In developing a long-range investment strategy, investors conduct strategic asset allocation (SAA) work in pursuit of the portfolio that best balances risk and return. SAA relies on coherent forecasts — capital market assumptions, for example — of long-term investment expectations and variability. Such forecasts are usually presented in the standard mean–variance framework of expected returns, volatilities, and correlations:
- Expected Return: Average annual return over the long-range horizon
- Volatility: The standard deviation of annual returns
- Correlation: How closely associated returns of various investments are
Investors have come to rely on JPMorgan’s long-term capital market assumptions (LTCMA) to inform the strategic asset allocation work used to build optimal portfolios. JPMorgan’s team of more than 50 economists and analysts revises its forecasts annually to incorporate new information from the markets, policymakers, and the economy.
For 2021, the JPMorgan forecasts attempt to abstract from near-term challenges and consider the lasting consequences of the COVID-19 crisis, in particular, the effects of the policy responses adopted to address the pandemic. Surprisingly, JPMorgan expects “very few” lasting consequences for economic activity around the world. Indeed, its growth forecasts are very similar to what they were pre-COVID.
“The alignment of monetary and fiscal policy in the same supportive direction is perhaps the biggest single difference in the fabric of the economy between this new cycle and the last one.” — JPMorgan
For the United States, JPMorgan expects equity market returns over the next 10 to 15 years to fall from 5.6% last year to 4.1%. This reduction largely reflects the impact of valuation normalization. For fixed income, JPMorgan’s forecast anticipates three phases for government bonds: two years of stable returns, followed by three years of capital depreciation, and ending in a return to equilibrium. As a result, 10-year Treasury expected returns decline from 2.76% to 1.54%. And, with a healthy and well-capitalized banking sector, JPMorgan believes the current cycle is unlikely to produce a credit-disruptive crisis, particularly with existing US Federal Reserve support.
Over the investment horizon, JPMorgan sees modest economic growth and constrained returns in many asset classes. Nevertheless, it remains optimistic that with nimble and precise portfolio actions, investors can harvest an acceptable return without an unacceptable increase in portfolio risk.
With that in mind, investors should compare the optimized portfolios presented here with their existing allocations — and with their own personal market outlook — and reconcile accordingly.
Method
With the Portfolio Visualizer online suite of portfolio analysis tools, I created an “efficient frontier” of portfolios based on the JPMorgan 2021 LTCMA for eight canonical asset classes and their corresponding Vanguard tickers:
- US intermediate Treasuries (VFITX)
- US investment grade corporate bonds (VWESX)
- US high yield bonds (VWEHX)
- Emerging markets sovereign debt (VGAVX)
- US large-cap equity (VFINX)
- US small-cap equity (VSMAX)
- EAFE equity (VTMGX)
- Emerging markets equity (VEMAX)
An efficient frontier traces the expected returns from optimized portfolios, or those that offer the highest expected return, over a range of risk points. I also produce the portfolio with the greatest Sharpe Ratio, defined as excess portfolio expected return over portfolio volatility.
Four optimal portfolios were found using JPMorgan’s LTCMA and Portfolio Visualizer’s Efficient Frontier tool:
- Max Sharpe Ratio: Maximize the Sharpe Ratio
- Conservative Risk: Match the volatility of a 35%/65% stock–bond portfolio
- Moderate Risk: Match the volatility of a 65%/35% stock–bond portfolio
- Aggressive Risk: Match the volatility of a 100% stock portfolio
The long-term capital market assumptions for the eight canonical asset classes are as follows:
Long-Term Capital Market Assumptions
| Exp Ret | Vol | |
| VFITX | 1.54% | 2.83% |
| VWESX | 2.69% | 6.22% |
| VWEHX | 5.13% | 8.33% |
| VGAVX | 5.57% | 8.82% |
| VFINX | 5.13% | 14.80% |
| VSMAX | 6.33% | 19.44% |
| VTMGX | 7.80% | 16.92% |
| VEMAX | 9.19% | 21.14% |
Source: JPMorgan
I used historical correlations among the eight asset classes.
Results
The asset allocation for the four optimal portfolios is as follows:
Optimal Portfolios
| ExpRet | Vol | VFITX | VWESX | VWEHX | VGAVX | VFINX | VSMAX | VTMGX | VEMAX | |
| Max Sharpe | 2.51% | 2.81% | 76.80% | 17.39% | 5.81% | |||||
| Conservative | 4.84% | 7.11% | 18.96% | 23.41% | 50.79% | 6.84% | ||||
| Moderate | 6.25% | 10.27% | 75.03% | 15.71% | 9.26% | |||||
| Aggressive | 7.60% | 14.69% | 33.88% | 25.61% | 40.51% |
Source: Anson J. Glacy, Jr., CFA
These results demonstrate that an investor of moderate risk affinity can expect to earn an average return of 6.25% over the next 10 to 15 years.
What’s striking is the absence of domestic large-cap and small-cap equity and of investment-grade bonds in any of the four optimal portfolios. This is due to the substantial headwinds posed by valuation normalization: In the United States, long cycles of stock market outperformance followed by long cycles of underperformance are not uncommon.
The diversifying role that intermediate Treasuries continue to play in the lower risk portfolios is also notable. Portfolio Visualizer exerts a -0.16 correlation between Treasuries and large-cap equity. A “balanced” portfolio for high-risk investors, in contrast, consists of non-US equity together with sovereign debt. JPMorgan’s forecasts imply that such a portfolio could deliver average returns in excess of 7.5% over the long term. For example, the Aggressive portfolio matches the S&P 500 in risk but improves expected returns by almost 2.5 percentage points!
The Max Sharpe Ratio portfolio exhibits a Sharpe Ratio of 0.88 but yields an expected return that may not be adequate for some investors. The other three portfolios have Sharpe Ratios between 0.515 and 0.675.
These bread-and-butter portfolios comprise the major public asset classes that are the building blocks of most mutual funds and exchange-traded funds (ETFs). Alternative assets, like hedge funds and commodities, are not included. JPMorgan’s view is that interest rates will stay “lower for longer” and that there will be shrinking opportunities for alpha, income, and diversification in traditional assets. This may make alternatives a compelling proposition since they exhibit low correlations with traditional assets and can deliver higher returns.
Conclusions
These optimal portfolios are appropriate for long-term investors of various risk affinities who measure risk by means of return variability. Investors using other risk measures — Sortino, minimal downdraft, for example — might see different results.
Even as equity markets set all-time highs and bond yields near generational lows, it is still possible to build resilient portfolios with reasonable return expectations. Thoughtful investors may consider building their long-range asset allocations around these optimal portfolios.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image credit: ©Getty Images / cosmin4000
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