What’s the point of forecasts for passive investors?

While investors may not want to change their portfolio allocation, information can be utilised in other ways.

A popular way to invest is to buy an index fund or exchange-traded fund (ETF) that provides broad market exposure and just sit on it.

Often this will take the form of buying some sort of allocation to shares and bonds. The most popular is 60% in equities and 40% in bonds.

The idea is that over time, share prices rise. And in those periods when they decline, bond prices rise. Vanguard, iShares and other asset managers offer passive funds that rebalance regularly to retain a certain allocation to shares and bonds. For many investors, it is the easiest and most reliable way to invest. And historically, it has provided strong returns.

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But is this all passive investors need to know? Does the passive, autopilot nature of this sort of portfolio mean the investor can now ignore the whims and gyrations of the global economy and financial markets? Can they do away with reading the news and forecasts about valuations and expectations of future returns?

According to a new note from Vanguard, it is still worth investors keeping up with market forecasts.

Joe Davis, Vanguard’s chief global economist, notes: “Why should long-term investors care about market forecasts? Vanguard, after all, has long counselled investors to set a strategy based on their investment goals and to stick to it, tuning out the noise along the way.

“The answer, in short, is that market conditions change, sometimes in ways with long-term implications. Tuning out the noise — the day-to-day market chatter that can lead to impulsive, suboptimal decisions — remains important. But so does occasionally reassessing investment strategies to ensure that they rest upon reasonable expectations.”

Davis gives the example of the strong returns seen in US markets over the past decade. He notes that much of this has been driven by “valuation expansion”,  meaning investors have been willing to pay more per dollar of company earnings. This was driven by low economic growth and the low interest rate environment.

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This is important for investors. The current high valuation of US stocks means that returns will potentially be lower over the next decade.

Davis notes: “Just as low valuations during the global financial crisis supported US equities' solid gains through the decade that followed, today's high valuations suggest a far more difficult climb in the decade ahead.

“The big gains of recent years make similar gains tomorrow that much harder to come by unless fundamentals also change. US companies will need to realise rich earnings in the years ahead for recent investor optimism to be similarly rewarded.”

But what does this mean for the investor in a global index fund, or something similar? If valuations are high and future returns likely (but not definitely) going to be lower going ahead, should this mean investors ought to change their allocation? Should they reduce their exposure to US stocks?

Perhaps. Vanguard does argue that non-US stocks are likely to outperform US stocks in coming years. Davis notes that according to one Vanguard forecast, “stocks in companies outside the US will strongly outpace US equities — in the neighbourhood of three percentage points a year — over the next decade”.

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But such allocation decisions are likely to be unappealing to the committed passive investor. For many investors taking this approach, the idea of tinkering with exposure to certain regions to try and outperform is fraught with difficulties and risk.

However, that’s not to say the expectation of lower returns from US shares cannot inform the decision-making of a passive investor. The investor may be reluctant to change their portfolio allocation, but the information can be utilised in other ways.

Davis explains: “Our forecasts today tell us that investors shouldn't expect the next decade to look like the last, and they'll need to plan strategically to overcome a low-return environment. Knowing this, they may plan to save more, reduce expenses, delay goals (perhaps including retirement), and take on some active risk where appropriate.”