Estimating Strategic Returns

If you were transported 100 years into the future, what would be your expected 10-year equity return? In other words, knowing nothing about the price-to-earnings level, the shape of the rates curve or the political zeitgeist, what is the intrinsic strategic return of each asset class? From a tactical viewpoint, returns will vary significantly from these strategic levels.  In reality, we know a lot about current conditions and can make tactical variations to these strategic estimates. Most importantly, we know the starting point of valuations, which we can then use to make future return projections.

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Introduction

If you were transported 100 years into the future, what would be your expected 10-year equity return?

In other words, knowing nothing about the price-to-earnings (PE) level, the shape of the rates curve or the political zeitgeist, what is the intrinsic strategic return of each asset class?

From a tactical viewpoint, returns will vary significantly from these strategic levels. As an example, Figure 1 illustrates the UK 10-year compound return ranging from -2% to +26%. Now, of course, we do have market data which helps us understand whether an asset will be closer to its long-term minimum or maximum. However, these tactical considerations are variations on a strategic ‘anchor’.

Identification of Strategic Risk and Return Numbers

For us, the starting point for an asset allocation process is the identification of these strategic risk and return numbers. For those interested in a lot more detail, we recommend reading “Expected Returns” by Antti Ilmanen. Below, we detail our broad methodology. This is not a purely scientific exercise – some judgment is involved. Our methodology combines art and science.

We approach the problem in four ways:

1. The Historical Approach – Using sources such as Ibbotson1 or Dimson, Marsh and Saunders2, assuming trailing returns repeat in the future;

2. The Market Approach – Based on { Volatility x Sharpe = Expected Return }. This assumes that volatility is more forecastable than return, and that there is a reasonable expected range of Sharpe ratios;

3. The Risk Premium Approach – How much excess return over the risk-free rate do investors require (i.e. trailing returns may include unanticipated, unrequired return above required returns);

4. The Analytical Approach – For equities, for example, this can be based on Gordon’s Growth formula:

{p = d / (r - g) }, where:

     p = value of stock;

     d = next year’s expected annual dividend per share

     r = the investor's discount rate or rate of return

     g = expected dividend growth rate.

For fixed income, for example, this can be based on breaking fixed income down into the individual components:
{Real Growth + Inflation + Appropriate Spread }.

Figure 1. UK Equity Performance; 10-Year Trailing CAGR

Source: Bank of Engalnd, Man AHL, Man GLG. August 1704 to September 30, 2018.

Following these approaches3, taking US large-cap equity (S&P 500 Index) as an example, we get the following:

1. Historical Approach: Our data since 1800 suggests annualised volatility of 15.1% and annualised compound return of 8.2%, for a Sharpe of 0.54. However, our preferred lookback period starts in 1970, which we consider long enough to encompass several cycles and inflation regimes and short enough to still be relevant. Since 1970, the S&P 500 Index has returned 9.2% CAGR on monthly annualised volatility of 15.0% for a Sharpe of 0.61 (see Figure 2);

2. Market Approach: Here, the volatility assumption is central. Indeed, our sample data shows remarkable stability in the annualised volatility over different timeframes, pointing to 15%. We assume that in future, the Sharpe degrades on an implicit lower return expectation versus the period since 1970. This is because many of the tailwinds are unlikely to be repeated: inflation, rates, economic volatility and corporate tax rates all fell, while globalisation increased. We assume a Sharpe of 0.5 going forward, not the 0.61 achieved since 1970, but keep volatility constant at 15% (the world is not less or more prone to shocks, in our judgment). This gives an expected return of 7.5% in future;

3. Risk Premium Approach: Ibbotson says the achieved trailing excess return over bonds has been 10% - 5% = 5%. We think that it is likely that not all of the 5% achieved excess return of equity over bonds was truly required, or would be truly required now by equity investors. Data from the Bank of America Merrill Lynch Fund Manager Survey in September says the average expected risk premium for equity is 3.5%. We assume global government bonds’ risk-free rate over time is 4% (~nominal GDP, 2% real, 2% inflation). Adding a 3.5% risk premium to 4% risk free return yields US equity returns of 7.5%;

4. Analytical Approach: The US large-cap equity dividend yield is currently 1.8%4. Adding in a 1.2% net buyback yield gives a total shareholder yield of 3%. For growth, we note that about 40% of S&P revenues are not US based, according to our calculations. So, for growth we assume 4% nominal in the US, 6% nominal non-US, gives 4.8% of growth. 4.8% growth + 3% yield = 7.8% return expected.

We follow a similar process for other asset classes, which are summarised in Figure 3.

These are strategic estimates, ignoring current conditions.

Conclusion

In reality, we know a lot about current conditions and can make tactical variations to these strategic estimates. Most importantly, we know the starting point of valuations, which we can then use to make future return projections. Our strategic return and risk estimates are inputs into our strategic allocations. We deviate from these based on our tactical models and insights.

For instance, today, we believe US equities are overvalued versus equities in the rest of the world. While that has not led to underperformance in recent quarters as earnings have continued to grow, we remain relatively cautious on US equities.

Similarly, our strategic estimate for developed markets (DM) sovereign bond return is 4%, made up of 2% real growth and 2% inflation. But it is clear that German bund yields at 0.36% imply a 10-year nominal return of … 0.36%. This is nowhere near close to the 4% we expect from developed-market sovereign bonds returns in aggregate, in our strategic estimate. As a result, we remain underweight in fixed income overall.

Figure 2. US Equities’ Summary Statistics
Longest possible (monthly)  US Equity
  Inception  February 1800
 # obervations  2,620
  CAGR  8.2%
  Monthly vol. (ann'd)  15.1%
  Sharpe  0.54
Pre-1970 (monthly)  US Equity
  Inception  February 1800
 # obervations  2,039
  CAGR  7.9%
  Monthly vol. (ann'd)  15.1%
  Sharpe  0.52
Post 1970 (monthly)  US Equity
  Inception January 1970
 # obervations  581
  CAGR  9.2%
  Monthly vol. (ann'd)  15.0%
  Sharpe  0.61
Post 2007 (weekly)  US Equity
  Inception Januar 2007
 # obervations 600
  CAGR  7.5%
  Monthly vol. (ann'd)  17.8%
  Sharpe  0.42
Antti Ilmanen  US Equity
Range 1990-2009
  CAGR  8.5%
  Monthly vol. (ann'd)  15.5%
  Sharpe  0.55
Forecast  US Equity
  CAGR  7.5%
  Monthly vol. (ann'd)  15.0%
  Sharpe  0.50

Source: Man AHL and Man GLG. Further details available on request.

Figure 3. Strategic Asset Class Returns (Historic and Expected)

Longest possible (monthly)

UK Equity

Europe ex UK Equity US Equity Japan Equity EM Equity Gov. Nominal Gov. TIPS EM Debt Global IG Global HY Global Convert.
Inception  Sep 1694  Oct 1882  Feb 1800  Jun 1921  Jan 1988  Nov
1790
 Jul 1981  Jan 1994  Jan 1976  Sept 1986  Jan
1994
#obervations  3,885  1,628  2,620  1,164  365  2,731  443  293  544  381  293
CAGR 6.4% 11.0% 8.2% 11.4% 10.8% 5.1% 6.3% 8.4% 7.6% 8.3% 5.6%
Monthly vol (ann'd)  13.1% 13.3% 15.1% 21.0% 22.6% 6.9% 10.6% 12.8% 6.8% 8.0% 8.6%
Sharpe  0.49  0.83  0.54  0.54  0.48  0.75  0.59  0.65  1.12  1.04  0.65

Post 1970 (monthly)

UK Equity

Europe ex UK Equity US Equity Japan Equity EM Equity Gov. Nomial Gov. TIPS EM Debt Global IG Global HY Global Convert.
Inception Jan 1970 Jan 1970 Jan 1970 Jan 1970 Jan 1988 Jan
1970
Jul 1981 Jan 1994 Jan 1976  Sept 1986  Jan
1994
#obervations  581 581 581 581 365 581 443 293 544 381 293
CAGR 9.0% 8.9% 9.2% 7.0% 10.8% 7.3% 6.3% 8.4% 7.6% 8.3% 5.6%
Monthly vol (ann'd)  21.4% 17.8% 15.0% 17.3% 22.6% 5.4% 10.6% 12.8% 6.8% 8.0% 8.6%
Sharpe  0.42 0.50 0.61 0.40 0.48 1.33  0.59  0.65  1.12  1.04  0.65

Forecast

UK Equity

Europe ex UK Equity US Equity Japan Equity EM Equity Gov. Nominal Gov. TIPS EM Debt Global IG Global HY Global Convert.
CAGR 7.2% 7.2% 7.5% 6.0% 10.4% 4.0% 4.0% 7.0% 4.8% 7.0% 4.8%
Monthly vol (ann'd)  18.0% 18.0% 15.0% 18.0% 23.0% 6.0% 8.0% 14.0% 8.0% 10.0% 8.0%
Sharpe 0.00 0.40 0.50 0.33 0.45 0.67 0.50 0.50 0.60 0.70 0.60

Source: Man AHL and Man GLG. Further details available on request.

1. Roger G. Ibbotson.
2. Paul Marsh, Elroy Dimson and Nick Saunders.
3. The performance results shown are being provided for illustrative and information purposes only, and should not be relied upon and do not represent, and are not indicative of actual or future performance or the results that may be achieved. Performance may vary substantially from year to year or even from month to month.
4. According to Bloomberg, as of September 30, 2018.

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