Compare Your Own Mid-Year Capital Market Assumptions with Wall Street

Optimization for strategic asset allocation involves the forecasts of  at least three types of information:

  • Expected returns of different asset classes
  • Expected risk (volatility) of different asset classes
  • Correlations of different asset classes

We recommend that investors avoid recency bias. Since the expected returns of all assets classes vary over time, we estimate expected return of an asset class by combining the following information:

  • Long-term historical average return over multiple economic cycles
  • Key drivers of historical returns and market forecasts of future performance of such drivers
  • Consensus estimate of reputable wealth management companies

Investors may be inclined to take the long-term average return of an asset class as the expected future return. Such an approach likely will not work as the market environment mid 2017 is substantially different from the average of the past decades. Instead, historical returns give us information on the range of the possible returns. More importantly, historical returns help investors understand the key drivers that have determined realized historical long-term returns.

The following equation shows one way to decompose S&P returns:

  • S&P return = equity risk premium + long-term bond return + noise

The first two terms explain the expected return:

Expected S&P return = equity risk premium + long-term bond return

= equity risk premium + short-term interest rate + term premium

= equity risk premium + (inflation + real short-term interest rate) + term premium

The last term explains the volatility in S&P returns. It is a random variable centered around zero.

We expect the inflation rate to stay at low level in the future as it did in the past decade. The real short-term interest rate depends on the Federal Reserve’s policy. In recent years, Federal Reserve has kept short-term interest to be below inflation rate. We do not expect dramatic policy change. The term premium depends on investors’ long-term view on economic growth. Market consensus is that the U.S. economy will grow at an average of ~2% in the next decade. All these factors indicate long-term bond returns are likely to be below historical average. As a result, return of S&P is likely to be below historical average as well. Consensus view: Estimates from wealth management firms suggest an expected return of +6%.

You can now compare and contrast your own views across +50 asset sub-classes with others.

 

 

 

 

Author: Sameer_Jain

Partner. Sameer Jain is founder of FinTech ActiveAllocator.com, the world’s first portal that seamlessly integrates traditional, illiquid and alternative investments within portfolios. Prior to this he was Chief Economist & Managing Director at AR Capital. Before that he headed Investment Content & Strategy at UBS Alternative Investments. At UBS, he served as a non-voting member of the Wealth Management Research investment committee, and as a capital allocator was responsible for all illiquid investing including fund manager selection and due diligence across the platform. Prior to UBS he headed product development & investment research at Citigroup Alternative Investments that managed over $75 billion of alternative investments across hedge funds, managed futures, private equity, credit structures, infrastructure and real estate. Here he led a team that developed proprietary models for portfolio strategy and asset allocation with alternative investments, provided investment support and research to pension plans, sovereign wealth funds, endowments as well as internal clients including Citi Private Bank. Before this he was with Cambridge Alternative Investments and SunGard (System Access) where he travelled to over 80 countries for work across Europe, Asia, Middle-East and Africa. He has written over 30 academic and practitioner articles on alternative investments with thousands of downloads at SSRN, presented at over a hundred industry conferences and has coauthored a book, Active Equity Management. Mr. Jain has multiple degrees in engineering, management, public administration and policy and is a graduate of Massachusetts Institute of Technology and Harvard University. He is a recipient of the Alfred Sloan Fellowship and subsequently was a Fellow of Public Policy and Management at the Harvard Kennedy School of Government for a year. He holds Series 7 and 66 securities licenses.

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