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Business School


Week 9
Capital Market Expectations and Asset Allocation
Greg Vaughan

This Week

•  Maginn, Tuttle et al ‘Managing Investment Portfolios’
Chapter 5. Prescribed reading as follows:
Sections 1; 2.1-2.3 ; 3.1 ; 4.1-4.3 ; 5 ; 6.6; 7.1-7.3; 9.1-9.4; 10
•  Group N to cover 2.3, 3.1, and 4.1
•  Group L/O to cover Grinold et al ‘A Supply Model of the
Equity Premium’ and also Dimson ‘Rethinking the Equity
Risk Premium’
•  Group M to cover Section 10 of Maginn and Tuttle, and
Perold and Sharpe ‘Dynamic Strategies for Asset


Capital Market Expectations (1)
•  Capital Market Expectations will shape the asset allocation
alternatives to be investigated in asset-liability studies
•  They are also important in quantifying risks (SRM)
•  Asset return models should be calibrated for consistency
with capital market expectations
•  Asset models will also be used to predict liability valuation
bases in some instances (Defined Benefit Superannuation)
•  Capital Market Expectations underpinned by financial/
economic structure are more likely to be realistic and

Expected Equity Returns - Equilibrium
•  The CAPM framework suggests a simple model for
expected equity returns:
E( R M ) = R f + ERP

•  If the bond market and the equity market were in
equilibrium, and ERP was constant we might simply add a
historical average ERP to the current bond yield
•  But what if the bond market is distorted?
•  Does the ERP vary over time with perceived risk? If so,
how do current risks compare to history?
•  Interpreting market history may not be straightforward
•  Is Australia different from the rest of the world?

Expected Equity Returns – Market History (1)
•  The reference work for the global equity risk premium is by
Dimson, Staunton and Marsh, first published in 2000, and
updated annually
•  Includes data across 19 countries from 1900
•  Inevitably many data issues but hopefully averaged out
•  Previously ERP estimates dominated by US analysis, but
the US has done better than most markets
•  About 0.5% has been added by an expansion of price
multiples (lowering of dividend yield)
•  This suggests an element of ‘pleasant surprise’ which
would not be expected in the future.

Geometric Average Real Equity Returns 1960-2014 Source: Credit Suisse Global Investment Returns Sourcebook 2015 6 .

Geometric Average Equity Risk Premium over Bonds 1960-2014 Source: Credit Suisse Global Investment Returns Sourcebook 2015 7 .

Equity Return Volatility 1900-2014 (excluding very high inflation markets) Source: Credit Suisse Global Investment Returns Sourcebook 2015 8 .

5% compared to 3.0% historically Note geometric averages have been converted to arithmetic for above .Current bond yields and inflation expectations give rise to different equity return expectations Current real bond yields are circa 0.

Expected Equity Returns – Market Implied (1) •  An alternative to the equilibrium ERP approach is to determine the return expectation implied by current market prices •  Recall the DDM D P= k−g •  So D k = +g P •  Currently numbers are approximately k = 5% + 3% = 8% .

we can consider the earnings retention.Expected Equity Returns – Market Implied (2) •  Although the DDM can be problematic at the stock level. and return on retained equity of the market (g=b x ROE) •  Alternatively from a macro perspective we can base growth on the performance of the economy •  We won’t always get the same result . it is useful for considering market return expectations •  The dividend yield of the market is observable so we just need to do something sensible about growth expectation •  There are two classic approaches •  Using a stock analog.

5% for Australia compared to 6% for global equities Source: MSCI. but might be inferred by market average P/E and P/B •  The figures below infer growth of circa 3-3. August 2015 .Expected Equity Returns – Market Implied (3) g = b x ROE •  We can observe the average dividend payout of the market •  The estimate of ROE is somewhat arbitrary.

7% (2.3% (5% + 0.28x11.53x11.Australian versus global equity return expectations •  Using these figures we might estimate Australian equity return expectation as circa 8.9%) •  The corresponding global equity estimate would be 8.6% + 0.5) – in this case very close •  This arithmetic concerns global equity returns before currency translation •  Global equity allocations tend to be only partly hedged •  Hedged overseas assets pick up any interest rate differential •  Unhedged assets should in theory pick up inflation differential .

. that implies growth of circa 3%.Expected Equity Returns – Market Implied (4) g = GDP – NI (nominal economic growth less new investment) •  The profit share of GDP should be reasonably constant •  So corporate profits should grow in line with nominal GDP •  The asset base for corporate profits is expanded by new capital raising so adjustment is necessary •  Capital raisings on the ASX consist of IPOs and secondary capital raisings by companies already listed •  The appropriate adjustment to growth with this approach corresponds to secondary raisings as a % of market cap •  This figure is typically 2-3% •  With nominal GDP of circa 5-5.5%.

Expected Equity Returns – Market Implied (5) Reconciling (b x ROE) and (GDP – NI) •  If earnings retention is high there will be less need for secondary capital raising •  Hence a high retention market will tend to have a low New Investment adjustment •  For example in the US. the NI adjustment might even be negative because share buybacks are common •  These buybacks are funded by very high earnings retention (in excess of 60%) .

Expected Equity Returns – Market Implied (6) •  Basing return expectations on market implied returns is OK if the market valuation is reasonably neutral •  In that case the ERP based estimates are likely to be reasonably consistent with market implied returns •  But if the market valuation is expensive the market implied return will be depressed so as to validate that price level •  It may then be necessary to factor in a correction to market pricing .

rather than the P •  When earnings are depressed the market P/E may be high in anticipation of an earnings recovery.Expected Equity Returns – Market Implied (6) D P E(R) = + GDP − NI + Δ P E •  Based on Grinold-Kroner (2002) •  If market multiples are extended or depressed expected returns might reflect a reversion to equilibrium pricing •  P/E s can revert to normal by movement in the E. •  So the market multiple adjustment should be applied carefully . In that instance prices may be underpinned by earnings growth and not recede.

often starting abruptly .The market cycle leads the business cycle •  •  The market cycle is more ahead of the business cycle at the peak than the trough The market cycle transpires in phases.

Current P/Es are normal (more or less) .

But our dividend yields are elevated by historically high payout ratios .

Log-normal returns •  If expectations are framed as simple expected nominal returns (m) and volatility (s) these need to be translated if the lognormal distribution is being used: µ = log 1+ m ! s $ & " 1+m % 1+ # 2 2* ' 2 ) ! s $. σ = log)1+ # )( " 1+m % . &.+ •  You can’t just log the expected return and volatility! .

but with the currency component is negative .Covariance •  In bear markets and at times of heightened volatility correlations across global equity markets tend to increase •  This compromises the benefits of diversification •  Regime switching models can allow for this effect directly •  Global equity returns translated to $A have a market component and a currency component •  Australian equity correlation with the market component is positive.

Equity Returns Over Time •  The P/E of the market tends to exhibit some stationarity •  Exceptionally high and low P/Es tend to revert •  The structure of equity prices over time is a stationary multiple applied to earnings moving around a trend •  This is different to a random walk as implied by the assumption of log-normal i.i.d returns •  Over a short-horizon (eg 1 year) not a significant issue •  However over longer horizons (5-10 years) ignorance of this dynamic may overestimate equity risk .

How would we model this? Australian Bank Bill and Bond Yields 12 10 Spread Bank Bills Yield % 8 6 4 2 0 -2 Jun-1994 Jun-1999 Jun-2004 Jun-2009 Jun-2014 .

Bond return distribution depends on yield level .

d •  They are a function of yield level and yield change (and the duration of the portfolio) •  But yields are not a random walk •  They are anchored by inflation expectations •  Inflation expectations have been very stable in the era of effective inflation targeting by central banks •  However there have also been major distortions in bond markets over recent years due to eccentric monetary policy (ie quantitative easing) •  Ideally we want to model the yield curve through time .i.Yield Curve Modeling (1) •  Bond returns. especially when yields are low. are not well described by log-normal i.

set at 0. maturity.0609 for months) y (τ ) t .7173 when τ .Yield Curve Modeling (2) The Nelson-Siegel model " 1− − λτ % " 1− − λτ % − λτ e e '' + c t $$ yt (τ ) = l t + s t $$ − e '' # λτ & # λτ & is the yield on a zero coupon bond at time t with τ years to maturity l t corresponds to the level of the curve at time t s t corresponds to the slope of the curve at time t c t corresponds to curvature at time t λ is a constant. is measured in years (or 0.

slope and curvature parameters . l t As maturity tends to zero the yield tends to l t + s t Implied forward rates are always positive It is parsimonious but flexible The evolution of the yield curve through time can be described by the time series behavior of level.Yield Curve Modelling (3) The Nelson-Siegel curve has several convenient properties: •  •  •  •  •  As maturity tends to infinity the yield tends to a constant.

Yield Curve Modelling (4) First-order vector autoregression (f t ) (f −µ = A t−1 ) − µ +η t Where f ! # =# t # # " curve l s c t t t $ & & & & % ! # # η t = ## # # " η η η noise l t s t c t $ & & & & & & % ! # # µ =# # # # " µ µ µ l s c $ & & & & & & % Mean or equilibrium ! # A =# # # " a a a 11 21 31 a a a 12 22 32 a a a 13 23 33 Yield curve dynamics $ & & & & % .

or has there been a structural shift (eg reduction in trend growth) ? •  Bond returns may be impacted by the gradual reversion to a higher yield curve level •  For example a 50bp lift each year over 3-4 years will reduce returns by circa 2% below the yield (currently 3%) .Yield Curve Modelling (5) •  The specification of the equilibrium curve is a judgement call in the current environment •  Over the last twenty years inflation targeting by the RBA and other central banks has been effective •  Pre-GFC bond yields averaged around 5.5% in current era against an inflation target of 2-3% •  How soon will we return to that regime.

Yield Curve Modeling (6) Broader Linkages •  The Nelson-Siegel framework can be applied to the global environment whereby local yield curve parameters are related to global bond yield curve parameters •  For example if global bond yields shifted abruptly then that should have a direct impact on Australian yields •  Broader economic variables including inflation. output gap etc can augment the vector autoregression .

Currency (1) •  Over the short term currency movements are unpredictable •  However over the medium term (5-10 yrs) the concept of equilibrium value (eg Purchasing Power Parity) is a popular anchor of currency expecations •  Currently Australia’s PPP is estimated at circa US$0. than they may seem .65 by the OECD (2014) •  Tests of currency stationarity are inconclusive – there is no strong reversion tendency back to PPP •  Currency movements are less predictable. even in the medium term.

RBA model of real exchange rate based on terms of trade and interest rate differentials Note the width of the deviation band and the duration of significant deviations .

and Australia inflation is 1% higher then the $A translated return expectation might be 8% .Currency (2) •  Sovereign bond yields differ due to sovereign risk premiums (real yield component) and inflation expectations •  These differences will carry across to equity market expectations (R = Bond Yield + ERP) •  Inflation differentials in theory will drive medium term currency adjustment (eg if Australia’s inflation is higher than the global average then the $A will tend to weaken) •  Generally avoid blending currency forecasts with market forecasts (eg global equities) – other than to recognise inflation differentials •  Eg If the local currency equity expectation is 7% for global equities.

terms of trade boost. How relevant is economic history? . increased demand) falling back until the early 1960s recession •  A low inflation Long Boom from early 1960s to the early 1970s •  Extreme inflation in the mid 1970’s due to oil prices and local wage increases •  Recurrent stagflation from mid 1970s to late 1980s with persistent high inflation and sluggish growth •  A low inflation environment since the recession of the early 1990s The structure of the economy has evolved significantly over this period.Australian Economic History and Inflation The Australian economy has experienced a number of distinct phases post WW2 •  High inflation at the time of the Korean war (high wool price.

Over this period modeling inflation looks easy – AR(1). .

5% Annual Inflation Rate 15.0% 17.Australian Inflation Experience 1950-2013 35 Up until 1990 30 1991 onwards Frequency 25 20 15 10 5 0 2. Why? .5% Low and stable inflation is a relatively recent phenomenon.0% 7.5% 10.5% 5.0% 12.

Some ‘L plate’ accidents in the late 1980s. Imported goods became cheaper and import price competition became constant. With these changes the management of the economy has been transformed. Global financial markets became a discipline on domestic economic policies •  Relaxation of capital flows so businesses and banks could freely borrow and invest overseas. Prior inflation experience would have been different under this framework. .The 1980s deregulation and the modern economy The structure of the economy changed in three important ways •  The floating of the dollar (1983). A more flexible labour market has also been very important. •  Recommitment to tariff reduction/elimination. Local costs of production improved with cheaper inputs. Global inflation trends became more relevant to domestic inflation.

Terms of trade and inflation •  A rise in the terms of trade. This mechanism was not available prior to the currency float of 1983. other things being equal. •  Hence the 1950s inflation spike •  Terms of trade/currency impact on inflation depends on whether the currency overcompensates or does not move enough •  Over time a floating currency should ameliorate the inflation disturbance of the terms of trade in a commodity based economy . can cause an inflationary demand surge through higher domestic incomes •  However the Australian dollar tends to move sympathetically to the terms of trade creating an offsetting deflationary effect.

better avoided •  The Reserve Bank is therefore focused on targeting inflation and dampening demand when necessary with higher interest rates •  Controlled inflation supports stable growth .Monetary policy and inflation (1) •  Inflation integrity matters with a floating currency and a small open economy •  Rampant demand can quickly create a current account deficit as imports rise faster than exports •  In the Balance of Payments a Current Account Deficit must be balanced by a Capital Account Surplus (equity or debt inflows) •  If a current account deficit is offset by sharply increasing foreign debt. global financial markets may lose confidence in the currency •  A currency crisis is a hard landing option.

inflation may increase. but output may be weak so monetary policy is conflicted •  It is tempting to understate inflation risk by extrapolating past success at inflation targeting .Monetary policy and inflation (2) •  The inflation targeting framework has been highly effective over the past twenty years – false confidence? •  Inflation expectations have been well anchored since the early 1990s recession •  But inflation has not been challenged by significant supply side shocks (eg energy prices or food prices) over that period •  With demand driven inflation the objectives of the RBA in regard to prices and output are aligned •  With a supply side shock (eg energy prices).

can be an important performance benchmark •  Actual asset allocation may differ due to market drift or deliberate asset allocation deviations from the SAA •  Investment governance should be explicit about permissible ranges around the SAA . as far as possible.Strategic Asset Allocation •  The conventional approach is to resolve a Strategic Asset Allocation (SAA) for a fund based on its liability profile (ALM) or risk definition (AO) •  The SAA implemented passively.

identify how sources of returns are expected to interact. b)  where the strategy includes multiple assets and/or classes.APRA’s requirements under SPS-530 ‘’18.’ . the variability in these interactions and the impact of these interactions on the overall diversification of the strategy in different market conditions. An RSE licensee must. when determining an appropriate level of diversification for each investment strategy: a)  identify the risk factors. and sources of return with which the risk factors are associated.

APRA refers to equity risk premium. macroeconomic risk. illiquidity etc •  The idea is that various asset classes will be exposed to several of these factors (eg leveraged infrastructure may be exposed to all of these) •  This factor perspective will lead to a better understanding of risk and return than traditional asset class allocation •  This ambition not followed through in SPG-530 •  But still a good way to think about diversification .APRA’s requirements under SPS-530 •  By investment risk factors. maturity premium. credit spreads.

APRA expects an RSE licensee would be able to demonstrate clearly the differences between dynamic and short-term tactical asset allocation decisions where both are used’ – SPG-530 . TAA) •  Superannuation funds over recent years have increasingly indulged Dynamic Asset Allocation (DAA) •  This is meant to adjust for short and medium term views that differ from long-term views on which SAA is based •  To make this activity respectful it is vaguely differentiated from Tactical Asset Allocation which is more fidgety •  ‘Where an RSE licensee also employs tactical asset allocation.Dynamic and Tactical Asset Allocation (DAA.

. Issue 4 •  9 years of monthly data (1986-94) for 306 UK pension funds across 8 asset classes •  Concentrated funds management industry with top 5 fund managers accounting for 80% •  For over 75% of pension funds tactical asset allocation detracted from performance The evidence suggests the rewards to dynamic/tactical asset allocation are questionable. Lehmann. Timmermann (1999) Asset Allocation Dynamics and Pension Fund Performance Journal of Business Vol 72. However its easy to demonstrate enthusiastic tactical asset allocation adds significantly to active risk.Is Tactical Asset Allocation (including DAA) successful? Blake.

previously discussed.Setting Strategic Asset Allocation •  Mean-Variance Optimisation (MVO) is an asset only concept but relevant in Asset Only contexts such as superannuation investment options •  MVO is based on a simplified asset return model •  Extremely sensitive to expected return assumptions •  Black-Litterman. is a substantial improvement •  Simulation approaches can use more sophisticated asset return models .

Setting Strategic Asset Allocation (2) •  Strategic Asset Allocation Constraints Ø  Nature of liabilities and funding Ø  Risk tolerance Ø  Investment horizon (ie long or short term) Ø  Income versus capital preference Ø  Tax (how are income and capital taxed) Ø  Liquidity Ø  Regulations (is borrowing allowed?) .

Setting Strategic Asset Allocation (3) Defining asset classes •  Assets within an asset class should be homogenous •  Asset classes should be mutually exclusive •  Asset classes should be diversifying (ie imperfectly correlated) •  Asset classes should span investment opportunities •  Asset classes should be practically liquid Are ‘Alternatives’. including infrastructure. private equity. and hedge funds. an asset class? .

so optimal portfolios are reshaped •  Variables examined will include risk of funding shortfall.Setting Strategic Asset Allocation (4) •  Asset/Liability Modeling simulates assets and liabilities •  Where liability valuation is based on bond yields. volatility of surplus. the modeling of yields needs to be realistic •  The variable of interest changes from asset return to surplus of assets over liabilities (eg Assets/PBO) •  Assets that hedge liabilities in this context (eg bonds) become risk free. variability of contributions .

rather than security selection •  For this reason investment options for superannuation funds (eg growth. conservative) are differentiated by strategic asset allocations •  However in practice there is much interest in whether performance is better than a passive implementation of the strategic asset allocation •  A similar question is ‘Why did Fund XYZ underperform the median of other funds last year?’ (eg comparing funds diversified options) •  The varying significance of asset allocation in answering these questions is different to its role in calibrating portfolio return volatility •  The importance of Strategic Asset Allocation. WB .is often falsely quoted as justification for Dynamic/Tactical Asset Allocation (WP-WB) . balanced. diversified.The importance of asset allocation •  Most of the volatility of portfolio returns over time is due to asset allocation.

Australian Super pre-mixed investment options .

FAJ Jan-Feb 1988 •  How to respond as market movements change the asset allocation •  Constant mix rebalancing (CMR) sells the outperforming asset class and buys the underperforming asset class •  CMR is effective.Managing asset allocation around the Strategic Asset Allocation (1) •  Perold and Sharpe. when markets oscillate without trend •  Usually operates after a threshold of drift is breached •  However if an asset class trends (equities in a bull market) CRM will underperform buy and hold . and enhances performance. Dynamic Strategies for Asset Allocation.

.Managing asset allocation around the Strategic Asset Allocation (2) •  An alternative to CMR is Constant Proportion Portfolio Insurance (CPPI) •  With CPPI the proportion in risk assets is a function of how far assets have appreciated above a floor value (eg risk free accumulation) •  A CPPI strategy sells risk assets as they fall and buys risk assets as they rise •  A CPPI will outperform buy and hold if markets trend strongly. but will underperform if markets oscillate without trend.

Constant Mix Rebalancing .

Tuttle et al ‘Managing Investment Portfolios’ Chapter 5.After the break •  Maginn. pp 286-295 (Group P) •  Ahlgrim et al ‘Modelling Financial Scenarios’ Sections 1-3 56 .