In this paper, we offer our 10-year strategic outlook for 40 asset classes across traditional equities and fixed income, as well as alternative investments including hedge funds and private investments.
Our long-term return and volatility expectations are key inputs that inform our strategic asset allocation decisions (along with other statistical inputs such as correlations, tail dependency, and higher moments of probability distributions).
While volatilities and correlations are relatively easier to forecast because they are persistent, expected returns are notoriously difficult to estimate. Short-term (e.g., one-year) returns tend to be dominated by momentum and macro factors and are extremely difficult to forecast with any level of accuracy. Longer-term (i.e., multi-year) returns have stronger predictability but still carry significant uncertainty.
We dedicate a significant portion of this paper to explaining how we develop our 10-year expected returns for the various asset classes. In fact, we encourage our readers to focus on the methodology, which arguably is more important than the numbers themselves.
Our methodology for constructing expected returns involves decomposing each asset class into individual risk factors and corresponding risk premiums.
Going through this process helps us obtain a systematic and transparent understanding of what is embedded in any given asset allocation: the underlying risk exposures and the drivers of potential future returns.
Why is this important?
Let’s take a step back and remind ourselves what we are ultimately hoping to achieve.
At Rockefeller Capital Management, we help our clients – ultra-high-net-worth and high-net-worth individuals and families, family offices, endowments and foundations – design bespoke multi-asset portfolios based on their investment objectives.
In order to build the optimal portfolio for each client, we begin our investment process by first understanding what risk and reward truly mean to our clients individually.
Building upon this understanding, we then take a structured approach to the investment advisory process through three sequential stages:
1. Strategic Asset Allocation. Constructing a portfolio’s long-term foundation based on clients’ objectives, preferences, and constraints.
2. Tactical Asset Allocation. Moderately tilting asset weights to capitalize on identified short-term opportunities in the market, while balancing between the potential upside adjusted for conviction level with the incremental increase in market timing risk.
3. Portfolio Implementation. Implementing the customized asset allocation with a combination of passive products and active managers which not only stand on their own merits but are complementary in the context of the broader portfolio; capturing the spirit of the beta targets while delivering excess alpha on a fee-efficient and tax-efficient basis.
While fluidity throughout the three stages is critical to maximizing the value creation potential of the portfolio construction process, empirical research on the performance of pension portfolios has found that the risk contribution of investment policy (i.e., strategic asset allocation) dominates that of market timing and security selection, explaining roughly 95% of the total variance of portfolio performance. The return contribution of strategic asset allocation similarly dwarfs that of market timing and security selection.
The importance of strategic asset allocation is well known among investors, including our clients. Invariably, a client would want to know, “What is the right asset allocation for me?”
In order to offer a genuinely satisfying answer with thoughtfulness and integrity, we feel the need to first address a more fundamental question, “What does asset allocation truly mean?”
At face value, asset allocation refers to assigning different weights of investable capital to various asset classes with distinct risk and return characteristics. But what makes those risk and return characteristics distinct? Asked differently, what “prices” are we paying in exchange for the corresponding expected returns?
For example, why do we typically believe that equities outperform bonds over a long time horizon? What is the justification for equity risk premium? Does it truly exist? If so, why does it vary over time?
Also, why do high yield municipal bonds typically offer higher taxable-equivalent yield spreads than high yield corporate bonds, despite municipal bonds’ historically lower default rates? How do we decompose and measure the embedded risk premiums, and how does one fully capture the corresponding ex ante return advantage?
What about asset classes that exhibit substantial cyclical variation and clustered tails? How should we assess the corresponding risk premium and how may we translate our interpretation into strategic versus tactical positioning?
And what about alternative investments? How should we analyze the true drivers of hedge fund and private investment returns? How much alpha, correlation benefit, and illiquidity risk premium do investors really capture? Which aspects of alternative investments truly warrant management fees substantially higher than those of traditional equity and bond strategies?
Ultimately, allocating to asset classes should manifest our conscious construction of various risk premiums that make up the expected returns from the corresponding asset classes.
A truly efficient and thoughtful strategic asset allocation should reflect a well-diversified and appropriate combination of risk factors customized for the given investor.
We believe that a well-designed asset allocation tells a story about the specific investor: what he/she hopes to achieve, and the corresponding plan to work towards that objective.
A strategic asset allocation is the anchor of a portfolio. It reinforces discipline during times of feast or famine and serves as a roadmap during times of uncertainty.
In order for a strategic asset allocation to accomplish what it has been designed for, we – as investors – must first believe in it. And in order to believe in a strategic asset allocation, we must first understand it: what risk exposures are we taking on and what corresponding returns should we reasonably expect?
The methodology discussed in this paper serves to translate a strategic asset allocation into an intuitive story that we hope to deliver to our clients – to ensure that it is understood, believed in, and ultimately successful.
For the complete version of the whitepaper, please download the PDF at the top of this page.