ASR Composite Equity Risk Premium estimates
Over the long run, US equities have given investors a higher return than US bonds. As total return data from Dimson, Marsh and Staunton show, US equities have had a total return of 9.9% pa since 1955, while US bonds have returned 7.1%, a difference of 2.8% each year. Of course there is a reason for this: holding equities in a portfolio is more hair-raising, since their price fluctuates more. This additional return is a premium for taking on risk and is called the Equity Risk Premium.
Since the art of portfolio construction is based around balancing risk and return, understanding and estimating future equity returns is a vital step in building a multi-asset portfolio. However, using this historic ERP in portfolio construction requires faith that the future is going to be like the past. In our view, a better, more forward looking approach is to use the ERP that is implied by current market prices.
All the major textbook methods of estimating the implied ERP have issues: the simpler ones have model risk (that the model is not representative of the real world), while the more complex ones have input risk (that the input variables might be incorrect). One solution to this issue is to harness ‘the wisdom of the crowds,’ in which the error of a set of estimates is lower than the error of a single one. So we combined 9 models into a composite. We have aggregated using the median, rather than the first component of a PCA analysis since it possibly detects more of the shifts in the underlying ERP, and is less affected by simple price moves.
We have built composite ERP estimates for 19 countries around the world. While the calculation of the Eurozone ERP as an aggregate of countries or a single entity might appear to be an important conceptual difference, in practice we have found the results of both methods to be similar. We have also created an ASR Global Composite ERP, weighted by equity market size. For more details on their construction click here.
To see our presentation on the construction of our ASR Composite ERP estimates and their relationship with macro variables, please click here .
Our ASR Composite ERP Estimates are available on the Thomson Reuters Datastream platform with the following codes.
The Equity Risk premium dataset is produced by Absolute Strategy Research Ltd, which is authorised and regulated by the Financial Conduct Authority. The ERP data provides general information only and is not intended to form the basis of an investment decision. The information on which the ERP data is based was obtained from sources that we believe to be reliable but we do not guarantee that it is accurate or complete, and it should not be relied upon as such.
© Absolute Strategy Research Ltd 2016. All rights reserved.