Forecasting Asset Class returns is a necessary but difficult task for any capital allocator. In this note, we break down the task into key components by investment time horizon.
The Importance of Investment Time Horizon
The first component is to consider the investment time horizon of the forecast return for the asset you are evaluating. All asset returns can be broken down to a greater or lesser extent by a longer-term, more stable, component and a shorter-term, more volatile component. The best means of illustrating this is to observe the relative stability of the rolling 5-year return in Australian Equities versus its rolling 1-year return (see chart below). As you can see, short term returns are far more volatile:
The longer-term component of an asset class return forecast is commonly referred to as the “risk premium”. In equities for example, longer-term fundamentals that drive valuation, such as P/E raio, growth and earnings quality and macro-economic drivers such as inflation, rates, and GDP across developed and emerging markets are key determinants of the longer-term return.
In contrast, the shorter-term component of an asset class return forecast, will be driven by sentiment, and trend. This might include changes in aggregate earnings, profitability, or simply recent trading flows.
Match the Time Horizon to that of Your Client
Matching the horizon of the forecast to the desired average holding period of the investor is crucial.
Excessive weighting of the shorter-term less stable forecast will increase turnover dramatically in the portfolio, producing undesired tax and trading costs.
In contrast, weighting excessively towards the longer-term risk premium may leave the client feeling that a tactical opportunity may have been missed.
Asset allocators, therefore, must align the asset return forecast with the requirements of the client in terms of tax, turnover, and trading cost.
For example, a long-term investor on a higher tax rate should weight more towards the longer-term risk premium. In contrast, a shorter-term investor on a low tax rate with shorter-term liabilities should weight more towards the shorter term signals.
Just One Component of an Asset Allocation
Expected returns are just one component of an asset allocation. The framework described lends itself particularly well to a Dynamic Asset Allocation (DAA), as opposed to the more traditional separation of asset allocation into a long-term strategic component and a short-term tactical one.
Ultimately the goal of DAA is to continuously re-evaluate the optimal asset mix for a multi-asset product, and this is most practically achieved using the framework described above.
Resonant Asset Management Pty Ltd, ABN 41 619 513 076, AFSL No 511759.
Disclaimer: The Information within this article does not constitute personal financial advice. In preparing this document, Resonant has not taken into account your particular goals and objectives, anticipated resources, current situation or attitudes. You should therefore consider the appropriateness of the material, in light of your own objectives, financial situation or needs, before taking any action. You should also obtain a copy of the PDS of any products referenced before making any decisions. The data, information and research commentary in this document (“Information”) may be derived from information obtained from other parties which cannot be verified by Resonant and therefore is not guaranteed to be complete or accurate, and Resonant accepts no liability for errors or omissions. Resonant does not guarantee the performance of any fund, stock or the return of an investor’s capital. Past performance is not a reliable indicator of future performance.