Capital Market Expectations
Aspiriant’s investment team constantly performs research, creates tools and implements processes in an ongoing effort to improve our investment platform. One of the most impactful elements of our investment process is the development of our Capital Market Expectations (CMEs), which we apply both broadly and deeply to the two primary services we offer our clients:
- Wealth Planning. Our CMEs establish a “planning compass” that helps our advisors revise client’s long-range analyses and creates a decision making environment that provides context for advising clients on important aspects of their long-term financial plans, such as retirement spending, wealth transfer planning and philanthropic giving.
- Investment Management. Our CMEs also form the basis by which we construct and manage all aspects of our clients’ investment portfolios.
Beginning with our 2014 CMEs (currently being rolled out to clients), we have bifurcated our CMEs into two frameworks: Long-Term Horizon (20+ Year CMEs) and Mid-Term Horizon (7-10 Year CMEs). Why? Because thinking about the CMEs across two distinct time frames accomplishes two important goals. Adopting a longer-term view is appropriate when making financial decisions with long-term consequences that play out over many decades, such as making irrevocable gifts to children and charity, or determining a durable spending amount in retirement. Conversely, the current market environment and valuation levels can be important drivers of portfolio performance over a shorter time frame, and we expect to use that information to significantly improve our investment management services.
Here is the headline message coming out of our 2014 CME process: while we have always recognized valuation effects at the security level, hence the value bias in our equity portfolios, we are now focusing on the role valuation plays in expected returns at a broader market level. At the moment, this means we believe the market is somewhere between fully-valued to modestly expensive with some pockets of overvaluation. Consequently, we are advising clients to expect less from investment markets over the next 7-10 years, and to take sensible steps to reduce risk in portfolios.
Evolution of our CME Process: Remain Focused on
Long-Term While Looking Through a Mid-Term
In our 2013 Insight article, “Five Years Later, Lessons Learned,” we described a variety of enhancements we made to our investment process, many of which were specifically designed to improve risk management. For example, one lesson we learned from the Global Financial Crisis (“GFC”) was that we needed to improve our process for assessing the expected impact of market volatility on a portfolio’s value before it occurs. But, we didn’t stop there. In fact, throughout 2014, we have intensified our research effort to develop a systematic approach to diminish the impact of a market drawdown on portfolio values, prior to the drawdown occurring. The developments to our CME process described below represent the next step forward in advancing our investment and risk management processes.
Historically, Aspiriant generated Capital Market Expectations approximately every two years with focus on a twenty (20) year investment horizon. Next, we applied those long-term expectations to the primary services we offer clients: Wealth Planning and Investment Management. This approach has worked very well from a wealth planning perspective because our clients tend to have long-term planning horizons. Decisions are less impacted by what the investment markets might do over the next several years; in fact, making big changes to goals like tolerable spending levels every few years based on our latest mid-term forecast strikes us as a helter-skelter approach to managing one’s financial affairs. That’s not to say the mid-term investment outlook shouldn’t influence financial decisions. For some clients, it may be prudent to manage spending a little more closely when the investment outlook is less robust, but we don’t think that outlook should drive wholesale spending changes.
And some clients have horizons extending well beyond twenty years, or even longer because they are, in effect, investing and planning for future generations. Consequently, the “noise” created by short-term market movements, whether rallies or sell-offs, is less of an issue because they recognize these events tend to “wash out” over time with good periods more than offsetting difficult times. As a result, using long-term CMEs for wealth planning engenders confidence, stability and patience, making it easier for clients to become neither overly pessimistic during bear markets nor overly optimistic during bull markets.
On the other hand, using long-term CMEs for investment management is not always optimal because the starting valuation point can make a difference. Specifically, using long-term CMEs for portfolio construction can mask opportunities and risks when the market has trended strongly in one direction or another for an extended period of time and is therefore either “expensive” or “cheap” based on a variety of both quantitative and qualitative factors. In those environments (i.e., when the market may be trading substantially away from fair value), using mid-term CMEs for investment management is expected to meaningfully improve the portfolio construction process, especially with respect to risk management.
This point is illustrated in Chart 1 using the three most recent time periods in which we published our updated Capital Market Expectations: March 2009, June 2011 and August 2014. Although each of those periods was defined by a distinct market environment, our Long-Term Forecasts (indicated by the blue circles) did not exhibit much variation, drifting up-and-down but always staying within the blue shaded band. That’s because our Long-Term Forecasts look out twenty (20) years, which on average encompasses two or three complete market cycles, thus “smoothing” out the impact…good or bad…shaped by the current market environment.
Chart 1: Stylistic Expected Return for a Globally Diversified Portfolio1
However, our research shows that by changing the lens of our investment horizon, we can glean insights and perspective that isn’t as evident with a long-term focus. As a result, we have developed Mid-Term Forecasts that look out seven to ten years, which on average encompasses just one complete market cycle. Therefore, our Mid-Term Forecasts are appreciably more sensitive to the current market environment and will fluctuate accordingly. Acting on that fluctuation allows us to better manage risk in client portfolios (e.g., helping identify when we should either increase or decrease risk relative to our clients’ individual, unique risk policy/budget). That’s another lesson we learned from the GFC: a sharper focus on absolute and relative valuations in investment markets can boost our ability to manage risk in client portfolios.
To illustrate, the GFC reached a trough in March 2009, with the S&P 500 index trading below 670. Accordingly, expected returns under a Mid-Term lens were much higher than the long-term 7%-9% “equilibrium band,” so it was a terrific time for long-term, risk-tolerant investors to embrace risk in various forms: levering their investment portfolios (e.g., via durable margin), reducing defensive investments (e.g., fixed income) and increasing exposure to risky investments (e.g., small cap stocks). Conversely, there are times when our Mid-Term Forecasts indicate that investors should shy away from taking on too much risk. June of 2007 was a very good example of that kind of environment. At that time, the market was reaching a peak with valuation levels for virtually all risk assets looking stretched. Forward-looking expected investment returns were much lower than the “equilibrium band” and expected volatility (not shown) was substantially above the normal historical ranges. Thus, the summer of 2007 was a terrific time for investors to rein-in risk by cutting leverage, augmenting allocations to defensive investments, and trimming risky investments.
Here’s a key insight from our research efforts to better understand and actively manage risk: irrespective of an investor’s risk tolerance/aversion or investment horizon, there are times when broader economic developments and market-based valuation signals can overwhelm conventional wisdom about risk tolerance and time horizon. In the summer of 2007, arguably every investor should have moved directionally toward decreasing risk, and in March 2009, virtually every investor should have moved directionally toward increasing risk. Understanding that logic and preparing to take action and make the right moves at the appropriate time is at the heart of our enhanced risk management process. Thus far, our research on market risk, along with the development of our Mid-Term Forecasts, has helped us form some interesting observations, but we’re not stopping there. Over the next several months, we expect further evolution transforming interesting observations into actionable decisions that we can implement within client portfolios. So, stay tuned.
In the past we adhered to an investment approach that placed more weight on our Long-Term Forecast and a long time horizon. In that paradigm, investment portfolios are tightly connected to individual clients’ long-term goals, and sticking to a long-term strategic asset allocation through both market peaks and troughs is a reasonable, low cost and tax efficient investment approach. But during periods of extreme market distress, such an approach can require a Herculean risk tolerance and ability to control emotion and not succumb to fear. During the GFC we helped many clients stay focused on their long-range financial plans and the vast majority rode out the volatility and their equity portfolios recovered substantial value. At the same time, clients emphatically told us that they did not want to go through that experience again!
That’s one motivation for the change in focus and greater emphasis on risk management. We believe a better approach to improve the investment experience is to systematically adjust portfolios to respond to extreme valuations that are a common feature of many market cycles. Of course, it takes greater effort and resources to monitor current market conditions and be in position to act at the appropriate time. Accordingly, we have committed additional investment resources to support our increased emphasis on risk management.
So, where are we today?
Aspiriant’s 2014 Capital Market Expectations
The outcome of our CME process is the development of expected returns, risks, and correlations (not shown) for the seventeen asset classes presented in Table 1 below. With a few exceptions, two overall observations can be made by scanning your eyes up-and-down the return and risk columns. First, our return expectations over the next 7-10 years are lower than our return expectations over the next 20+ years. In other words, at today’s valuation levels, we expect more muted investment returns going forward until investment assets either i) decrease in value or ii) grow into the valuations they have been awarded by the market. Second, our risk expectations (as expressed by annualized volatility) over the next 7-10 years are higher than our risk expectations over the next 20+ years. In other words, we expect more volatile investment returns for the foreseeable future.
Combining the results of our CME process in Table 1 and referring back to Chart 1 (above), our Long-Term Forecast for a 60/40 portfolio is 7.2% while our Mid-Term Forecast for a 60/40 portfolio is 6.1%. As a result, we believe the market is somewhat expensive (albeit not as severe as June 2007), and we are recommending clients move toward a more defensive posture within their portfolios. Of course, individual client circumstances vary and the degree to which this orientation is adopted will vary based on each client’s unique objectives, capacity to bear risk, and other considerations, such as taxes and fees.
Table 1: 2014 Long-Term & Mid-Term CMEs
That said, directionally, a more defensive posture is appropriate at this time. Now is not a sensible time for clients to reach for incremental returns because we think they will be undercompensated for assuming those incremental risks over the Medium-Term. Importantly, we are recommending that clients remain fully invested because we are keenly aware of the difficulty of timing markets and because we expect corporate earnings to advance, which helps support current prices and creates space for equities to grow into their current valuations. Moreover, there are some areas of the markets that we believe are relatively attractive (e.g., MLPs and private real estate) and we have reallocated our client portfolios to take advantage of those opportunities.
We are Artists and Scientists
Being skilled investors requires the application of both art and science to portfolio management. Generally speaking, science can be readily applied to historical data. For example, it’s not very difficult (nor very insightful) to determine the risk, return and correlation of asset classes merely because “the data is the data” and past events have already occurred. That approach alone is insufficient; art plays a role when we interpret the data to develop meaningful insights that can be translated into specific portfolio recommendations.
Take US Small Caps, for example. Since 1925 US Small Cap stocks have outperformed US Large Cap stocks by ~150bps, (i.e., 1.5%) annualized. Observing that return premium, one might reasonably conclude that maintaining a systematic overweight to Small Cap stocks is generally a good decision, especially for investors with high risk tolerance and a long time horizon (more than five years). But it’s not that simple, and here’s the catch: the most important word in the preceding sentence was the word “generally.” We should have italicized it, but we didn’t want to give away where we’re going. Looking at the data more closely one finds that there have been prolonged periods of time in which Small Cap stocks have underperformed Large Cap stocks (see Chart 2 below).
7-Year Rolling Returns to Small Caps versus Large Caps
These prolonged periods of underperformance (or out performance) prompt the question: can a prudent investor dial-up or dial-down his/her exposure to US Small Caps to reliably create a better risk-adjusted portfolio return? We think the answer is yes, and here’s where the art comes into play. Our portfolio construction process requires us to do more than simply analyze significant amounts of data—our process requires us to apply our judgment, skill and experience to that data. Having done so, we are fairly confident that we are entering a period in which US Small Cap stocks may not outperform US Large Cap stocks, especially on a risk-adjusted basis, which is a big reason why we have dramatically reduced our US Small Cap allocation. Our conviction leads us to advise clients to significantly trim small cap exposure, realize long-term capital gains when necessary (which for many of our clients is significant) and pay the associated taxes.
A Note on Our Portfolio Construction Process
We are passionate about helping our clients achieve their financial and life goals, and a crucial component of our work is constructing efficient portfolios designed to provide attractive risk-adjusted, after-tax returns, net of fees over a complete market cycle. Due to the size and scope of our firm, we possess the capability to “leverage and use every tool in the investment toolbox,” in relentless pursuit of that objective. And while we strive to design investment portfolios to meet the unique needs and circumstances of each individual client, we make every investment decision within one unified guiding principle across all client portfolios: we will only take risk when we expect to be appropriately compensated for that risk.
A case in point is shown in Table 2, which highlights the Global Public Equities portion of Table 1. The Market Cap Weights are based on the total market capitalization of all public equities around the world. As such, they represent a “neutral” equity allocation decision. Absent a view about the relative attractiveness of different equity sub-asset classes, an investor should hold the global market-cap weighted portfolio. In effect, the Market Cap Weights do not express an active decision and are the equivalent of simply buying a global index fund or ETF.
Table 2: Global Public Equity Allocations: 2011 vs 2014
|Market Cap Weights||2011 CMEs||2014 CMEs|
|GPE||As a % of GPE|
|Dev. Overseas Large||34%||23%||35%|
|Dev. Overseas Small||4%||7%||7%|
We are long-term oriented investors and tend not to get overly preoccupied with short-term results. But intellectual honesty compels us to look back and as an intermediate assessment, review the outcome of our recommendations in 2011 and summarize our recommendations in 2014 follows:
2011 CMEs. Our decision to underweight allocations to US Large Cap and Developed Overseas Large Cap equity in order to “fund” overweight positions in US Small Caps and Developed Overseas Small Caps worked very well. Thus far, our overweight to Emerging Markets has underperformed other equities.
2014 CMEs. We are maintaining our underweight to US Large Cap, removing our underweight to Developed Overseas Large Cap, reining-in our overweight to US Small Cap, and maintaining our overweight to Emerging Markets.
2014 CME Key Takeaways
- Expect Less. Investors have earned solid appreciation in their portfolios since March 2009, but going forward, we believe return expectations should be substantially more muted.
- Reduce Risk. Unlike March 2009, this is not a time to increase risk, and, in fact, we are recommending that clients
reduce risk by:
- Eliminating/reducing leverage (e.g., durable margin)
- Adding/increasing fixed income exposure
- Adding/increasing defensive equities (e.g., risk-managed equities, and tilt to quality)
- Significantly reducing US Small Cap equities
- Maintaining underweight to US Large Cap to fund an overweight to emerging markets
Client service teams are in the process of reaching out to review the themes underlying our new capital market expectations, review the expectations with you, and apply them to your specific investment portfolio.
John Allen, CFA®
Chief Investment Officer
David Grecsek, CFA®
Director of Research
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