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Abstract
Decomposition analysis, which breaks down the Total Return on an asset into constituents of Income Yield, Income Growth and the Revaluation Effect, can be used prospectively and retrospectively. To date, it has been mainly applied retrospectively to Equities. In this article, we break new ground, demonstrating that, with appropriate data series, it can be extended to Bonds, which means that Equity and Bond returns and their constituents can now be compared on a like–for–like basis. Empirical analysis of UK Index data since 1976 produces some unexpected results on Fixed Interest and Index–Linked Gilts: for example, throughout the period, the Revaluation Effect has been a consistently significant contributor to the Total Returns of both classes and at a much higher average level than that for Equities; also, the Revaluation Effect for Index–Linked Gilts has recently been at an unprecedented level for any asset class. Seeking to explain them, we examine the role of regulatory activity, arguing that it has created a dangerous dynamic on unsound foundations. We demonstrate that our method of analysis does not consist only of technical operations devoid of practical applications but actually enables us to address important issues in economics and political economy.
Acknowledgements
I thank the referees for their comments on a previous version of this article. The usual disclaimer applies.
Notes
1 There is anecdotal evidence that some asset managers were well aware of them, as indicated by the great disparity between the allocation in their clients’ portfolios and that in their own private portfolio. Under the prevailing conventional peer–group mandate of the time, with constraints in both asset allocation and security selection on divergences from the respective Benchmark weightings, an asset manager could have had an aggregate Equity weighting of around 75% in a client portfolio and a much lower proportion—even 0%!—in his/her own, most of the portfolio being in “liquid” assets (i.e. Cash).
2 Even some academic economists (e.g. Mills Citation1991; Clare, Thomas, and Wickens Citation1994) succumbed to the temptation.
3 Tracking-error, as measured by the standard deviation of a portfolio’s return relative to its Benchmark Index, is conventionally employed as the main indicator of the portfolio’s “risk” relative to its Benchmark.
4 We have chosen the 20 Year Fixed Interest Gross Redemption Yield as proxy for the Over 15 Year Gilt Index because it starts at the end of 1975, whereas the Over 15 Year Index Gross Redemption Yield starts only in November 1998: in any event, the differences are quite small.
5 To re-iterate: there is no reason why the Revaluation Effect should be positive, even over the Long Term. For example, for 1950–1979 inclusive, the Revaluation Effect for the All–Share Index was –1.1% p.a.
6 To illustrate: in the six-month period, April–September 1998, the UK Debt Management Office (DMO) issued four “tap stocks” with coupons 2.5%, 2.5%, 4.125% and 4.375%; in the First Quarter of 2006, it issued three stocks with coupons 1.25%, 1.25% and 2%; and in the Third Quarter 2018, it issued three stocks, all with coupon 0.125%.
7 For example, in the Third Quarter 1998, the DMO issued one long-dated stock with a 6% coupon; in the First Quarter 2006, there were two long-dated issues with coupons 4.25% and 4.75%; and in the Third Quarter 2018, another two long-dated stocks, each with coupon 1.75%.
8 Since 1753 (Source: Bank of England Citation2018).
9 Of course, a negative Index-Linked Yield means a negative real rate of return if held to maturity.
10 Inspection of suggests that variations in the Revaluation Effect are the main influence on variations in the Total Real Return, a conclusion confirmed by analysis of annual data: the correlation coefficient between Return and Revaluation Effect is around 0.9 for Equities, 0.8 for Fixed Interest and 0.65 for Index-Linked; whereas the correlation coefficients between Return and the other two factors do not exceed 0.25 and are usually much lower.
11 and Tables A1–A2 are in the Appendix.
12 Smith (Citation1924, 3). This was the generally accepted view that Smith challenged in his 1924 Monograph. A similar view was quoted by Graham and Dodd (Citation1934, 8, fn. 1) in the following extract from Investment and Speculation by L Chamberlain and W W Hay (1931): “[Equities], as such, are not superior to bonds as long term investments, because primarily they are not investments at all. They are speculations.”
13 Aside from the evidence adduced above and illustrated in the Appendix, there is anecdotal evidence that the Regulator regards asset–liability matching as the over-riding consideration, with little, if any, regard to cost (in terms of negative Index-Linked Gilt Yields).
14 ‘An investment operation is one which, upon thorough analysis promises the safety of principal and an adequate return. Operations not meeting these requirements are speculative.’ (1973, 1).
15 The Equity Yield exceeded the Gilt Yield from 1900 to the late-1950s, when the Reverse Yield Gap emerged, remaining a feature of UK markets until 2010. There was a similar pattern to the USA Yield Gap in the 20th century, the switch to a Reverse Yield Gap occurring at the same time as in the UK (Source: Barclays Capital Citation2015).
16 See Chapter IX of Smith (Citation1924) and Woods (Citation2019).
17 Benjamin Graham also recognized this point: “as Edgar Lawrence Smith’s studies have suggested, the growth of common–stock values as a whole is related chiefly to the upbuilding of net worth through the reinvestment of surplus earnings as well as the raising of new capital” (Graham and Dodd Citation1934, 319). In The Intelligent Investor, Graham referred to the “profitable reinvestment” theory: “There was always a strong theoretical case for reinvesting profits in the business where such retention could be counted on to produce a goodly increase in earnings” (Graham Citation1973, 271, emphasis added).
Additional information
Notes on contributors
J. E. Woods
J. E. Woods is an Independent Researcher, based in Tadworth, Surrey, UK.