Capital Market Assumptions
October 26, 2015
Table of Contents
• 3-‐5: Expected returns for 60/40 • 6-‐11: Implications • 12-‐18: Capital market asumptions from Schwab, JP Morgan, Northern Trust, AQR and Bank of NY
• 19-‐21: FactSet data; corporate margins • 22-‐27: Asset allocations used by institutions • 28-‐29: Links to sources
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10-Year Expected Returns
• SPY: 6.0% • AGG: 2.0% • 60/40: 4.4%
Note: Expected returns include a projected inflation rate of 2.0%. Returns are compounded for the ten-‐year period ending 12/31/26.
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Methodology
• Expected equity returns: 6% = Dividend yield of 2.0% + Inflation of 2.0% + Real earnings growth of 2.0%
• Expected bond returns: 2% = SEC Yield on AGG of 2.0%
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Track Record of This Methodology
Expected Returns Are Low: What Is Attractive?
• Income: • Bond ladders or bullet ETFs • Fixed annuities: DIAs and SPIAs • Covered call writing
• Diversification • Hedge funds: Structure and strategy depend on account size and advisor expertise
• Managed futures: Uncorrelated returns • Commodities: Long-‐term rebalancing
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Enhanced Equity Returns
• Private equity • Illiquidity premium • High dispersion requires heavy due diligence
• Emerging market equities: Asia ex-‐Japan • UK equities: Low valuation and high global exposure
• High yield bonds: Proxy for equity exposure
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Enhanced Equity Returns: Factor Exposures
• Value • Momentum • Quality: profitability measures such as ROE and ROA
• Carry: Defined as the initial yield of the asset
• Low beta: Reduces volatility more than it enhances returns
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What Variables Am I Watching?• Inflation
• Drives both CMAs and financial plans • Focus on Employment Cost Index
• Corporate Margins • Long-‐term margin expansion reflects lower SG&A, taxes, and interest costs (slide 21)
• Trends may have peaked • Balance Sheets and Backbacks
• Debt levels and net cash (slide 20) • Buybacks (slide 19)
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Tactical OverlayExpected returns are low, and portfolio drawdowns are devastating, so it sometimes makes sense to shift to cash.
Defensive Use of Cash • Cash is the gold standard for mitigating risk (and client sanity)
• Shift to cash on 2-‐sigma events (a work in process) • BUT tactical tilts undermine strategic diversification
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Tactical Overlay: Methodology
• Valuation: Provides information about risk • Momentum: Provides information about timing
• Economic momentum: Dash of Insight • Earnings momentum: Fundamentalis and FactSet
• Price momentum: Long-‐term support on SPY • Monitoring… Inflation, margins, balance sheets
• Integrate, integrate, integrate • No framework = no results
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Schwab’s Retirement Assumptions
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Int’l stocks return less than U.S. stocks. Hmmm…
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JP Morgan: Expected Return Assumptions 10-‐15 Year
Returns Annual Volatility Highest Expected
Returns
SPY 6.5% 15.5% Emg Mkts: 8.75% Asia ex-‐Jap: 9.75%
AGG 4.0% 4.0% High Yield: 6% EM Sov: 7.5%
Cash / Inflation 2.0% / 2.25% 1.5% TIPS: 4.25%
Private Equity 7.75% 22.0% An “alpha class” not an asset class.
Real Estate 6% to 7.75% 12% to 15% “Value-‐added” U.S. RE: 7.75%
Diversified HFs 4.5% 5.75% Long-‐bias hedge funds
Commodities 3.5% 19.0% Gold: 4.0%
https://am.jpmorgan.com/gi/getdoc/1413613727995
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Northern Trust5-‐Year Returns Highest Expected Returns
SPY 5.6% Global: 6.5% UK: 7.0%, EM Asia: 8.5%
AGG 3.0% High Yield: 5.6%, EM Debt: 6.5%
Cash 1.5% TIPS: 2.4%
Private Equity 8.6% Venture Capital: 9.7%
Real Estate 6.9%
Diversified HFs 4.4% Long-‐bias hedge funds
Commodities 5.0%
• The Northern Trust 2015 report on CMAs focuses on investment themes. • On page 11 the report cited historical return premia from factor exposures such as quality and value. These premia have ranged from 3% to 7%.
• In a low return environment, I expect return premia of more like 1% to 3%.
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AQR: Equities
• AQR uses a dividend discount model and the Shiller P/E. Both approaches reach roughly the same conclusion about expected returns: DDM projects 3.5% and Shiller P/E projects 4.0%.
• I add 0.5% to the DDM to account for the buyback yield since I believe that recent buyback trends will persist.
(Page 2 of 1Q 2015 report; timeframe is 5 to 10 years)
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AQR: Fixed Income
• AQR projects real returns of 0.6% for U.S. 10-‐year bonds. • The steepness of the yield curve does NOT accurately predict rising rates. History shows instead that the steepness reflects a term premium for LT bonds.
• Nominal yields do NOT tend to revert to the mean due to the persistence of inflation, when it occurs.
• Outlook argues for buy-‐and-‐hold portfolio of bonds or target-‐duration ETFs.
1Q 2015
If the yield curve is unchanged, a bond rises in price as it “rolls down” the curve.
Page 3 of 1Q 2015 report
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Bank of NY: Equity Returns
2.6% real EPS growth
Dividends + “buyback yield” (see next page)
2.2% inflation
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What Is “Buyback Yield”?
2.6% real EPS growth is too high.
• FactSet Data show that corporations have been net buyers of stock over the last ten years (especially tech firms). This boosts returns, just as dividend yield does.
• I expect this to persist, and add about 0.5% to long-‐term equity returns.
Page 8 of Buyback Quarterly 9/21/15
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Levering Up: Not Captured in DDM
• Net corporate debt issuance has reached more than $100 billion per quarter. This has occurred even as cash on balance sheets hits $1.4 trillion .
• In 2Q 2015, the three biggest issuers of debt were: • AbbieVie: $16B • AT&T: $15B • Apple: $11B
(Page 12 Cash and Investment 9/24/15)
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Falling SG&A Has Boosted Margins
• SG&A has have fallen from 24% to 16% from 1990-‐2013. • Can this continue? Source: Figure 14, Why Jeremy Grantham Is Right About Corporate Profit Margins, Advisor Perspectives, 11/11/2014
22Source: PCM Partners, LLC, proprietary database.
What Do Wealth Managers Recommend?
Equity''51%'
Fixed'Income'27%'
Cash'3%'
Real'Estate'3%'
Commodi=es'2%'
Hedge'Funds'10%'
Private'Equity'3%'
Other'1%'
Alterna=ves'19%'
2015'Asset'Alloca=ons:''Average'of'41'Top'Wealth'Managers'
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Source: PCM Partners, LLC, proprietary database.
Wealth Managers Asset Allocations: Summary Statistics
EquityFixed+Income Cash+ Alts
Real+Estate CMDT
Hedge+Funds
Private+Equity Other+Alt
Average 51% 27% 3% 19% 3% 2% 10% 3% 2%Median 50% 28% 3% 20% 2% 2% 9% 3% 0%Std.+Dev. 8% 8% 2% 9% 2% 2% 7% 4% 4%High 67% 44% 9% 35% 10% 6% 28% 14% 20%Low 37% 10% 0% 0% 0% 0% 0% 0% 0%
Summary2Statistics2for2412Top2Wealth2Managers20152Asset2Allocation:
• Recommendations tend to cluster around the same asset allocations. • This may reflect overconfidence in Mean Variance Optimization. • If it is herd behavior, a contrarian position may make sense.
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BoNY Allocations for Institutions
Pensions Are Optimistic
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To get 7.4% returns from a 60/40 portfolio, you must assume 9% for stocks and 5% for bonds.
Source: Distribution of Alternative Investments through Wirehouses, May 2015.
A Dose of Reality from BoNY
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CALSTERS Expects History to Repeat
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To get 7.4% returns from a 60/40 portfolio, you must assume 9% for stocks and 5% for bonds.
Sources: California State Teachers Retirement System (CALSTERS) Investment Policy and Management Plan, 2014 November, page 10; CALSTERS Annual Financial Report page 135
• CALSTERS manages $190 billion, and is an example of optimistic assumptions for expected returns. • The portfolio returned 7.7% for the 10 years ending 6/30/14. This included returns of 8.3% on global stocks, 5.5% on fixed income, 7.4% on real estate, and 13.8% on private equity.
Wow!
Resources
1. Expected Returns by Research Affiliates from 2012. Shows returns from a 60/40 portfolio for 14 decades.
2. Schwab assumptions used in retirement calculator. Also see this article from April 2015.
3. JP Morgan: See page 60 for equities 4. Northern Trust: Thematic approach 5. AQR Library: Meticulous financial theory, esp. Alternative Thinking 6. Distribution of Alternative Investments Through Wirehouses,
Money Management Institute, May 2015. 7. Bank of New York 8. CALSTERs Investment Policy and Management Plan.
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Research Links
1. McKinsey’s bearish report on global corporate margins. It got lots of press but I prefer…
2. Deconstructing corporate margins: Ramraika/Trivedi. Uses a granular, bottom-‐up approach.
3. FactSet Cash and Investment Quarterly. Tracks cash and debt, as well as capex and R&D. Also see FactSet Buyback Quarterly and FactSet Dividend Quarterly.
4. Dash of Insight by Jeff Miller 5. Fundamentalis by Brian Gilmartin
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