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Effective investment strategies rely on coherent forecasts of long-term investment expectations. Choosing not to make a forecast is still a forecast. J.P. Morgan annually publishes long-term capital market assumptions that are useful in building optimized portfolios. Using its 2020 edition, here are a selection of optimal portfolios that can be used by investors of different risk affinities.
In developing a long-range investment strategy, investors conduct strategic asset allocation (SAA) in pursuit of the portfolio that optimally balances risk and return. SAA relies on coherent forecasts (i.e., capital market assumptions) of long-term investment returns, variability and correlation. Such forecasts are usually presented in a standard mean-variance framework:
- 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
Over the years, investors have come to rely on J.P. Morgan’s long-term capital market assumptions (LTCMA) to inform their strategic asset allocation work, build optimal portfolios and establish coherent forecasts for risk and return over a 10- to 15-year time frame. J.P. Morgan’s team of more than 50 economists and strategists recalibrates its forecasts annually to incorporate new information presented by markets, policymakers and the economy itself.
For 2020, the J.P. Morgan forecasts considered the trade-offs and complications of late-cycle investing, in particular the challenges to portfolio construction from zero or negative bond yields. Over the investment horizon, they see modest global growth and constrained returns in many asset classes, yet continue to see the prospect for “reasonable” investor returns. Investors should compare the optimized portfolios that I present here with their existing allocations (and with their own personal market outlook) and reconcile accordingly.
Method
Using Portfolio Visualizer (an online suite of portfolio analysis tools), I created an “efficient frontier” of portfolios using the J.P. Morgan 2020 LTCMA for eight keystone asset classes (and their corresponding Vanguard tickers):
- U.S. intermediate Treasury bonds (VFITX)
- U.S. investment-grade corporate bonds (VWESX)
- U.S. high-yield bonds (VWEHX)
- Emerging-markets sovereign debt (VGAVX)
- U.S. large--cap equity (VFINX)
- U.S. small-cap equity (VSMAX)
- EAFE equity (VTMGX)
- Emerging-markets equity (VEMAX)
An efficient frontier traces the expected returns from optimized portfolios (i.e., those that offer the highest expected return) over a range of risk points. The portfolio offering the greatest Sharpe Ratio, defined as excess portfolio expected return over portfolio volatility, is also produced.
Using J.P. Morgan’s LTCMA and Portfolio Visualizer’s efficient frontier tool, four optimal portfolios were found:
- 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
Long-term capital market assumptions for the eight keystone asset classes are as follows:
Long-Term Capital Market Assumptions
| |
Exp Ret
|
Vol
|
|
VFITX
|
2.76%
|
3.45%
|
|
VWESX
|
3.57%
|
5.96%
|
|
VWEHX
|
5.52%
|
8.22%
|
|
VGAVX
|
5.43%
|
8.36%
|
|
VFINX
|
6.55%
|
14.34%
|
|
VSMAX
|
8.12%
|
18.95%
|
|
VTMGX
|
8.48%
|
16.81%
|
|
VEMAX
|
11.15%
|
21.12%
|
Source: J.P. Morgan
Historical correlations among the eight asset classes were used.
Results
An investor of moderate risk affinity can expect to earn a nominal return of approximately 6.5% over the next 10 to 15 years.
Portfolio protection is at the top of investors’ minds in the current late-cycle environment. Equity markets are at or near all-time highs, bond yields are at generational lows, and incendiary geopolitical risks (e.g., Hong Kong, North Korea, Iran, Brexit) are at all compass points. For many investors, the Global Financial Crisis of 2008 remains a haunting memory. These investors wonder what they can do now to build more resilient portfolios.
At the same time, economic activity is brisk, trade wars are largely contained, and tax rates are remarkably low. The much-bruited recession of 2019 failed to appear and animal spirits in the markets are high. The capitalist system remains a marvel of capital allocation and wealth creation. Investing opportunities persist.
J.P. Morgan expects low interest rates and muted inflation to persist over the life of its LTCMA forecasts. It expects intermediate Treasury bonds to continue providing valuable portfolio diversification in such periods. Paraphrasing J.P. Morgan: “Bonds are likely to ensure a return of capital, even if they don’t provide a return on capital.” So, despite generationally low yields, bonds still have a significant role to play in portfolio composition.
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
|
4.08%
|
4.11%
|
73.59%
|
|
10.46%
|
|
|
6.66%
|
2.81%
|
6.48%
|
|
Conservative
|
4.64%
|
5.14%
|
65.35%
|
|
16.48%
|
|
|
7.08%
|
0.74%
|
12.34%
|
|
Moderate
|
6.47%
|
9.23%
|
20.49%
|
7.64%
|
23.74%
|
12.78%
|
|
8.92%
|
|
26.43%
|
|
Aggressive
|
8.58%
|
14.27%
|
|
|
21.52%
|
16.58%
|
|
12.47%
|
|
49.43%
|
Source: Author
The important diversifying role that intermediate Treasury bonds (VFITX) play in the low-to-moderate risk portfolios declines as more aggressive risk stances are pursued. High-yield bonds (VWEHX) is the only asset class with significant presence in all four portfolios, while large-cap equity (VFINX) and investment-grade corporates (VWESX) are notable for their absence. Emerging markets equity (VEMAX), with an expected return over 11%, is the go-to investment for those investors pursuing high returns.
The Max Sharpe Ratio portfolio has a Sharpe ratio of 0.61, but sports an expected return that may not be adequate for some investors. The other three portfolios have Sharpe ratios between 0.50 and 0.60.
Conclusions
The optimal portfolios presented are appropriate for long-term investors of various risk affinities who measure risk by means of return variability. Investors using other risk measures (e.g., Sortino, minimal downdraft) would see different results.
Even with equity markets at or near all-time highs and bond yields at generational lows, it is possible to build resilient portfolios exhibiting reasonable return expectations. Thoughtful investors should consider building their long-range asset allocations around the optimal portfolios presented here.
Anson J. Glacy, Jr., ASA, CERA, CFA, is a financial professional with extensive risk management and value optimization experience in the consulting, asset management and corporate settings. He presently serves as managing director at Prescriptive Analytics GmbH
Read more articles by Anson J. Glacy, Jr.
