Asset formula

Risk Premia Forecasts: Main Asset Classes – July 6, 2022

Igor Kutyaev

The estimated risk premium for the Global Market Index (GMI) continues to decline. The revised long-term outlook calls for an annualized return of 4.9%. Echoing previous updates in recent history, today’s estimate reaffirms the need to manage downside expectations for globally diversified multi-asset class portfolios compared to the returns achieved in previous years.

The forecast, based on data through June 2022, is defined as the long-term projected return relative to the “risk-free” rate, according to a risk-based model (detailed below). GMI is an unmanaged market-weighted portfolio that holds all major asset classes (except cash) and represents a theoretical benchmark of the optimal portfolio for the average investor with an infinite time horizon. GMI is useful as a starting point for asset allocation research and portfolio design. GMI’s track record suggests that the performance of this passive benchmark is competitive with most active asset allocation strategies overall, especially after adjusting for risk, trading costs and taxes .

Using short-term momentum and mid-term mean-reverting market factors (defined below) to adjust forecasts raises (slightly) GMI’s ex ante risk premium to 5.3% on an annualized basis.

Risk premiums

Author

All forward-looking estimates will likely be off to some degree, but GMI’s long-term projections should be relatively reliable compared to the forecasts for the individual asset classes that are used to generate the benchmark forecasts. Forecasts for individual market components are subject to greater uncertainty than the aggregation of forecasts to project GMI’s risk premia – a process that can negate some of the errors in the underlying market estimates.

For historical context, here is a chart of the 10-year annualized risk premia for the GMI, US stocks (Russell 3000) and US bonds (Bloomberg Aggregate Bond) up to last month. Note that the performance of GMI’s 10-year realized risk premium (red line) in recent history has been relatively stable and is currently 5.9% annualized. This is well below the previous peak of 8% and more. Current risk premium forecasts for GMI suggest that multi-asset class strategies will generate lower returns overall than they have seen in recent years.

Rolling 10-year annualized risk premiums

Author

We now turn to a summary of the methodology and rationale for the above estimates. The basic idea is to reverse engineer the expected return, based on risk assumptions. Rather than trying to predict return directly, this approach relies on the moderately more reliable model of using risk measures to estimate asset class performance. The process is relatively robust in that it is slightly easier to predict risk than to project return. With the necessary data in hand, we can calculate the implied risk premia with the following inputs:

    • an estimate of the expected market price of GMI’s risk, represented here by the Sharpe ratio, which is the ratio of risk premia to volatility (standard deviation).

    • the expected volatility (standard deviation) of each asset

    • the expected correlation for each asset with the overall portfolio (GMI)

The estimates are taken from historical records since the end of 1997 and are presented as a first approximation for modeling the future. The projected premium for each asset class is calculated as the product of the three inputs above. GMI’s ex ante risk premia are calculated as the market value weighted sum of individual projections for asset classes.

The framework for estimating equilibrium returns was originally described in a 1974 paper by Professor Bill Sharpe. For a more practical summary, see Gary Brinson’s explanation of the process in Chap. 3 of the Portable MBA in Investment. I also review the model in my book Dynamic Asset Allocation. Here is how Robert Litterman explains the concept of estimating the equilibrium risk premium in Modern Investment Management: An Equilibrium Approach:

We don’t need to assume that the markets are always in equilibrium to find a useful equilibrium approach. Rather, we view the world as a complex and highly random system in which there is a constant barrage of new data and shocks to existing valuations that, more often than not, push the system away from equilibrium. However, while we expect these shocks to constantly create deviations from the financial market equilibrium, and recognize that frictions prevent these deviations from immediately disappearing, we also assume that these deviations represent opportunities. Wise investors who attempt to take advantage of these opportunities take actions that create the forces that continually push the system back towards equilibrium. Thus, we consider financial markets as having a center of gravity defined by the balance between supply and demand. Understanding the nature of this equilibrium helps us to understand financial markets as they are constantly jolted and pushed back towards this equilibrium.

The adjusted risk premia estimates in the table above reflect changes based on two factors: short-term momentum and long-term mean reversion. Momentum is defined here as the current price relative to the moving average of the last 10 months. The average reversion factor is estimated as the current price relative to the 36-month moving average. Estimates of gross risk premiums are adjusted for current prices relative to 10-month and 36-month moving averages. If current prices are above (below) moving averages, estimates of unadjusted risk premia are decreased (increased). The adjustment formula is simply to take the inverse of the average of the current price at the two moving averages as a signal to change the projections. For example: If the current price of an asset class is 10% above its 10-month moving average and 20% above its 36-month moving average, the risk premium estimate will not adjusted is reduced by 15% (the average of 10% and 20%) .

What can you do with the predictions in the table above? You might start by asking yourself whether the expected risk premia are satisfactory… or not. If the estimates are lower than your required return, you may consider designing a higher return rate by customizing the asset allocation and rebalancing rules. Keep in mind that GMI’s gross implied risk premia are based on an unmanaged market value-weighted mix of major asset classes. In theory, this is the optimal asset allocation for the average investor with an infinite time horizon. Unless you are a foundation or a pension fund, this time horizon assumption is impractical and so there is a reasonable case for a) changing Mr. Market’s asset allocation based on your particular needs and your risk budget; and b) add a rebalancing component to your investment strategy.

You can also estimate risk premia with alternative methodologies to better understand the short-term future (a great resource: Expected Returns: An Investor’s Guide to Harvesting Market Rewards by Antti Ilmanen). For example, suppose you are confident in the Dividend Discount Model (DDM) to predict stock market performance over the next 3-5 years. After analyzing the numbers, you find that DDM is telling you that the expected performance of the stock market will differ significantly from the estimate based on the long-term equilibrium. In this case, you have some tactical information to consider.

Also keep in mind that combining forecasts through multiple models can provide a more reliable set of forecasts than estimates from a given model. Indeed, a number of studies published over the years show that combined forecasts tend to be more robust than single-model projections.

What you can’t do is remove blood from a stone. Nobody really knows what the risk premia will be in the months and years to come, so relying solely on forecasts (especially for the near-term future) is frustrating. In other words, you should deviate from Mr. Market’s asset allocation carefully, thoughtfully, and for reasons other than assuming you’re smarter than everyone else (i.e. the market).

Original post

Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.


Source link