Trending
Written by: Jim Masturzo, CFA
There is an old saying in finance: "There are only two kinds of forecasts—the lucky and the wrong." Like many clichés, this one has some truth to it, even if it doesn’t provide much practical guidance. After all, by nature, most investment decisions or conventions, from the 60/40 portfolio to the 4% rule, are influenced, if not determined, by implicit forecasts. These forecasts stem from our assumptions about what the future will look like based on past events and our expectations of how present conditions will play out going forward.
This is where capital market expectations (CMEs) come in. Asset managers of all sizes use them to guide their asset allocation decisions. Given the sheer size and complexity of the financial markets, no one should expect CMEs to be 100% accurate. But if they are directionally correct, if they anticipate the rank order of asset returns over a significant time horizon, say five or 10 years, with some degree of precision, they will have served their purpose as a critical portfolio construction tool.
The Challenge of Forward-Looking Accuracy
Of course, checking that box takes a lot more than luck. Too many asset owners approach CMEs only as a backward-looking enterprise. They assume the past is a reasonable approximation of the future and estimate the future return of assets in their portfolios based on historical averages, or historical risk premia. But modern finance isn’t like other disciplines. Its track record isn’t long enough for historical averages to have meaningful value, whether they are constant or not. Think about it. What could the historical average returns of REITs tell us about their future performance? Such a novel and fast-evolving asset class has far too short and volatile a sample period for past averages to be predictive of anything but past averages.
At Research Affiliates, we take a fundamentals-based approach to our CMEs, which we make freely accessible through our Asset Allocation Interactive (AAI) tool. AAI utilizes a bottom-up, three-component model that is updated monthly and spans over 140 assets across six global currencies. As portfolio construction has evolved far beyond traditional stocks and bonds, so too have our CMEs.
Navigating a Decade of Market Anomalies
Obviously, the phrase “fundamentals-based” may raise some skeptical eyebrows these days, and for good reason. AAI’s launch in 2014 coincided with a period of market performance that has defied conventional fundamental analysis. The equity bull market soared in spite of valuations while depressed bond yields eclipsed the zero lower bound in many countries. Then global inflation took off to heights not seen in generations. Such an idiosyncratic environment rendered many of the metrics and gauges of classical finance irrelevant and led many to question, quite rationally, the utility of long-term fundamentals-based CMEs.
To say the last 10 years have been challenging would be an understatement. However, the performance of AAI’s CMEs offers a powerful counterpoint to those who believe fundamentally derived CMEs have outlived their usefulness. Indeed over five- and 10-year time horizons, our CMEs across U.S., international, and emerging markets, when grouped by return cohort, have anticipated future returns and, in the last 10 years, the rank order of realized returns by asset.
Like all models, AAI’s CMEs are far from perfect. The fundamentals-defying market of the last 10 years has given us a fair share of black eyes, particularly in relation to AAI’s currency expectations time series. But financial modeling by nature is as much art as science and in an extremely difficult environment our admittedly imperfect model has proven its mettle.
Lessons from the Ring
Former heavyweight champion Mike Tyson once said that everyone has a plan until they get punched in the mouth. Everyone who attempts to model financial markets comes to understand this intuitively. Anticipating market behavior is a perennial lesson in humility. Bruises are inevitable, but that doesn’t mean such efforts aren’t worthwhile. Whether lucky or wrong, we should strive to understand the mechanisms that resulted in the particular outcome and adjust our models accordingly to better serve our clients. That is what we are trying to accomplish with AAI. With 10 years behind us, we believe AAI has shown its value in the portfolio construction and asset allocation process. We are confident it will prove even more useful in the decades ahead.
Related: Why Drawdown Funds Are Better Suited for Qualified Purchasers Than Evergreen and Interval Funds