Premium investments

While the importance of equity risk premiums is unquestionable, their estimation is often complex and far from uniform. The first of three main methods is the historical approach, where ERP is based on the past returns of equities versus high-grade government securities. A second approach is to survey investors and ask about their required rate of return to compensate for the risk of buying shares. Finally, the implied equity risk premium aims to calculate the excess return for shares that appears to be currently priced in by the market. Each methodology has its own merits and uses - certainly, the historical equity risk premium should be considered by investors at the outset when choosing their long-term asset allocation strategy - but in the context of whether shares are good value right now, the implied ERP is the sharpest tool.

The implied equity risk premium approach

The box 'Solving implied ERP for the FTSE 100' details the calculation of a risk premium from the price level of the index, the overall dividend yield, analysts' estimates for long-term earnings growth and the gross redemption yield of UK 10-year benchmark gilts. The table below shows implied ERPs for the FTSE 100 at the end of March, for each year from 2007. To demonstrate how the implied ERP was affected at the height of the financial crisis, the table also includes calculations for September and December 2008. Data from August and September 2015 show the changes in implied ERP due to recent market volatility.

Higher implied ERPs occur during periods of market stress, which reflects the desire for greater compensation as perceived risk increases. Sometimes, in periods of market correction, a higher implied premium can be a sign of value. This might be the case currently as equity markets adjust to the fallout of China's economic slowdown. On a cautionary note, however, as the financial crisis of 2007-09 underlined, rising ERPs are not necessarily a signal to buy shares during severe downturns when markets may have further to fall. In these scenarios, more research is always advisable (and in the case of the impact China's woes may have, Simon Thompson's article 'A sense of perspective', 1 September, provides a cogent analysis of the bull case for European and US equities). While a flawed measure for predicting market moves, the question equity risk premiums do consistently help answer is: which shares (and other risky assets) offer the best value?

Based on low forecast earnings growth, the expected future returns for the FTSE 100 are not high by historical standards. When we consider the make-up of the index, the largest sectors by market capitalisation such as banking, oil & gas and mining are going to have a proportionate influence on the numbers. Other sectors may have stronger growth forecasts and hence a better implied premium. It follows that ERP can be used when deciding the level of exposure to different sectors and also as an additional tool to value individual companies. Widening the scope, using a standard risk-free rate such as US Treasury bonds or German bunds, investors can assess premiums on offer from various international equities markets. (Tactical asset allocation opportunities looking at overseas markets, as well as specific sectors and companies in the UK, will be looked at in future Investors Chronicle 'Market Tactics' updates.)

Examining the spread between the returns on other investments and 'risk-free' government bonds is also useful, to compare how the risk of different asset classes is being priced. Looking at corporate bonds, for example, the spread between the gross redemption yield of AAA-rated 10-year UK corporate debt and the benchmark 10-year gilts is revealing. In March 2015, the GRY for corporate debt was 1.891 per cent (source: Thomson Datastream) compared with 1.575 per cent for gilts. The spread of 0.316 per cent helps put into perspective the valuation of blue- chip equities at the same time. The premium of 3.89 per cent for the FTSE 100 was over 10 times that for the equivalent class of corporate debt. So, while UK shares were not as cheap as they had been looking at the implied ERPs a year or two earlier, relative to fixed income, equities remained attractively priced.

Using the ERP to help build and manage your portfolio

Taking a top-down approach to portfolio construction, in the first instance decisions should be made to take the least risk in pursuit of clearly defined goals. The premium on offer from riskier investments directly affects the amount of money that must be saved, in order for investors to outpace inflation and achieve objectives. Used in conjunction with a risk management model (see Ideal Portfolio: Managing Risk, 24 July), the historical ERP can help investors gauge the allocation they need to make towards shares and assess the level of risk to take. A historical premium is the more appropriate estimate when trying to model for long-term returns as it reflects the mean reversion of the ERP over time, evening out periods of boom and bust (the weakness of the implied premium is that it does not allow for any market imperfection). The 3.7 per cent estimate of the historical premium for the UK, made by Dimson, Marsh and Staunton (2015) is based on data for 1900-2014 and can be used for this important strategic exercise.

In the shorter term, the implied ERP is useful to inform tactical asset allocation and decisions on specific regions, sectors and individual securities. With interest rates still at record lows and the yields on government debt suppressed, as a consequence both of the low rates and £375bn of quantitative easing, we have been living in a low return world. In this context, although earnings have disappointed and future estimates are underwhelming, equities have offered a worthwhile premium in recent years and made outstanding returns since 2009.

Looking at current events, the volatility markets are experiencing is seeing implied ERPs move around too and, as mentioned above, some may see this as a buying opportunity. There are concerns, however. As well as China's economic slowdown and stock market crash, no one can be certain how strongly markets will react when the Federal Reserve starts normalising monetary policy in the US. If the current market turbulence does prove to be the start of a more serious downturn, then keeping an eye on the premiums implied for asset classes and shares can help spot outstanding value when the dust settles. In the meanwhile, long-term investors can use the implied ERP to top-up holdings in their favourite companies as the premiums become irresistible, while maintaining plenty of cash and monitoring the overall risk in their portfolios.