When developing a long-term investment strategy, investors make Strategic Asset Allocation (SAA) in pursuit of the portfolio that best balances risk with return. SAA relies on coherent forecasts—capital market assumptions, for example—of long-term investment expectations and changes. Such projections are usually presented under the standard mean of variance of expected returns, volatility and correlations:
- Expected return: Long term average annual return
- volatility: Standard deviation of annual returns
- relationship: How closely are the returns of different investments related?
Investors have come to rely on JPMorgan’s Long-Term Capital Market Assumptions (LTCMA) to inform the strategic asset allocation business used to build optimal portfolios. JPMorgan’s team of more than 50 economists and analysts revises its forecasts annually to include new information from markets, policymakers, and the economy.
For 2021, JPMorgan’s outlook attempts to distill from near-term challenges and consider the lasting consequences of the COVID-19 crisis, particularly the effects of the policy responses adopted to address the pandemic. Surprisingly, JPMorgan expects “very few” consequences for economic activity around the world. In fact, its growth outlook is very similar to what it was before COVID.
“Aligning monetary and fiscal policy in the same supportive direction is perhaps the single biggest difference in the fabric of the economy between this new cycle and the last.” – JPMorgan
For the US, JPMorgan expects stock market returns over the next 10 to 15 years to decline from 5.6% last year to 4.1%. This decline largely reflects the effect of valuation normalization. For fixed income, JPMorgan’s outlook forecasts three phases for government bonds: two years of stable returns, followed by three years of capital amortization, and ending with a return to equilibrium. As a result, the Treasury expected the 10-year Treasury yield to decline from 2.76% to 1.54%. With a healthy and well-capitalized banking sector, JPMorgan believes that the current cycle is unlikely to lead to a credit crunch, especially with the current support from the US Federal Reserve.
Over the investment horizon, JPMorgan sees modest economic growth and limited returns in several asset classes. However, he remains optimistic that with smart and careful portfolio actions, investors can reap an acceptable return without an unacceptable increase in portfolio risk.
With this in mind, investors should compare the optimized portfolios presented here with their current allocations – and with their personal expectations of the market – and reconcile accordingly.
Using the Portfolio Visualizer’s online suite of portfolio analysis tools, I have created an “effective limit” for portfolios based on the JPMorgan 2021 LTCMA for eight primary asset classes and their corresponding Vanguard indices:
- US Treasury Intermediate (VFITX)
- Investment Grade US Corporate Bonds (VWESX)
- US High Yield Bonds (VWEHX)
- Emerging Markets Sovereign Debt (VGAVX)
- Great American Capital (VFINX)
- Small Capital in the United States (VSMAX)
- Equity in EAFE (VTMGX)
- Emerging Market Equities (VEMAX)
An effective limit tracks the expected returns from portfolios that are optimized, or those that offer the highest expected return, across a range of risk points. I also produce the portfolio with the largest Sharpe ratio, which is defined as the excess of the expected return of the portfolio over the volatility of the portfolio.
Four optimal portfolios were found using JPMorgan’s LTCMA tool and Portfolio Visualizer’s Efficient Frontier:
- Max Sharpe ratio: Maximize the Sharpe ratio
- Conservative risks: Matches volatility in a portfolio of 35%/65% stocks and bonds
- Fair risk: Matches volatility in a 65%/35% bond portfolio
- Aggressive risks: 100% match stock portfolio volatility
Here are the long-term capital market assumptions for the eight core asset classes:
Long-term capital market assumptions
I used historical correlations between the eight asset classes.
The asset allocation for the four optimal portfolios is as follows:
Source: Anson J. Glacy, Jr., CFA
These results show that an investor with a moderate affinity for risk taking can expect to achieve an average return of 6.25% over the next 10 to 15 years.
What is striking is the absence of domestic large- and small-cap stocks and investment-grade bonds in any of the four optimal portfolios. This is due to the headwinds imposed by valuation normalization: In the US, long cycles of stock market performance followed by long cycles of underperformance are not uncommon.
The diversified role that intermediate treasury bonds continue to play in low-risk portfolios is also noteworthy. The portfolio photographer exercises a correlation of -0.16 between treasuries and large-cap equity. By contrast, the “balanced” portfolio of riskier investors consists of non-US equities along with sovereign debt. JPMorgan’s projections indicate that such a portfolio could generate an average return of more than 7.5% over the long term. For example, the Aggressive portfolio matches the S&P 500 in risk but improves expected returns by about 2.5 percentage points!
The Max Sharpe Ratio portfolio displays a Sharpe ratio of 0.88 but produces an expected return that may not be suitable for some investors. The other three wallets have Sharpe ratios between 0.515 and 0.675.
These bread and butter portfolios include the major public asset classes that are the building blocks of most mutual funds and exchange-traded funds (ETFs). Alternative assets, such as hedge funds and commodities, are not included. JPMorgan’s view is that interest rates will remain “low for longer” and that there will be diminishing opportunities for alpha, income and diversification in traditional assets. This may make alternatives a compelling proposition as they show lower correlations with traditional assets and can yield higher returns.
These optimal portfolios are suitable for long-term investors of various risk affinities who measure risk by return volatility. Investors who use other risk measures — Sortino, Minimum Drawdown for example — may see different results.
Even as stock markets are at all-time highs and bond yields are near generational lows, it is still possible to build resilient portfolios with reasonable return expectations. Thoughtful investors may consider building their long-term asset allocation around these optimal portfolios.
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All posts are the opinion of the author. As such, it should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of the CFA Institute or the author’s employer.
Photo credit: © Getty Images / cosmin4000
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