Over the course of our travels, the team at Infinity has met with many investors. These meetings range from various family offices, foundations and endowments, and institutional consultants, but the large majority of our meetings have been with the registered investment advisor community. In our conversations over the years, we generally see a consensus build around return goals, for both private and institutional clients. As one would expect, target return goals vary from year to year given the market environment. In talking with investors this year, we have seen a common portfolio return target within a range of 6.5% – 7.5% per year over a longer-term horizon (common assumptions include a 5% spending rate plus 1.5% – 2.5% for inflation). As we thought about this return goal within the framework commonly used by investment advisors to determine asset allocations for client portfolios, some interesting research jumped out that leads us to believe there is a higher probability that a typical investment advisor’s client portfolio may have more difficulty in meeting these return objectives going forward. In fact, we believe that client portfolios could significantly underperform their stated objectives.
Historical Research: Difference in Historical Forecast vs Actual Performance
Our research focused on the large difference in past capital market forecasts relative to actual performance. If you compare the returns from January 2009 to July 2018, domestic equities have returned 14.2% annualized, outperforming their 2009 10-year expected forecasted return of 8.94% by about 1.6 times.
The “Performance Gap” between actual returns and the 10 year forecast is the largest in domestic equities with an outperformance of; 14.2% vs 8.9% respectively. The question then becomes do we expect future underperformance due to this oversized “Performance Gap”.
Shown another way, the actual performance in dollars in domestic equities has massively outperformed the forecasted returns.
Turning our attention to historical volatility in client portfolios, we used Research Affiliates data to analyze the last 10-year forecasted volatility for each category. Comparing this to the most recent 5-year actual volatility, we observe that the asset classes have experienced significantly lower volatility than their original forecast.
U.S. large and small cap equities and international equities have been running at about 65% – 70% of their forecasted volatility of 14.2%, 18.9%, and 17.6% respectively. Fixed income has been about 75% of its expected volatility of 3.6%.
Forward Looking: What does this mean for portfolio construction?
When you combine the recent outsized returns in domestic equities and a potential rising interest rate environment with historically low volatility, we believe this changes the forward looking profiles of risk/return in portfolios. We believe the average current equity capital market return assumptions may be too aggressive, and that future realized volatility has the potential to come back in line with higher forecasted volatility assumptions. This creates an obvious mathematical dilemma when trying to construct a durable portfolio using only traditional asset classes to achieve client return objectives.
We decided to take a deeper look at the models and inputs that the top investment firms use to construct their asset allocation. Most sophisticated investment advisory firms use forecasted capital market assumptions which include future expected return, standard deviation, and correlation studies for most asset classes. Based on these inputs, portfolios are run through Monte Carlo simulations that can have 10,000 or more outcomes. The outcomes of a projected portfolio’s returns are grouped by probabilities or percentiles of actually achieving certain levels of returns. For example, the simulation may show that there is a 50% probability of achieving a 6.5% or higher return over 10 years; which also means there is a 50% probability that returns can fall below the 6.5% return. Simulations also include outliers, such as a 2.5% probability that the portfolio could be down 20% or more.
If we assume the common target return goal of 6.5% to 7.5%, then an investment advisor’s role is to construct a client portfolio that has the “highest probability” of achieving this return objective. We looked at some of the industry’s top investment firms to gather their 2018 forecasts for the markets over the next 10 years and calculated the average of these forecasts (see chart #4). The data reveals that a typical global 60/40 client portfolio is forecasted to return 4.93%over the next 10 years with a volatility of 9.7% (portfolio constructed using 40% U.S. Large Cap stocks, 10% Small Cap stocks, 10% International stocks, and 40% U.S. bonds). Clearly, a balanced portfolio such as a global 60/40 stock/bond allocation is forecasted to miss its target based on the typical expected return targets mentioned above.
We believe that the level of forecasted return for equities or a global 60/40 portfolio seems to be disproportionate to the level of risk investors must take. In addition, if we account for the “performance gap” over the last decade with the outperformance of domestic equities and the potential for rising rates, it is easy to imagine a mean reversion environment where these returns will possibly be much lower than forecasted, with potential higher volatility.
Conventional wisdom would prompt investment advisors to adjust the asset allocation of the portfolio to a more aggressive allocation to try and achieve higher returns. This may include adding more equity and high yielding credit exposures, which introduces significantly more forecasted volatility and potential liquidity risk.
The question we feel is important at this stage in the market cycle to address is, “Going forward for the next five to 10 years, will current client portfolios have a high probability of meeting the expected 6.5% – 7.5% target?” In other words, how “durable” are these portfolios?
The investment industry is full of charts and graphs that illustrate how alternative investments, when added to a historical 60/40 portfolio, can add risk and return diversification benefits. While hypothetical back-testing for portfolio construction is a common practice, advisors should adjust their focus to where the markets have been recently and what is forecasted ahead.
We observe that L/S equity has the highest projected return at 6.18%, with volatility of 8.37%, compared to a global equity portfolio of 6.04% return with 17.09% volatility.
With higher forecasted returns and almost half the forecasted volatility, the data above would suggest that a better allocation mix for advisors should be to reallocate a portion of long-only domestic and/or global equity portfolio allocations to invest in a well-diversified portfolio of long short equity managers.
Additionally, given the low return assumption for fixed income of 2.97%, combined with a possible rising rate environment, the forecast data would suggest that reallocating a portion of fixed income to a well-diversified portfolio of multi-strategy hedge funds has the potential to diversify returns with a limited increase in volatility due to non-correlation benefits.
We also took a look at the forecasted 2018 10 year Sharpe ratios and observed that it is highest for multi-strategy hedge funds with the second highest being L/S equity (see chart #6). This is a result of the commensurate return, but with much less volatility. (Risk free rate is 3 month T-bill at 2.02% rate, source www.treasury.gov)
Given the current investment environment and the challenges advisors face to meet client expectations, we believe that advisors need to take a forward looking approach to improve the durability of client portfolios. We encourage you to contact us for further input on how Infinity can help you incorporate alternative investment strategies to meet your client’s goals.
Infinity Capital Partners works with advisors around the country to provide thoughtful portfolio implementation ideas and alternative investment solutions to maximize the probability of meeting client return objectives. Our solutions include multi-manager multi-strategy hedge funds, multi-manager long/short equity funds, hybrid private credit, and customized portfolios.