the magnitude of the SMSF portfolio returns,
relative to the premium above the riskless rate of interest that characterised Australian
stocks over comparative time horizons. Figure 4 shows that the sample of SMSFs has,
on average, not generated returns that match or exceed the equity risk premium.
Indeed, the SMSFs have generated returns that fall short of Australia’s equity risk
premium by an average of 6 percent per annum[3]. However, a small number of the
SMSFs generated an average annual return equal to or in excess of the equity risk
premium.
This ?nding should not be interpreted as a severe indictment of SMSF performance.
Rather, the ?nding should be considered as an indication of the performance of SMSFs
vis-a` -vis the “headline ?gures” that denote the performance of the stock markets in
aggregate. It is inappropriate, for instance, for ?nancial economists, policy makers and
regulators to undertake policy analysis and evaluation and the development of regulatory
frameworks without relevant information concerning the performance of individual
SMSFportfolios, relative to broader market averages. The equity risk premiumgenerated
by Australian stocks in aggregate may over-shadow the returns that characterise
individual portfolios. Our ?nding highlights that the premium above the riskless rate of
interest generated by Australian stocks in aggregate is not a performance statistic that
re?ects the premium above the riskless rate of interest generated by SMSFs, at least not
within the context of the sample of SMSFs considered here.
Figure 4.
Annual SMSF return
minus the equity risk
premium (n ¼ 100)
10%
5%
0%
–5%
–10%
–15%
–20%
–25%
0 10 20 30 40 50 60 70 80 90 100
Notes: This figure shows the average annual SMSF return minus the average annual risk
premium measured over the period since each SMSF's inception. Positive values are
recorded for SMSFs that earn a return in excess of the equity risk premium. The fact that
most observations lay below the horizontal axis indicates that most of the SMSFs did not
earn returns that matched or exceeded the equity risk premium
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The second step in the analysis is to determine whether the SMSFs have generated
returns on the equity components of the portfolios that match or exceed the premium to
the riskless rate of interest generated by Australian stocks in aggregate. Since the
portfolios have large allocations to cash and ?xed interest securities, the returns
generated by the equity components of the SMSF portfolios will tend to be the main
engine that drives the returns on the overall portfolios. It is, therefore, important to
know just how the returns on this critical component of the portfolios compare with the
premium to the riskless rate interest generated by Australian stocks. When the returns
generated on the equity components of the funds are compared with the equity
premium measured over the appropriate horizon, as shown in Figure 5, it is revealed
that 29 percent of the SMSFs in the sample generated returns on the equity components
of their portfolios that match or exceed the Australian equity premium. On average, the
equity components of the SMSFs generated returns that fall short of the equity
premium generated by Australian equities by just 3 percent. This compares favourably
to the 6 percent shortfall detected when considering the overall portfolios.
The engine that drives the returns of the SMSF portfolios – the equity components
of the portfolios – does not appear to be malfunctioning. On the contrary, the premium
above the riskless rate of interest that this “growth engine” generates is sometimes
much higher than that generated by the Australian stock market in aggregate.
However, it is important to recognise that the equity components of individual
portfolios do not necessarily generate returns that match the premium above the
riskless rate of interest that is generated by the broader Australian stock market
averages. Again, the headline ?gure is shown to be a misleading indicator of the
performance that likely typi?es individual portfolios. For example, when forecasting
SMSF members’ retirement incomes, it is important to understand that the returns on
Figure 5.
SMSF Equity component
returns minus the
Australian equity
premium (n ¼ 100)
20%
15%
10%
5%
0%
–5%
–10%
–15%
–20%
–25%
–30%
–35%
0 10 20 30 40 50 60 70 80 90 100
Notes: This figure shows each SMSF's average annual equity component return minus
the Australian equity risk premium measured over the corresponding period since the
inception of the SMSF. This part of the analysis was only undertaken on the first part of
the sample. The computational burden of undertaking the analysis on all of the SMSFs
was too great given the number of data points involved
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the overall portfolios are unlikely to match the much-discussed equity risk premium on
Australian stocks in aggregate, and although the equity components of SMSF
portfolios apparently perform well, they do not perform so well as to drive the entire
portfolios’ returns towards those that characterise the stock market in aggregate.
V. Did the SMSF’s earn any equity premium?
Whilst it is important to determine the magnitude of SMSFs’ premium to the riskless
rate of interest vis-a` -vis the premium generated by Australian stocks in aggregate, few
unexpected conclusions may be drawn regarding the actual performance and
management of SMSFs. Relatively, of course, the performance is not good. Even on a
risk-adjusted basis, the performance is unlikely to compare favourably with the
unmanaged stock market indices (Phillips et al., 2007, 2009). Given that the portfolios
are not fully invested in Australian equities, the premium generated by the broader
Australian stock market averages is not expected to be matched by SMSFs. However,
given that the SMSFs have, on average, some allocation to Australian equity securities
(and other risky assets) it is expected that they will generate at least some premium to
the riskless rate of interest. Failure to do so would be evidence of poor portfolio
management and evidence that SMSF trustees’ investment decisions detract value
from the portfolios.
Having established that the SMSFs have not, on average, matched the observed
equity premium on Australian stocks, it is logical to also investigate whether the
SMSFs earned any return in excess of the riskless rate of interest. As mentioned in the
previous section, because the SMSFs contain some risky assets it should be expected
that they have earned at least some premium above the riskless rate of interest.
Whether or not the SMSFs in the sample have earned any risk premium at all is easily
determined. By comparing the average annual return generated by each SMSF with the
average interest rate on Australian Commonwealth Government ten-year bonds
measured over the relevant time horizon, it is a straightforward matter to determine the
magnitude of the premium to the riskless rate of interest that these portfolios have
generated. For completeness, both the returns on the overall portfolios and the returns
on the equity components of the portfolios are compared with the relevant riskless rate
of interest.
Figure 6 shows that in comparing the average annual returns generated on the
overall portfolios with the average interest rate on Australian Commonwealth
Government ten-year bonds during corresponding periods, most of the SMSFs did not
earn a premium to the riskless rate of interest. Rather, on average, the SMSF portfolios
earned returns that fell short of the riskless rate of interest by 2 percent per annum, and
only 13 percent of the SMSFs earned returns in excess of the riskless rate of interest.
This result is signi?cant in that it indicates inferior security selection by the SMSF
trustees in that their selections result in negative value. The inability of the SMSF
portfolios to, on average, earn a risk premium is surprising given that almost all of
the portfolios contain at least some risky assets. This result is probably explained by
poor portfolio management (Phillips et al., 2007) and the absence of an adequately
documented investment strategy to guide the construction and management of the
SMSFs’ investment portfolios.
As shown in Figure 7, when the average annual returns since the inception of each
SMSF that have been generated on the equity components of the 100 portfolios in the
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sample are compared with the riskless rate of interest, the results are more favourable.
A much larger number of portfolios earned a premium to the riskless interest rate when
the equity components of the portfolios are considered in isolation, and, on average, the
SMSFs earned a small premium above the riskless rate of interest on the equity
components of the portfolios. This premium was much lower than that which has been
Figure 6.
SMSF returns minus the
riskless rate of interest
(n ¼ 100)
20%
15%
10%
5%
0%
–5%
–10%
0 10 20 30 40 50 60 70 80 90 100
Notes: This figure shows the average annual SMSF returns minus the average riskless
rate of interest that prevailed during the corresponding period since the inception of the
SMSF. Positive values indicate average annual returns on the overall portfolios in excess
of the riskless rate of interest. This analysis was undertaken on all of the SMSFs in the
sample
Figure 7.
SMSF Equity component
returns minus the riskless
interest rate (n ¼ 100)
20%
15%
10%
5%
0%
–5%
–10%
–15%
–20%
0 10 20 30 40 50 60 70 80 90 100
Notes: This figure shows the average annual returns generated by the equity components
of each SMSF portfolio minus the average riskless rate of interest that prevailed during
the corresponding period since the inception of the SMSF. Positive values indicate average
annual returns on the equity components of the portfolios in excess of the riskless rate of
interest. This analysis was undertaken on the SMSFs in the first part of the sample
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experienced by the broader Australian share market. On average, the equity portions
of the SMSF portfolios earned a premium to the riskless rate of interest of 1 percent per
annum during the lifetime of the portfolios. Although the signi?cance of this ?nding
can only be con?rmed through further empirical analysis, it is interesting to note that
the average equity premium earned by the SMSFs on the equity portions of the
portfolios found here is, coincidentally or otherwise, much closer to Mehra and Prescott
(1985) estimate of 0.35 percent than the equity premium generated on Australian
shares in aggregate.
On balance, risky SMSF portfolios would be expected to generate returns above the
riskless rate of interest, and the failure of the sample funds to do so indicates that far
from being superior security selectors, SMSF trustees are making choices that detract
from the performance of their portfolios. A purely risk-free portfolio containing
Australian Government securities would, in the majority of cases, generate returns in
excess of those generated by the risky SMSFs. On a risk-adjusted basis, these SMSF
trustees are overseeing and are responsible for a real diminution in the value of their
retirement assets. All the costs involved with setting up and running these funds have
hardly been worth the effort. Finding that the SMSFs have not generated returns in
excess of the riskless rate of interest leads to the conclusion that the risks borne by
SMSF trustees have not delivered the expected returns.
VI. Discussion and conclusions
The analysis presented in this paper generated three main results:
(1) the sample of SMSFs generated a much lower premium to the riskless rate of
interest than the aggregate Australian share market;
(2) even when considered in isolation, the equity portions of the portfolios earned
only a very small premium to the riskless rate of interest; and importantly
(3) the SMSF portfolios did not earn a premium to the riskless rate of interest, even
though the portfolios contain risky assets.
This latter result has implications for policymakers and is indicative of poor portfolio
management. The ?ndings show that although most of the portfolios generated
positive returns since inception, the returns are far below those generated by the
Australian share market, and below the yield of Australian Commonwealth
Government ten-year bonds. In retrospect, higher returns could have been generated
by simply allocating some portion of each portfolio to a managed bond fund or cash
management trust and an index fund that mirrors the Australian share market in a
proportion consistent with trustees’ risk preferences.
Constructing an investment portfolio for SMSFs, like most portfolios, is a complex
task. In essence, the portfolios are combinations of securities with risk and return
characteristics that must be carefully managed in order to generate returns that are
commensurate with the risk being borne. When returns are not commensurate with
risks being borne, the dif?cult exercise of forming and managing a portfolio has, it
might be said, hardly been worthwhile. This is particularly the case when a much more
straightforward approach would have generated higher returns. It is one of the main
results of modern ?nance theory that investors should simply divide their portfolios
between the risk-free asset and the market portfolio. In light of the returns generated
by the sample SMSF portfolios examined in this study, this simple approach appears
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all the more attractive. Simply allocate a portion to the riskless security and a portion
of the portfolio to a fund that mirrors the Australian share market. For most of the last
three decades, such an approach would have generated returns far in excess of those
that were generated by the SMSFs.
Since the SMSFs contain risky assets, at least some premium to the riskless rate of
interest should be expected. Poor diversi?cation could be one possible reason for the
failure of the funds to generate returns in excess of the riskless rate of interest.
However, the portfolios of the SMSF sample appear to comprise suf?ciently different
securities to be considered as adequately diversi?ed. It is more likely that poor
portfolio construction – poor security selection and perhaps over-diversi?cation,
especially in managed investments – is the source of the low returns. This is dif?cult
to rectify without ?rst considering the appropriateness of the fund’s investment
strategy. The fact that such wide-ranging allocations such as 20 percent cash and
40 percent shares are permissible under the investment policy statements suggests a
problem with the construction of the plan which the managers (in this case trustees)
follow in their day-to-day management of the SMSFs. Investigation of this issue would
form the basis for an interesting research program, focussing on trustees’ rationale that
informs their portfolio construction and management decisions. Furthermore, it would
be instructive to know more about the knowledge set of SMSF managers and the
amount of time they spend engaged in SMSF-related activities.
In bringing this paper to a close, it is worthwhile returning to the discussion on the
equity risk premium. Asset pricing continues to present numerous challenges. Even
though the “classical” period of asset pricing theory has long since receded, the
reconciliation of the theoretical work undertaken during the 1970s and 1980s with
“stylised facts” may yet take a generation or more of solid endeavour on the part of
?nancial economists (Campbell, 2000). The premium of aggregate stock returns above
the riskless rate of interest is dif?cult to reconcile with the C-CAPM unless one is
willing to accept an implausibly high value for the risk-aversion parameter. However,
as Siegel (1999) conjectured, there is a very strong possibility that investors may not
actually earn the equity premium on their portfolios. The results of this investigation,
though not based on a suf?ciently large sample to permit the generalisation of the
?ndings to all investors, provide some support for this conjecture.
The results generated during this investigation are somewhat concerning but they
are by no means surprising or perplexing. SMSF portfolios have been shown to be
poorly constructed (Phillips et al., 2007). Portfolio management, relying on Markowitz
diversi?cation and portfolio programming, is a complex task and may be beyond the
capabilities of unsophisticated investors. Even if this were not the case, it is not
unreasonable to suggest that very few SMSF trustees would have been educated on the
mechanics of portfolio management. Whilst na? ¨ve diversi?cation is possible and may
have been attempted by most investors, this method of portfolio construction may not
be effective if it ignores the correlation structure of the returns on the securities in the
portfolio. The low-excess returns generated by the SMSFs are probably due to poor
portfolio management, including low diversi?cation, the inclusion of too many
managed investments in the portfolios and high weightings in low return-low risk
assets such as cash in bank accounts.
The high-historical equity premium provides encouragement to investors seeking to
build their wealth over the long term. However, the recommendation that SMSFs be
The equity
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heavily invested in Australian shares must be considered in light of the actual ability
of SMSF trustees to manage a portfolio in such a manner as to extract some or the
entire available premium. The failure of the risky SMSFs to generate returns in excess
of the riskless rate of interest is evidence that SMSF trustees do not possess the ability
to select securities that generate returns in excess of the returns that would have been
expected given the risks involved. Rather than attempt to implement any active
portfolio management strategy, SMSF investors seeking to bene?t from any premium
that may characterise Australian shares in the future are likely to perform better than
the average SMSF trustee by taking a very simple approach and dividing their assets
between the risk-free security and the market portfolio (an index fund). Those who are
uncomfortable with such an approach might consider whether the right choice for them
is to start-up a SMSFs.
Notes
1. Of course, the terminal value could be less even if the average return is 7.5 percent
per annum. Increased volatility will decrease the terminal value.
2. The average SMSF invests 36 percent of the overall portfolio in Australian shares (ATO,
2008).
3. Whilst the SMSF returns may be partially or wholly after tax, allowing for taxation effects
does not change the conclusions presented in this section (or other sections) of this paper.
Allowing for taxation would reduce the shortfall from 6 to 5.1 percent.
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Corresponding author
Peter J. Phillips can be contacted at: [email protected]
The equity
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This article has been cited by:
1. Peter J. Phillips. 2011. Will Self-Managed Superannuation Fund Investors Survive?. Australian Economic
Review 44:10.1111/aere.2011.44.issue-1, 51-63. [CrossRef]
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