There was an interesting piece by John Ralfe, pioneering asset allocator, in the FT on Saturday. He was challenging the assumption that, although subject to short-term volatility, equities would always be a superior long term investment in terms of returns. Although this has largely been true in the past – albeit there have been long term bear markets – he points to the cost of trying to buy insurance that guarantees future equity prices in the long term.
What does the cost of long-dated equity put options tell us about the riskiness of owning shares? Lots. If the risk of owning shares really does reduce over time, the cost of equity put options should be lower for, say, 10 years than one year, and should be even lower for 20 years. But in fact, the cost of the option insurance is higher the longer the option period. The theoretical price — and the actual prices charged by banks — is about 25 per cent for 10 years and 30 per cent for 20 years. So insurance for £100,000 for 20 years would cost around £30,000 on day one. The increasing cost of this insurance shows that in the real world, equity risk increases, not decreases, the longer the period. Private investors should think long and hard about this when looking at their fundamental asset allocation of equities versus bonds.
Basically, the equity derivative market is saying that there is a fairly high probability that the value of shares will be less than their current value in the future and that the further in the future it is, the more likely it is that the value will be less.
It’s difficult to imagine similar expectations in the housing or commercial real estate markets. If you had a house worth £1 million, how much would you expect to pay to insure that you could sell it for £1 million in 25 years? £300,000? I’d imagine that the actual premium would be much, much smaller – especially given the political support for house prices.
However, given that yields remain low by historic standards and the secular stagnation thesis, it’s more likely to be more expensive in the commercial real estate sector. Between 1947 and 1967, (estimated) nominal capital growth in the IPD All Property index was approx. 0.5% per annum. Between 1981 and 2009, it was just under 2% per annum. That’s still a lot of positive growth over the period when compounded.
Possibly, if rental growth stays in low single figures, then depreciation becomes a major issue in 25-30 year time horizons. I suspect insuring capital values would be much more expensive for the IPD capital value index compared to a residential price – albeit residential values would ‘protect’ commercial values to some extent.
However, I’m not aware of a similar long term put option in commercial or residential real estate. It’s been thought about but not implemented.