Rethinking Capital Market Assumptions
Some years ago when I was a risk analyst, I had a monthly ritual. Once every 4 weeks, I ran my models, and they computed my monthly risk report, a full set of risk metrics used for portfolio management. It contained all the usual suspects: active risk, tracking error, Sharpe ratios, Value-at-Risk (VaR), Conditional Value-at-Risk (CVaR), and Marginal Value-at-Risk (MVaR).
And then I sat through countless meetings where we intensely debated minor changes in the metrics crucial to our Tactical Asset Allocation (TAA) process. These discussions focused on fine-tuning measured, conviction-driven deviations from our Strategic Asset Allocation. In turn, our strategic asset allocation were based on capital market assumptions (CMAs). Today still, the reliance on capital market assumptions (CMAs) remains critical in shaping strategic decisions.
Understanding CMAs
CMAs are essentially long-term forecasts that project the expected returns, risks, and correlations of various investment assets. These forecasts are rooted in historical data and current economic conditions, serving as a backbone for strategic portfolio allocation. By enabling effective diversification, CMAs help optimize returns and minimize risks. But as the financial landscape undergoes significant transformations, the static nature of traditional CMAs is being questioned.
The Evolving Dynamics of Stock-Bond Correlations
Historically, the 60/40 stock-bond portfolio has benefited from a consistently negative correlation, providing a reliable risk buffer during equity market downturns. However, recent trends indicate a shift, with US stocks and bonds displaying higher levels of positive correlation than seen in the last two decades. This change reflects new dynamics that challenge the traditional capital market assumption methodologies.
The Challenge of Estimating Future Returns
Estimating future returns is a complex endeavour, with various asset managers publishing CMAs with their own return estimates, which differ from one another. This diversity in forecasts can make it difficult for investors to determine which projections are most likely to align with future market behaviour. No forecast is infallible, and the varied methodologies used to create these CMAs can lead to significantly different outcomes. This variability underscores the need for investors to not blindly trust these numbers but rather to understand them deeply enough to gauge their reasonableness and applicability.
Rethinking Assumptions
One of the key challenges for investors is the ongoing rethinking of their underlying assumptions. The financial world is not static, and neither should be the assumptions that guide our investment decisions. With fundamental relationships, such as stock-bond correlations, showing signs of breakdown, it has become imperative for investors to continuously challenge and adapt their strategies based on evolving economic and market conditions. And indeed, we should constantly challenge the assumptions we hold - in particular those that guide our investment decisions.
Have a great week ahead!
Maryann
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***Disclaimer***
All opinions are my own and personal. This is not investment advice. I do not provide any buying or selling recommendations, nor do I offer any investment advice. You are advised to conduct your own research and due diligence when making financial and investment decisions.