2018 Capital Market Assumptions - Sellwood Consulting LLC · Emerging Markets Equity ... not to...
-
Upload
nguyenquynh -
Category
Documents
-
view
212 -
download
0
Transcript of 2018 Capital Market Assumptions - Sellwood Consulting LLC · Emerging Markets Equity ... not to...
![Page 1: 2018 Capital Market Assumptions - Sellwood Consulting LLC · Emerging Markets Equity ... not to rely only on mean‐variance analysis when constructing portfolios. ... horizons. For](https://reader031.fdocuments.in/reader031/viewer/2022030815/5b24cb327f8b9a10578b4b1e/html5/thumbnails/1.jpg)
2018CapitalMarketAssumptionsFebruary2018
![Page 2: 2018 Capital Market Assumptions - Sellwood Consulting LLC · Emerging Markets Equity ... not to rely only on mean‐variance analysis when constructing portfolios. ... horizons. For](https://reader031.fdocuments.in/reader031/viewer/2022030815/5b24cb327f8b9a10578b4b1e/html5/thumbnails/2.jpg)
TABLEOFCONTENTS
TableofContents.....................................................................................................................................................................1
INTRODUCTION.......................................................................................................................................................................2
INFLATION.................................................................................................................................................................................6
FIXEDINCOME..........................................................................................................................................................................7
CashEquivalents...............................................................................................................................................................10
Low‐DurationFixedIncome........................................................................................................................................11
CoreFixedIncome............................................................................................................................................................12
Non‐CoreFixedIncome..................................................................................................................................................13
Core‐PlusFixedIncome.................................................................................................................................................14
Long‐DurationFixedIncome.......................................................................................................................................15
USTreasuryInflationProtectedSecurities(TIPS).............................................................................................16
Short‐TermUSTreasuryInflationProtectedSecurities(TIPS)....................................................................16
EQUITY.......................................................................................................................................................................................17
USLarge‐CapEquity........................................................................................................................................................18
USSmall‐CapEquity........................................................................................................................................................20
USEquity..............................................................................................................................................................................22
Non‐USLarge‐CapEquity..............................................................................................................................................22
Non‐USSmall‐CapEquity..............................................................................................................................................24
EmergingMarketsEquity..............................................................................................................................................24
Non‐USEquity....................................................................................................................................................................25
ALTERNATIVES......................................................................................................................................................................26
RealEstate...........................................................................................................................................................................26
DiversifiedInflation‐Related........................................................................................................................................27
MarketableAlternatives................................................................................................................................................28
Non‐MarketableAlternatives......................................................................................................................................28
RISK.............................................................................................................................................................................................29
CORRELATIONCOEFFICIENTS........................................................................................................................................33
APPENDIX:SOURCES...........................................................................................................................................................35
1
![Page 3: 2018 Capital Market Assumptions - Sellwood Consulting LLC · Emerging Markets Equity ... not to rely only on mean‐variance analysis when constructing portfolios. ... horizons. For](https://reader031.fdocuments.in/reader031/viewer/2022030815/5b24cb327f8b9a10578b4b1e/html5/thumbnails/3.jpg)
INTRODUCTIONSellwoodConsultingupdatesitscapitalmarketsassumptionsonanannualbasis.Our2018assumptionsreflectinformationasofDecember31,2017,unlessotherwisenoted.Thisreportdocumentsourprocessforcreatingthesecapitalmarketsassumptions,andweprovidedetailedmethodologyforeach.Severalover‐archingprinciples,however,informallofouranalysis:
1. Webelievethatforward‐lookingcapitalmarketassumptionsareanimportant,butfarfromtheonlyimportant,inputforproperlyconstructingportfolios.Greatcareshouldbetakennottorelyonlyonmean‐varianceanalysiswhenconstructingportfolios.Ananalysisthatreliesonlyonmean‐varianceanalysiswillover‐allocatetoassetswithinsignificantlysuperiorrisk/returnestimates,andassetsthatarelessliquidorlessfrequentlypriced,resultingininferiordiversificationandtheassumptionofunintendedrisks.
2. Ourassumptionsareforward‐lookinginnatureandreflectaten‐yearhorizon.Theyareappropriateforanalysisofportfolioswithlong‐term(10yearorgreater)horizons.Forportfolioswithshorterhorizons,alternatemethodsofanalysisshouldbeemployed.
3. Wepurposefullyusedifferentmethodstoestimatereturnandrisk.Thefirstpartofthispaperexplainsthedifferentmethodsweemploytoestimatethefuturereturnofeachindividualassetclass.Laterinthepaper,weexplainamorestandardizedapproachtoestimatingfutureriskofthesameassetclasses.
4. Ourreturnassumptionsutilizeabuild‐upapproachbasedonthecurrentvaluesoftheindividualdriversofexpectedreturnthatareuniquetoeachassetclass.
5. Forassetclasseswherethemarketprovidesacurrentviewofforward‐lookingreturns,ourassumptionsheavilyweightthemarketview.
6. Wherepossible,allofourreturnassumptionsincorporatecurrentvaluations.Wherewehaveidentifiedacurrentvaluationanditslong‐termmean,ourestimatesconsidera50%reversionfromthecurrentvaluationleveltoitslong‐termmeanoverthenexttenyears.
7. Ourassumptionsarepresentedinnominalterms.Wherewehaveusedhistoricalreturnsinourinputanalysis,wehavealwaystransformedthemtoreal,after‐inflation,returns,soastostripouthistoricalinflation.Attheendofthebuild‐upprocess,whereappropriate,weaddthemarket’scurrentmeasureofforward‐lookinginflationbacktotheassumptionstocreateforward‐lookingnominalreturnassumptions.
8. Ourbasereturncalculationsareofandforcompoundreturns.Aftercalculatingacompoundreturnandariskassumption,wecombinethetwomathematicallytocalculateanarithmeticaverageexpectedreturn,whichisanecessaryinputformean‐varianceanalysis.
2
![Page 4: 2018 Capital Market Assumptions - Sellwood Consulting LLC · Emerging Markets Equity ... not to rely only on mean‐variance analysis when constructing portfolios. ... horizons. For](https://reader031.fdocuments.in/reader031/viewer/2022030815/5b24cb327f8b9a10578b4b1e/html5/thumbnails/4.jpg)
9. Ourassumptionsarepassiveinnatureandassumenoactivemanagement.
10. Ourapproachtomodelingtheexpectedriskofeachassetcategoryismulti‐faceted.First,weexaminethehistoricalstandarddeviationofthereturnsforaproxyindexfortheassetcategory(boththefullhistoryandmostrecent10years).Next,weexaminethehistoricalworst‐caseannualreturnexperience(orinthecaseofassetcategoriesthatarenotpricedtomarket,themaximumtwo‐yearpeak‐to‐troughexperience)fortheassetclass.Ifnecessary,weadjustourriskestimatesupwardtoensurethattheactualworst‐caseexperiencehadatleasta2%probabilityofoccurring(onceevery50years)underourassumedreturnandriskdistributionparameters.Finally,forassetclasseswhereourconfidenceinthedataavailableforexaminationislimited,wequalitativelyadjustourriskassumptiontoreflectthisuncertainty.
11. Ourcorrelationcoefficientassumptionsaremostlyderivedfromhistory,withanemphasis
ontherecentpast.Weseekaproxyforeachassetcategorywehavemodeledwithaslongahistoryaspossible,andthencalculateourcorrelationassumptionsusingasimpleaverageofthefollowing,foreachpairofassetcategories:
Longest‐termcorrelation 10‐yearcorrelation 5‐yearcorrelation 3‐yearcorrelation
Thisapproachpurposefullyoverweightstherecentpast,whileacknowledgingthelong‐termpast.Itisalsoamoreconservativemeasureforcorrelationbenefittoaportfolio,becauserecentcorrelationshavebeenhigherthantheyhavebeenhistorically.
12. Weroundourassumptionstothenearest10basispoints,inthecaseofarithmeticaveragereturn,andnearest25basispoints,inthecaseofrisk.
13. OurassumptionsareapplicabletoUS‐based,non‐taxableinvestors.FortaxableclientslocatedintheUnitedStates,wemaintainaseparatemethodologythatconsiderstheeffectsoftaxesonexpectedreturnsandrisk.
14. Wehavestrivedtoconstructasetofassumptionsthatisstraightforward,explainable,fullydocumented,andreplicablebyotherresearchers.Ourassumptionsareascomplexasnecessarybutnomorecomplexthannecessary,andtheyhavenohiddenconstraints.Wecouldmakethemmorecomplicated,butwedonotbelievethatdoingsowouldmakethembetter.
Insummaryform,our2018forward‐lookingassumptionsfollowonthenextpage.
3
![Page 5: 2018 Capital Market Assumptions - Sellwood Consulting LLC · Emerging Markets Equity ... not to rely only on mean‐variance analysis when constructing portfolios. ... horizons. For](https://reader031.fdocuments.in/reader031/viewer/2022030815/5b24cb327f8b9a10578b4b1e/html5/thumbnails/5.jpg)
NominalCompoundReturn Risk
NominalArithmeticReturn
SharpeRatio
Inflation 1.96% 3.00% 2.00% ‐‐‐CashEquivalents 1.79% 1.00% 1.80% ‐‐‐Low‐DurationFixedIncome 2.55% 3.00% 2.60% 0.25CoreFixedIncome 2.57% 5.00% 2.70% 0.16Core‐PlusFixedIncome 2.58% 5.25% 2.70% 0.15Non‐CoreFixedIncome 2.58% 14.25% 3.50% 0.06Long‐DurationFixedIncome 2.47% 10.25% 3.00% 0.07TIPS 2.12% 6.25% 2.30% 0.05Short‐TermTIPS 2.28% 3.75% 2.30% 0.13USEquity 4.46% 18.75% 6.10% 0.14USLarge‐CapEquity 4.48% 18.75% 6.10% 0.14USSmall‐CapEquity 4.25% 20.00% 6.10% 0.12Non‐USEquity 5.83% 23.75% 8.30% 0.17Non‐USLarge‐CapEquity 5.80% 23.25% 8.20% 0.17Non‐USSmall‐CapEquity 6.05% 28.00% 9.50% 0.15EmergingMarketsEquity 6.56% 29.25% 10.30% 0.16RealEstate 4.57% 19.00% 6.20% 0.15DiversifiedInflation‐Related 3.65% 14.50% 4.60% 0.13MarketableAlternatives 4.12% 11.75% 4.80% 0.20Non‐MarketableAlternatives 6.52% 29.75% 10.30% 0.16
GlobalEquities
Alternatives
FixedIncome
4
![Page 6: 2018 Capital Market Assumptions - Sellwood Consulting LLC · Emerging Markets Equity ... not to rely only on mean‐variance analysis when constructing portfolios. ... horizons. For](https://reader031.fdocuments.in/reader031/viewer/2022030815/5b24cb327f8b9a10578b4b1e/html5/thumbnails/6.jpg)
Historicalreturndistributions(historicalrealreturns,plusourassumedfutureinflation)aredepictedbelowinblue,andourforward‐lookingassumedreturndistributionsareshownintan:
5
![Page 7: 2018 Capital Market Assumptions - Sellwood Consulting LLC · Emerging Markets Equity ... not to rely only on mean‐variance analysis when constructing portfolios. ... horizons. For](https://reader031.fdocuments.in/reader031/viewer/2022030815/5b24cb327f8b9a10578b4b1e/html5/thumbnails/7.jpg)
INFLATION
Modeled:USCPI‐UInflationCompoundReturn:1.96%
ArithmeticAverageReturn:2.00%Risk:3.00%
Themarkettellsusitsexpectationforforward‐lookingten‐yearinflation,andourassumptionreflectsthatmarketassumption.OnDecember31,2017,themarket’syieldfora10‐YearUSTreasuryBondwas2.40%,andtherealyieldfora10‐YearTIPSsecuritywas0.44%.Thedifferencebetweenthetwoapproximatesthemarket’sinflationexpectationoverthenexttenyears,1.96%.TheFederalReservehaspublishedthisinflationapproximation–theso‐called“TIPSbreakevenspread”–since2003.Thefollowingchartdepictsthefullhistoryofthismeasure,laidagainsttheactualsubsequentinflation(asmeasuredbytheConsumerPriceIndex,“CPI”)thatoccurredoverthefollowingfiveyears.Wehavechosentodepictthefive‐yearTIPSbreakevenspreadandsubsequentfive‐yearinflation,becausethe10‐yearvaluesdonotyetoffersufficientdataforevaluation.Withtheexceptionofespeciallyilliquidmarketperiods,whichdistortthemeasurebecauseofliquiditydifferencesbetweenTIPSandnominalTreasuryBonds,themeasurehasdoneafairjobofpredictingsubsequentinflationanddoesnotappeartobebiasedpositivelyornegatively.
‐2.0%
‐1.0%
0.0%
1.0%
2.0%
3.0%
4.0%
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
TIPSBreakevenSpreadandSubsequentCPI‐ 5Years
Subsequent5‐YearCPI 5‐YearBreakevenSpread
6
![Page 8: 2018 Capital Market Assumptions - Sellwood Consulting LLC · Emerging Markets Equity ... not to rely only on mean‐variance analysis when constructing portfolios. ... horizons. For](https://reader031.fdocuments.in/reader031/viewer/2022030815/5b24cb327f8b9a10578b4b1e/html5/thumbnails/8.jpg)
FIXEDINCOMEFixedincomereturnsareverydependentonentryyields.FortheBloombergBarclaysAggregateIndex,since1976,going‐inyieldshaveexplained85%ofsubsequent10‐yearreturns:
Itwouldbetemptingtosimplysetourbond‐marketassumptionsasthecurrentyield,buttodosowouldbetoignoreprospectsforchanginginterestrates,changingcompositionofthebondbenchmarks,andthenegativeeffectsofbonddefaults.Instead,webuildavaluationmodelforeachbondcategoryforwhichweassumeareturn.Still,currentyieldsanchorouranalysis:ineachcase,thecompoundreturnassumptionthatwecalculatewiththismodelisclosetothecurrentnominalyieldfortheassetclass.Allofourfixedincomeassumptionsuseanidenticalbuilding‐blockmodelasourbaseanalysis,butwehavemadesomequalitativeadjustmentstotheanalysis,wherenoted.Ourbuildingblockmodelbeginswiththefixedincomeassetclass’scurrentrealyieldandduration.Wethenexaminethelong‐termaverageoftherealyield,andassumethatovertheprospectiveten‐yearperiod,theasset’srealyieldrevertshalfwaytothataverage.Forassetcategoriesthatpayayieldspreadascompensationforhigherrisk,weusesimilarcalculationstoassumethereversionoftheyieldspreadhalfwaytoitshistoricalaverage.Forthemostpart,weassumethatlong‐termaveragedefaultandrecoveryrateswillpersistintotheprospectiveten‐yearperiod.1Giventheseinputs,wecancalculatetheasset’sexpectedforward‐looking10‐yearreturnusingarithmetic.
1OursourceforhistoricaldefaultandrecoveryratesforallbondsisMoodys.
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
14.0%
16.0%
18.0%
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
2016
BloombergBarclaysAggregateYield&Subsequent10‐YearReturn
BarclaysAggregateYield Subsequent10‐YearReturn
R2=0.85
7
![Page 9: 2018 Capital Market Assumptions - Sellwood Consulting LLC · Emerging Markets Equity ... not to rely only on mean‐variance analysis when constructing portfolios. ... horizons. For](https://reader031.fdocuments.in/reader031/viewer/2022030815/5b24cb327f8b9a10578b4b1e/html5/thumbnails/9.jpg)
WeuseaUSTreasuryBondasourfirstfixedincomebuildingblock–theblockuponwhichwestackyieldspreadsandinflation.Tocalculatetheforward‐lookingten‐yearreturnforTreasuryBonds,webeginwithtoday’srealyieldandassumeten‐yearreversionhalfwaytothelong‐termaveragemeanrealyield.Tocapturethelongesttimehorizonpossible,wecalculateallrealyieldsbyadjustingthenominalyieldbyaninflationseries2.Weassumethatthereversiontoameanrealyieldwilloccurinevenincrementsineachofthefuturetenyears.Weassumefurtherthatthesecurity’sdurationwillstayconstantovertheten‐yearperiod.Thelastbuildingblock,thoughitisassumedtobezeroforaTreasurysecurity,isanassumeddefaultrate,adjustedforanassumedrecoveryrate.Finally,becauseallofthisanalysisiscalculatedinrealterms,weaddbackthemarket’sinflationassumptiontoarriveatanominalreturnassumption.Ourcalculationsforthe2‐,5‐,10‐,and20‐YearUSTreasuryBondsfollow.Ourassumptionsare:Maturity: 2years 5years 10years 20yearsDuration: 1.86years 4.67years 8.77years 14.50yearsCurrentRealYield: 0.12% 0.34% 0.44% 0.61%Long‐TermAverageRealYield: 1.60% 2.00% 2.27% 2.51%CumulativeYieldChange(10Years): +0.74% +0.83% +0.92% +0.95%ExpectedDefaultRate: 0% 0% 0% 0%
2 Since2003,ourrealyieldsarebasedontheconstantmaturityTIPSyieldscalculatedbytheFederalReserveformaturitieslongerthan2years.Priorto2003,inordertocalculaterealyieldsweadjustedtheapplicableyieldwiththeprior12‐monthcoreCPIindex.Forexample,fora5‐yearTreasurybond,wecalculateahistoricalrealyieldseriesbysubtractingprior12‐monthcoreCPIfromhistorical5‐yearTreasurybondyieldspriorto2003,andbyusingthethen‐current5‐yearTIPSbreakevenyieldafter2003.Becauseofitslowervolatility,thecoreCPIindexhasprovenabetterpredictorofsubsequentCPIinflationthanhastheCPIindexitself.
8
![Page 10: 2018 Capital Market Assumptions - Sellwood Consulting LLC · Emerging Markets Equity ... not to rely only on mean‐variance analysis when constructing portfolios. ... horizons. For](https://reader031.fdocuments.in/reader031/viewer/2022030815/5b24cb327f8b9a10578b4b1e/html5/thumbnails/10.jpg)
Foreachassumptionweaddourinflationassumptiontotheexpectedannualizedcompoundreturn.Basedonthiscalculationwearriveatthefollowingcompoundreturnassumptions: Ourprojectednominal10‐yearannualizedreturnforeachTreasuryBondis:
2Year 5Year 10Year 20Year2.28% 2.29% 2.01% 1.62%
2-Year Treasurys -- Total ReturnYear 0 1 2 3 4 5 6 7 8 9 10 Cumulative AnnualizedStarting Real Yield 0.12% 0.20% 0.27% 0.34% 0.42% 0.49% 0.57% 0.64% 0.71% 0.79% 0.86%Duration 1.86 1.86 1.86 1.86 1.86 1.86 1.86 1.86 1.86 1.86 1.86 Parallel Yield Change 0.07% 0.07% 0.07% 0.07% 0.07% 0.07% 0.07% 0.07% 0.07% 0.07% 0.74%12-month return -0.01% 0.06% 0.13% 0.21% 0.28% 0.35% 0.43% 0.50% 0.58% 0.65%Compound Factor 99.99% 100.06% 100.13% 100.21% 100.28% 100.35% 100.43% 100.50% 100.58% 100.65% 3.22% 0.32%
market 10-year inflation 1.96%
nominal 10-yr annualized return 2.28%
5-Year Treasurys -- Total Return
Year 0 1 2 3 4 5 6 7 8 9 10 Cumulative AnnualizedStarting Real Yield 0.34% 0.42% 0.51% 0.59% 0.67% 0.76% 0.84% 0.92% 1.01% 1.09% 1.17%Duration 4.67 4.67 4.67 4.67 4.67 4.67 4.67 4.67 4.67 4.67 4.67
Parallel Yield Change 0.08% 0.08% 0.08% 0.08% 0.08% 0.08% 0.08% 0.08% 0.08% 0.08% 0.83%
12-month return -0.05% 0.03% 0.12% 0.20% 0.28% 0.37% 0.45% 0.53% 0.62% 0.70%
Compound Factor 99.95% 100.03% 100.12% 100.20% 100.28% 100.37% 100.45% 100.53% 100.62% 100.70% 3.30% 0.33%market 10-year inflation 1.96%
nominal 10-yr annualized return 2.29%
10-Year Treasurys -- Total ReturnYear 0 1 2 3 4 5 6 7 8 9 10 Cumulative AnnualizedStarting Real Yield 0.44% 0.53% 0.62% 0.72% 0.81% 0.90% 0.99% 1.08% 1.17% 1.27% 1.36%Duration 8.77 8.77 8.77 8.77 8.77 8.77 8.77 8.77 8.77 8.77 8.77 Parallel Yield Change 0.09% 0.09% 0.09% 0.09% 0.09% 0.09% 0.09% 0.09% 0.09% 0.09% 0.92%12-month return -0.36% -0.27% -0.18% -0.09% 0.00% 0.09% 0.19% 0.28% 0.37% 0.46%Compound Factor 99.64% 99.73% 99.82% 99.91% 100.00% 100.09% 100.19% 100.28% 100.37% 100.46% 0.48% 0.05%
market 10-year inflation 1.96%
nominal 10-yr annualized return 2.01%
20-Year Treasurys -- Total ReturnYear 0 1 2 3 4 5 6 7 8 9 10 Cumulative AnnualizedStarting Real Yield 0.61% 0.70% 0.80% 0.89% 0.99% 1.08% 1.18% 1.27% 1.37% 1.46% 1.56%Duration 14.50 14.50 14.50 14.50 14.50 14.50 14.50 14.50 14.50 14.50 14.50 Parallel Yield Change 0.09% 0.09% 0.09% 0.09% 0.09% 0.09% 0.09% 0.09% 0.09% 0.09% 0.95%12-month return -0.77% -0.67% -0.58% -0.48% -0.39% -0.29% -0.20% -0.10% -0.01% 0.09%Compound Factor 99.23% 99.33% 99.42% 99.52% 99.61% 99.71% 99.80% 99.90% 99.99% 100.09% -3.34% -0.34%
market 10-year inflation 1.96%
nominal 10-yr annualized return 1.62%
9
![Page 11: 2018 Capital Market Assumptions - Sellwood Consulting LLC · Emerging Markets Equity ... not to rely only on mean‐variance analysis when constructing portfolios. ... horizons. For](https://reader031.fdocuments.in/reader031/viewer/2022030815/5b24cb327f8b9a10578b4b1e/html5/thumbnails/11.jpg)
CashEquivalentsModeled:91‐DayT‐Bills
CompoundReturn:1.79%ArithmeticAverageReturn:1.80%
Risk:1.00%WeusethemodeloutlinedaboveforCashEquivalents.Assumptions(91‐DayT‐Bills):
Maturity: 91daysDuration: 0.25yearsCurrentRealYield: ‐0.44%Long‐TermAverageRealYield: 0.82%CumulativeYieldChange(10Years): +0.63%(halfwayfromcurrenttolong‐termaverage)ExpectedDefaultRate: 0%
Theseassumptionsyieldanominalcompoundreturnexpectationof1.79%:
Wecautionthatthereisaninherentproblemwithforecastinga10‐yearreturnforanassetthatmaturesevery91days.Nominalcashreturnsarehighlysensitivetonominalshort‐terminterestrates,whichweexpecttobeasvariableoverthenextdecadeastheyhavebeenhistorically.Asillustratedinthechartbelow,whileinvestorstypicallydemandapositiverealyieldfromcash,periodsofnegativerealreturntocashhaveexistedforconsiderableperiodsoftime–includingthemostrecentperiodsince2008.Ourriskassumptionreflectsanappropriaterangeofuncertaintyaroundourreturnprojectionforcashequivalents.
91-Day T-Bills -- Total ReturnYear 0 1 2 3 4 5 6 7 8 9 10 Cumulative AnnualizedStarting Real Yield -0.44% -0.37% -0.31% -0.25% -0.19% -0.12% -0.06% 0.00% 0.07% 0.13% 0.19%Duration 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 Parallel Yield Change 0.06% 0.06% 0.06% 0.06% 0.06% 0.06% 0.06% 0.06% 0.06% 0.06% 0.63%12-month return -0.45% -0.39% -0.33% -0.26% -0.20% -0.14% -0.08% -0.01% 0.05% 0.11%Compound Factor 99.55% 99.61% 99.67% 99.74% 99.80% 99.86% 99.92% 99.99% 100.05% 100.11% -1.69% -0.17%
market 10-year inflation 1.96%
nominal 10-yr annualized return 1.79%
‐6%
‐1%
4%
9%
14%
19%
24%
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
2016
Historical RealCashYieldRealCashYield
FederalFundsRate
10
![Page 12: 2018 Capital Market Assumptions - Sellwood Consulting LLC · Emerging Markets Equity ... not to rely only on mean‐variance analysis when constructing portfolios. ... horizons. For](https://reader031.fdocuments.in/reader031/viewer/2022030815/5b24cb327f8b9a10578b4b1e/html5/thumbnails/12.jpg)
Low‐DurationFixedIncomeModeled:1‐3YearAggregateFixedIncome
CompoundReturn:2.55%ArithmeticAverageReturn:2.60%
Risk:3.00%OurLow‐DurationFixedIncomeassumptionreflectsa50%proportiontoboththe2‐YearTreasuryBondandcorporatebonds.Forhalftheassumedportfolio,then,weaddtoour2‐YearTreasurybondreturnexpectationaspreadfor1‐3yearcorporatebonds:Assumptions:
ProportioninCorporates: 50%SpreadDuration: 1.55yearsCurrentSpread: 0.52%Long‐TermAverageSpread: 1.27%CumulativeSpreadChange(10Yrs): +0.38%(halfwayfromcurrenttolong‐termaverage)
Finally,wemakeassumptionsfortheexpecteddefaultrateandrecoveryratefordefaulted1‐3yearcorporatesecurities.Thesecalculationsonlyapplytotheproportionoftheassumptionpertainingtocorporatesecurities.Thefollowingfiguresrepresentthehistoricalaveragefortheassetclass:Assumptions:
ExpectedDefaultRate: 0.15%ExpectedDefaultRecoveryRate: 44%Default/RecoveryReturnContribution: ‐0.08%Multipliedby0.5(halfofportfolio); ‐0.04%
Insummary,ourreturnassumptionforlow‐durationfixedincomebuildsupseveralsourcesofreturn:
2‐YearTreasuryReturn 2.28%SpreadEffect +0.32%DefaultEffect ‐0.04%ReturnAssumption 2.55%3
3Afterrounding.
1-3 Year Corporates -- Spread Effect (over Treasurys) Year 0 1 2 3 4 5 6 7 8 9 10 Cumulative AnnualizedStarting Spread 0.52% 0.56% 0.60% 0.63% 0.67% 0.71% 0.75% 0.78% 0.82% 0.86% 0.90%Duration 1.55 1.55 1.55 1.55 1.55 1.55 1.55 1.55 1.55 1.55 1.55 Parallel Yield Change 0.04% 0.04% 0.04% 0.04% 0.04% 0.04% 0.04% 0.04% 0.04% 0.04% 0.38%12-month return 0.46% 0.50% 0.54% 0.57% 0.61% 0.65% 0.69% 0.72% 0.76% 0.80%
Compound Factor 100.46% 100.50% 100.54% 100.57% 100.61% 100.65% 100.69% 100.72% 100.76% 100.80% 6.49% 0.63%
Proportion 50.00%
Spread Effect (Total) 0.32%
11
![Page 13: 2018 Capital Market Assumptions - Sellwood Consulting LLC · Emerging Markets Equity ... not to rely only on mean‐variance analysis when constructing portfolios. ... horizons. For](https://reader031.fdocuments.in/reader031/viewer/2022030815/5b24cb327f8b9a10578b4b1e/html5/thumbnails/13.jpg)
Combiningthe2‐YearTreasuryBondreturnandtheexpectedreturnfromspread,andthensubtractingtheexpecteddefaultrateafteradjustingforrecovery,yieldsourreturnassumptionof2.55%incompoundterms.CoreFixedIncome
Modeled:USInvestment‐GradeAggregateandHedgedNon‐USAggregateFixedIncomeCompoundReturn:2.57%
ArithmeticAverageReturn:2.70%Risk:5.00%
Thebaselevelofourbuilding‐blockapproachforCoreFixedIncomeisthe5‐YearTreasuryBond,outlinedabove.Tothisexpectedreturn,weaddanexpectationforspreadreturn:
SpreadDuration: 3.35yearsCurrentSpread(BCAggregate): 0.36%Long‐TermAverageSpread: 0.55%CumulativeSpreadChange(10Yrs): +0.10%(halfwayfromcurrenttolong‐termaverage)
Ourassumptionsfordefaultandrecoveryratesareinlinewithhistory.Wesubtractadefaultcontributionbasedontheseinputvariables:Assumptions:
ExpectedDefaultRate: 0.15%ExpectedDefaultRecoveryRate: 44%Default/RecoveryReturnContribution: ‐0.08%
Insummary:
5‐YearTreasuryReturn 2.29%SpreadEffect +0.37%DefaultEffect ‐0.08%ReturnAssumption 2.57%
Addingthe5‐YearUSTreasuryBondreturn,theexpectedspreadreturn,andadjustingfordefaultsyieldsacompoundreturnexpectationof2.57%.
BC Aggregate -- Spread Effect (over Treasurys) Year 0 1 2 3 4 5 6 7 8 9 10 Cumulative AnnualizedStarting Spread 0.36% 0.37% 0.38% 0.39% 0.40% 0.41% 0.42% 0.43% 0.44% 0.45% 0.46%Duration 3.35 3.35 3.35 3.35 3.35 3.35 3.35 3.35 3.35 3.35 3.35 Parallel Yield Change 0.01% 0.01% 0.01% 0.01% 0.01% 0.01% 0.01% 0.01% 0.01% 0.01% 0.10%12-month return 0.33% 0.34% 0.35% 0.36% 0.37% 0.38% 0.39% 0.40% 0.41% 0.42%
Compound Factor 100.33% 100.34% 100.35% 100.36% 100.37% 100.38% 100.39% 100.40% 100.41% 100.42% 3.78% 0.37%
Proportion 100.00%
Spread Effect (Total) 0.37%
12
![Page 14: 2018 Capital Market Assumptions - Sellwood Consulting LLC · Emerging Markets Equity ... not to rely only on mean‐variance analysis when constructing portfolios. ... horizons. For](https://reader031.fdocuments.in/reader031/viewer/2022030815/5b24cb327f8b9a10578b4b1e/html5/thumbnails/14.jpg)
WebelievethatthisapproachworksequallywellforUSAggregatefixedincomeandforNon‐USAggregatefixedincomewherethecurrencyexposureishedgedbacktotheUSdollar.Bystrippingoutcurrencyexposure,theNon‐USfixedincomeinvestorisleftwithaportfoliooffixedincomesecuritiesexpectingsimilarunderlyingcharacteristicstotheUSfixedincomeportfolio.Non‐CoreFixedIncome
Modeled:USandNon‐USBelow‐Investment‐Grade&EmergingMarketsFixedIncomeCompoundReturn:2.58%
ArithmeticAverageReturn:3.50%Risk:14.25%
OurNon‐CoreFixedIncomeassumptioncombinesUSbelow‐investment‐grade(highyield)bondsandemergingmarketssovereignbonds.Weassumea50%weightingtoeachassetclass.Thematurityofthehigh‐yieldindexiscurrently6.3years.Tomatchthismaturity,weassumethereturnforasynthetic6.3‐yearTreasurybondbyappropriatelyweightingtheexpectedreturnswecalculatedforthe5‐and10‐yearTreasurybonds.Thecurrentmaturityofanindexofemergingmarketssovereignbondsis11.7years.Tomatchthisduration,wecalculateaspreadoveraweightedaverageofexpectedreturnsfor10‐and20‐yearUSTreasuryBondsthatyieldsanexpectedreturnfora11.7‐yearTreasuryBond.Totheseexpectedreturns,wethenaddaspreadbuildingblock,andfinallysubtractadefaultbuildingblock. HighYieldBonds EmergingMarketDebt
Maturity: 6.3years 11.7years6.3‐YearTreasuryAssumedReturn: 2.21% 1.94%SpreadDuration: 3.74years 7.05yearsCurrentSpread: 3.63% 2.75%Long‐TermAverageSpread: 5.74% 3.52%CumulativeSpreadChange(10Yrs): +1.05% 0.39%
High Yield -- Spread Effect (over Treasurys) Year 0 1 2 3 4 5 6 7 8 9 10 Cumulative AnnualizedStarting Spread 3.63% 3.74% 3.84% 3.95% 4.05% 4.16% 4.26% 4.37% 4.47% 4.58% 4.68%Duration 3.74 3.74 3.74 3.74 3.74 3.74 3.74 3.74 3.74 3.74 3.74 Parallel Yield Change 0.11% 0.11% 0.11% 0.11% 0.11% 0.11% 0.11% 0.11% 0.11% 0.11% 1.05%12-month return 3.24% 3.34% 3.45% 3.55% 3.66% 3.76% 3.87% 3.97% 4.08% 4.18%
Compound Factor 103.24% 103.34% 103.45% 103.55% 103.66% 103.76% 103.87% 103.97% 104.08% 104.18% 43.94% 3.71%
Proportion 50.00%
Spread Effect (Total) 1.85%
EMD -- Spread Effect (over Treasurys)Year 0 1 2 3 4 5 6 7 8 9 10 Cumulative AnnualizedStarting Spread 2.75% 2.79% 2.83% 2.86% 2.90% 2.94% 2.98% 3.02% 3.06% 3.10% 3.14%Duration 7.05 7.05 7.05 7.05 7.05 7.05 7.05 7.05 7.05 7.05 7.05 Parallel Yield Change 0.04% 0.04% 0.04% 0.04% 0.04% 0.04% 0.04% 0.04% 0.04% 0.04% 0.39%12-month return 2.47% 2.51% 2.55% 2.59% 2.63% 2.67% 2.71% 2.75% 2.78% 2.82%
Compound Factor 102.47% 102.51% 102.55% 102.59% 102.63% 102.67% 102.71% 102.75% 102.78% 102.82% 29.87% 2.65%
Proportion 50.00%
Spread Effect (Total) 1.32%
13
![Page 15: 2018 Capital Market Assumptions - Sellwood Consulting LLC · Emerging Markets Equity ... not to rely only on mean‐variance analysis when constructing portfolios. ... horizons. For](https://reader031.fdocuments.in/reader031/viewer/2022030815/5b24cb327f8b9a10578b4b1e/html5/thumbnails/15.jpg)
Ourassumedreturncontributionfromourspreadbuildingblockapproach,beforeaccountingfordefaults,is(assuming50%oftheportfolioforeachassetclass):
HighYieldBonds EmergingMarketDebt1.85% 1.32%
Ourfinalbuildingblockisanadjustmentforexpecteddefaultandrecoveryrates.Thequalitycompositionoftheemergingmarketsdebtuniversehaschangedovertime,sowedonotapplyhistoricaluniverse‐widedefaultandrecoveryrates.Instead,weexaminethehistoricaldefaultandrecoveryratesbybondqualityratingandapplythoseratestothecurrentuniversequalitycomposition.Historically,investment‐gradeemergingmarketsissueshaveexperienced1.7%defaultrates.Speculative‐gradeemergingmarketsissueshaveexperienced18.3%defaultrates.Theuniverseiscurrently48%investmentgradeand52%speculativegrade;applyingtheseproportionsresultsinanexpecteddefaultrateof10.4%.Historicalrecoveryratesindefault,regardlessofrating,hasbeen65%.
ExpectedDefaultRate: 10.4% ExpectedDefaultRecoveryRate: 65%
Wesubtracttheexpectedunrecovereddefaultfromthetotalyield:
DefaultRate
RecoveryRate
UnrecoveredRate
DefaultEffectonReturn
HighYield 2.8% 38% 62% ‐1.74%EMDebt 10.4% 65% 35% ‐3.62%Insummary: HighYield EMDebt Combined
TreasuryReturn 2.21% 1.94% ‐‐‐SpreadEffect +3.71% +2.65% ‐‐‐DefaultEffect ‐1.74% ‐3.62% ‐‐‐ReturnAssumption 4.18% 0.97% 2.58%WeaveragetheHighYieldandEmergingMarketsDebtassumptionstoarriveatourforward‐lookingcompoundreturnexpectationfornon‐corefixedincome:2.58%.Core‐PlusFixedIncome
Modeled:80%USInvestment‐GradeAggregate;20%Non‐CorePlusSectorsCompoundReturn:2.58%
ArithmeticAverageReturn:2.70%Risk:5.25%
Thisreturnassumptionexpectsareturncalculatedasfollows:
14
![Page 16: 2018 Capital Market Assumptions - Sellwood Consulting LLC · Emerging Markets Equity ... not to rely only on mean‐variance analysis when constructing portfolios. ... horizons. For](https://reader031.fdocuments.in/reader031/viewer/2022030815/5b24cb327f8b9a10578b4b1e/html5/thumbnails/16.jpg)
80%oftheexpectedreturnofCoreFixedIncome(2.57%) +20%oftheexpectedreturnofNon‐CoreFixedIncome(2.58%)Thisprocessyieldsanexpectedcompoundreturnof2.58%.Long‐DurationFixedIncome
Modeled:USLong‐TermGovernment/CreditFixedIncomeCompoundReturn:2.47%
ArithmeticAverageReturn:3.00%Risk:10.25%
Ourmodelassumes50%eachin(i)10‐and20‐YearUSTreasuryBondsand(ii)long‐durationUSinvestment‐gradecorporatebonds.Whilethecompositionofsomelong‐durationfixedincomeindexesdiffersslightlyfromthisapproach,webelievethatmostdifferenceswillcanceleachotherout.
TreasuryComponent
FortheTreasurycomponent,weuseourbasicmodeltoaveragetheexpectedreturnsfor10‐and20‐yearTreasuryBonds(outlinedabove)toapproximatethereturnofa15‐yearTreasuryBond.ThisaverageexpectedreturnfortheTreasurycomponentis1.81%.
SpreadComponent
Weaddaspreadcomponentconsistingoflong‐termUSinvestment‐gradecorporatebonds:
Assumptions:
ProportioninCorporates: 50%SpreadDuration: 13.90yearsCurrentSpread: 1.50%Long‐TermAverageSpread: 1.75%CumulativeSpreadChange(10Yrs): 0.12%(halfwayfromcurrenttolong‐termaverage)ExpectedDefaultRate: 0.15% ExpectedDefaultRecoveryRate: 44%
Long Corporates -- Spread Effect (over Treasurys) Year 0 1 2 3 4 5 6 7 8 9 10 Cumulative AnnualizedStarting Spread 1.50% 1.51% 1.52% 1.54% 1.55% 1.56% 1.57% 1.59% 1.60% 1.61% 1.62%Duration 13.90 13.90 13.90 13.90 13.90 13.90 13.90 13.90 13.90 13.90 13.90 Parallel Yield Change 0.01% 0.01% 0.01% 0.01% 0.01% 0.01% 0.01% 0.01% 0.01% 0.01% 0.12%12-month return 1.33% 1.34% 1.35% 1.37% 1.38% 1.39% 1.40% 1.42% 1.43% 1.44%
Compound Factor 101.33% 101.34% 101.35% 101.37% 101.38% 101.39% 101.40% 101.42% 101.43% 101.44% 14.74% 1.38%
Proportion 50.00%
Spread Effect (Total) 0.69%
15
![Page 17: 2018 Capital Market Assumptions - Sellwood Consulting LLC · Emerging Markets Equity ... not to rely only on mean‐variance analysis when constructing portfolios. ... horizons. For](https://reader031.fdocuments.in/reader031/viewer/2022030815/5b24cb327f8b9a10578b4b1e/html5/thumbnails/17.jpg)
Insummary:
TreasuryReturn 1.81%(averageof10‐and20‐yearTreasurys)SpreadEffect +0.69%(50%proportion)DefaultEffect ‐0.04%(50%proportion)ReturnAssumption 2.47%
USTreasuryInflationProtectedSecurities(TIPS)
Modeled:USTIPSCompoundReturn:2.12%
ArithmeticAverageReturn:2.30%Risk:6.25%
GiventhatthefirstUSTIPSissuancewasin1997,wearehesitanttorelyonany“long‐term”yieldorspreadaveragestofurthermodeltheassetclass.Instead,wemodelaproxyfortheBloombergBarclaysUSTIPSIndex,whichcurrentlyhasamaturityof7.9years.Aportfolioof42%5‐yearTreasuryBonds,and58%10‐yearTreasurybondsresultsinahypotheticalTreasurybondwith7.9‐yearmaturity.Assumingourinflationexpectationof1.96%peryearfortheprospective10‐yearperiod,theexpectedTIPSreturnissimplyaweightedaverageofourreturnexpectationsforthenominal5‐yearand10‐yearTreasurybonds.Applyingtheseweightstoourreturnprojectionsforthosebondsresultsina10‐yearTIPSreturnassumptionof2.12%:
(42%x2.29%)+(58%x2.01%)=2.12%.Short‐TermUSTreasuryInflationProtectedSecurities(TIPS)
Modeled:Short‐TermUSTIPSCompoundReturn:2.28%
ArithmeticAverageReturn:2.30%Risk:3.75%
WeemployasimilarprocesstoourTIPScalculationforourShort‐TermTIPSassumption,althoughwemodelaproxyfortheBloombergBarclaysUS0‐5YearTIPSIndex,whichcurrentlyhasamaturityof2.5years.Aportfolioof85%2‐yearTreasuryBondsand15%5‐yearTreasurybondsresultsinahypotheticalTreasurybondwith2.5‐yearmaturity.Assumingourinflationexpectationof1.96%peryearfortheprospective10‐yearperiod,theexpectedShort‐TermTIPSreturnissimplyaweightedaverageofourreturnexpectationsforthenominal2‐yearand5‐yearTreasurybonds.Applyingtheseweightstoourreturnprojectionsforthosebondsresultsina10‐yearShort‐TermTIPSreturnassumptionof2.28%:
(85%x2.28%)+(15%x2.29%)=2.28%.
16
![Page 18: 2018 Capital Market Assumptions - Sellwood Consulting LLC · Emerging Markets Equity ... not to rely only on mean‐variance analysis when constructing portfolios. ... horizons. For](https://reader031.fdocuments.in/reader031/viewer/2022030815/5b24cb327f8b9a10578b4b1e/html5/thumbnails/18.jpg)
EQUITYToderiveourequityreturnassumptions,weusetwomethodologies:(i) abuilding‐blockapproachusingtheso‐calledShillerprice‐to‐earnings(P/E)measure;and(ii) anequityriskpremiumestimatethataveragesthecurrentimpliedequityriskpremium
basedonafreecashflowtoequitymodelandthehistoricalaverageequityriskpremium. EquityRiskPremium/BuildingBlockApproachFreeCashFlowtoEquityModel
WhereourbuildingblockscallforaP/Emeasure,weassumethatthiscurrentvaluationmetricwillreverthalfwaytoitslong‐termmeanovertheprospectiveten‐yearperiod.Ourapproachemploys“Shillerearnings,”whichrepresentaten‐yearaverage,adjustedforinflation.Webelievethatthisapproachappropriatelysmoothestheimpactofyear‐to‐yearearningsvolatility,andresearchshowsthatofallthevariedwaystocalculateaP/Eratio,theShillerP/Emeasurehashistoricallyshownthehighestpredictivepoweroverfuture10‐yearreturns.4Ourbuildingblockapproachisconsistentacrossequitycategories:
Assumed(Expected)USInflation+CurrentDividendYield+ExpectedRealEarningsGrowth+ReversioneffectofP/E(halfwaytolong‐termmean,over10years)
TheseinputsareavailablewithreliableandrobustdatafortheUSlarge‐capstockmarket,butnotforUSsmall‐capequitiesorforglobalequities.Forthisreason,wehavechosentoanchorourUSsmall‐capandglobalequityassumptionstoourUSlarge‐capequityassumptioninseveralways.
4 Vanguard.Forecastingstockreturns:Whatsignalsmatter,andwhatdotheysaynow?https://personal.vanguard.com/pdf/s338.pdf
CurrentDividendYield
ExpectedReal EarningsGrowth
Inflation
(+/‐)P/EReversionEffect
EquitySecurityReturn
CapitalizationPremiumImpliedEquityRiskPremium
Expected10‐YearTreasuryReturn
17
![Page 19: 2018 Capital Market Assumptions - Sellwood Consulting LLC · Emerging Markets Equity ... not to rely only on mean‐variance analysis when constructing portfolios. ... horizons. For](https://reader031.fdocuments.in/reader031/viewer/2022030815/5b24cb327f8b9a10578b4b1e/html5/thumbnails/19.jpg)
USLarge‐CapEquityModeled:USMid‐andLarge‐CapitalizationEquities
CompoundReturn:4.48%ArithmeticAverageReturn:6.10%
Risk:18.75%OurreturnassumptionsforUSlarge‐capequityaretheaverageoftwoseparateapproaches:(i) avaluation‐basedbuilding‐blockapproachand;(ii) afreecashflowtoequitymodel.
BuildingBlockApproachWefindtheShillerP/Emetrictobethemostusefulofvariousvaluationmetricsfromtheperspectiveofutilityinforecastingreturns.ThefollowingchartdepictstheShillerP/EmetricfortheUSmarket,since1951(thepost‐WWIIperiod).TheShillerP/Eatagivenpointintimeisdepictedonthehorizontalaxis,andthesubsequent10‐yearinflation‐adjustedreturnisdepictedontheverticalaxis.Wehavedecomposedthedataarrayintothreeeconomicregimes–thepost‐warboom(inblue;1951‐1965);thegreatinflationaryperiod(intan;1966‐1984);andthegreatmoderation(ingrey;1985‐2017).Examiningthedatathiswayyieldsusefulinsightsand,importantly,highpredictivepowerfortheShillerP/Emetricoversubsequentrealreturn.TheS&P500’scurrentpositiononthechartisindicatedbytheboldverticalline.
R²=0.878
R²=0.880
R²=0.8744
‐10%
‐5%
0%
5%
10%
15%
20%
0 5 10 15 20 25 30 35 40 45 50
Subsequent10‐YearRealReturn
Starting‐PointShillerP/EValuation
Long‐TermShillerP/Eversus10‐yrInflation‐AdjustedReturnsByEconomicRegime,Since1951(Postwarperiod)
CurrentValue PostwarBoom GreatInflation GreatModeration
18
![Page 20: 2018 Capital Market Assumptions - Sellwood Consulting LLC · Emerging Markets Equity ... not to rely only on mean‐variance analysis when constructing portfolios. ... horizons. For](https://reader031.fdocuments.in/reader031/viewer/2022030815/5b24cb327f8b9a10578b4b1e/html5/thumbnails/20.jpg)
Forthevaluation‐basedbuildingblockapproachcomponentofUSLarge‐CapEquityreturn,wecreateourbuildingblocksfromtheS&P500Index:
1.96% Inflation 1.84% CurrentDividendYield 1.53% Long‐TermCompoundAverageRealEarningsGrowth(Since1871) Forthevaluationbuildingblock,wemeasureexpectedP/Ereversionhalfwaytolong‐termmean: ShillerP/E Current 32.25
Long‐TermAverage 16.81 AnnualReversionEffect ‐3.15% (halfwaytolong‐termaverage)
ThebuildingblocksapproachresultsinanexpectedcompoundreturnforUSLarge‐CapEquityof2.17%.ThisapproachrepresentshalfofourcalculationforLarge‐CapUSEquity.EquityRiskPremium/DiscountedFreeCashFlowModelFortheimpliedequityriskpremium,wereferenceandmodifyadiscountedfreecashflowmodelcreatedbyProfessorAswathDamodaranoftheSternSchoolofBusiness5thatusesafreecashflowtoequityapproachtoaccountfordividendsaswellasstockbuybacks.Ourmodifiedfree‐cash‐flow‐to‐equitymodelemploysseveralinputvariables:Beginning(current)S&P500level= 2,673.61Baseyearfreecashflowtoequity,S&P500= $108.286ExpectedS&P500earningsgrowthovernext5years= 6.10%7ExpectedS&P500earningsgrowthforyears5‐10= 2.01%8WeapplyastandarddiscountedcashflowmethodologytothesevariablesandsolvefortherateofgrowththatmakesthediscountedforecastedvalueoftheS&P500identicaltotoday’svalue.
2,673.61108.28 1.061
1108.28 1.061
1108.287 1.061
1108.28 1.061
1108.28 1.061
1108.28 1.061 1.0201
0.0201 1
SolvingforryieldstheexpectednominalreturnfortheS&P500overthenext10years,undertheseassumptions.Thatrateofreturnis6.95%.Subtractingourassumed10‐YearTreasuryreturnof2.01%resultsinanexpectedequityriskpremiumof4.95%.
5 http://pages.stern.nyu.edu/~adamodar/ 62017S&P500Dividends=$48.12+buybacks=$60.16.7I/B/E/Sanalystconsensusearningsgrowthoverthenextyearis7.05%.Historically,theI/B/E/Sconsensusanalystforecasthasoverstatedsubsequentactualearningsgrowthby15.6%.Wereduceourassumptionforearningsgrowthby13.5%(1‐(1/1.156))accordingly.
8 Ourforecastedreturnforthe10‐yearTreasuryBond,asaproxyfortheten‐yearrisk‐freerate.
19
![Page 21: 2018 Capital Market Assumptions - Sellwood Consulting LLC · Emerging Markets Equity ... not to rely only on mean‐variance analysis when constructing portfolios. ... horizons. For](https://reader031.fdocuments.in/reader031/viewer/2022030815/5b24cb327f8b9a10578b4b1e/html5/thumbnails/21.jpg)
Thisimpliedequityriskpremiumishigherthanwhathistoryhasdelivered.Tocorrectforthis,weaveragethecurrentimpliedforward‐lookingequityriskpremium(4.95%)andthelong‐termhistoricalgeometricaveragerealizedequityriskpremium(4.62%)toderiveanequityriskpremiumestimateof4.78%forUSLarge‐CapEquity.Substitutingthisassumedequityriskpremiumintothemodelresultsinareturnestimateof6.79%.CombiningtheTwoApproachesAveragingtheexpectedreturnsgeneratedbythebuilding‐blocksapproachandthediscountedfreecashflowmodelyieldsanexpectedcompoundreturnof4.48%.USSmall‐CapEquity
Modeled:USSmall‐CapitalizationEquitiesCompoundReturn:4.25%
ArithmeticAverageReturn:6.10%Risk:20.00%
OurreturnassumptionforUSSmall‐CapEquityusesasimilarbuildingblocksapproachasourapproachforUSLarge‐Cap.Becausedataismuchmorelimitedforsmall‐capequitiesthanforlarge‐capequities,weevaluatesmall‐capequitiesrelativetolarge‐capequitiesratherthanrelativetotheirownhistory.ForUSSmall‐CapEquity,wecomparethebuild‐upmethodfortheRussell2000IndexandS&P500Indexoverthelongestcommontimeperiodforthetwoindexes(1979‐2017).Thebuild‐upmethodisonlyhalfofourUSLarge‐CapEquityassumedreturn,sowedividethepremiuminhalfandaddorsubtractitfromourfinalUSLarge‐CapEquityreturn.Whileourassumptionmodelsthefulluniverseofsmall‐capstocks,thedataweuseexcludescompanieswithnegativeearnings.Ouranalysishasshownthat,ascomparedtousingthedatafromthefulluniverseofsmall‐capstocks,usingthedatasetthatexcludesnegativeearnershasyieldedhigherpredictivepoweroverfuturereturnsofthefullindex,whichincludesthenegativeearners.OurbuildingblocksforUSSmall‐CapEquityareasfollows:
1.96% Inflation 1.25% CurrentDividendYield 2.47% Long‐TermRealEarningsGrowth WemeasureexpectedP/Ereversionhalfwaytolong‐termmean: ShillerP/E Current 31.20
Long‐TermAverage 21.63 AnnualReversionEffect ‐1.80% (halfwaytolong‐termaverage)
20
![Page 22: 2018 Capital Market Assumptions - Sellwood Consulting LLC · Emerging Markets Equity ... not to rely only on mean‐variance analysis when constructing portfolios. ... horizons. For](https://reader031.fdocuments.in/reader031/viewer/2022030815/5b24cb327f8b9a10578b4b1e/html5/thumbnails/22.jpg)
Thebuild‐upapproachresultsinanexpectedcompoundreturnforUSSmall‐CapEquityof1.92%,anegativepremiumof0.76%relativetoUSLarge‐CapEquityusingasimilarmethodologyoverthelongestcommontimeperiod(1988‐2017)forwhichwehavereliabledata. USLarge‐CapBuild‐up 2.69% USSmall‐CapBuild‐up 1.92% Small‐CapPremium ‐0.76%
Since1994,thisapproachhassystematicallyunderstatedsubsequent10‐yearreturnstosmall‐capstocks,by0.30%peryear:
Toaccountforthisbias,wetakethedifferencebetweenthemodel’scurrentpredictedpremium(‐0.76%)andthelong‐termaveragepredictedpremium(‐0.30%)andapplyonlythedifferential.Then,weaddonlyhalfofthatdifferentialtoourassumptionforUSLarge‐CapEquities,becausethebuilding‐blockscalculationitselfrepresentedonlyhalfofourcalculationofUSLarge‐CapEquityreturn.
USLarge‐CapAssumedReturn4.48% Small‐CapPremium ‐0.23%(halfofthecalculatedpremium) ReturnAssumption 4.25%Ourmodelingresultsinanegativereturnpremiumforsmall‐capstocksrelativetolarge‐capstocks.Historyhasshownthatsmall‐capstockshaveoutperformedtheirlarge‐capcounterpartsonlywhenbeginningatarelativevaluationdiscount,whichisnotthecasetoday:
‐2%
‐1%
0%
1%
2%
3%
4%
5%
6%
1993
1994
1995
1996
1996
1997
1998
1999
1999
2000
2001
2002
2002
2003
2004
2005
2005
2006
2007
2008
2008
2009
2010
2011
2011
2012
2013
2014
2014
2015
2016
2017
2017
PredictedvsActualSmall‐CapPremiumOverLarge‐Cap
Predicted(SmallCap‐LargeCap)
Actual(Small‐Large)
Predicted(SmallCap‐LargeCap)AverageSince94
21
![Page 23: 2018 Capital Market Assumptions - Sellwood Consulting LLC · Emerging Markets Equity ... not to rely only on mean‐variance analysis when constructing portfolios. ... horizons. For](https://reader031.fdocuments.in/reader031/viewer/2022030815/5b24cb327f8b9a10578b4b1e/html5/thumbnails/23.jpg)
USEquity
Modeled:USEquities,AllCapitalizationsCompoundReturn:4.46%
ArithmeticAverageReturn:6.10%Risk:18.75%
OurreturnassumptionforUSEquityisintendedtomodeltheentireUSequitymarket.Itassumesthecurrentweightingoflarge‐andsmall‐capitalizationequitiesintheUSequitymarket–92%large,and8%small9.TheseweightsareappliedtotheunderlyingUSLarge‐CapandUSSmall‐CapEquityassumptionstoyield4.46%incompoundterms:
(92%x4.48%)+(8%x4.25%)=4.46%.
Non‐USLarge‐CapEquityModeled:Non‐USLarge‐CapitalizationEquities,DevelopedandEmerging
CompoundReturn:5.80%ArithmeticAverageReturn:8.20%
Risk:23.25%Webuildseparateassumptionsfordevelopedandemergingnon‐USmarkets,andthenweighthemaccordingtocurrentmarketweightstoconstructourNon‐USLarge‐CapEquityassumption,whichisintendedtomodelequitiesofbothdevelopedandemergingmarkets.OverthelongestcommonperiodforwhichwehavebothUS(S&P500Index)andnon‐USdevelopedmarkets(MSCIEAFEIndex)earningsdata(since1993),non‐USdevelopedmarketshavegrownatonly53%timestherateofUSlarge‐capitalizationstocks,inrealterms.Weapplythis
9FTSE/Russell.
LargeCapOutperforms
SmallCapOutperforms
‐6%
‐4%
‐2%
0%
2%
4%
6%
0.4
0.5
0.6
0.7
0.8
0.9
1.0
1.1
1.2
1.3
1994
1994
1995
1996
1997
1998
1999
1999
2000
2001
2002
2003
2004
2004
2005
2006
2007
2008
2009
2009
2010
2011
2012
2013
2014
2014
2015
2016
2017
Outperformance
RealativeValue(Sm
all/Large)
RatioofUSSmall‐CaptoUSLarge‐CapShillerP/EandSubsequent10‐YearRelativePerformance
RatioofUSSmall‐CaptoUSLarge‐CapShillerP/E AverageRelativeValuation
22
![Page 24: 2018 Capital Market Assumptions - Sellwood Consulting LLC · Emerging Markets Equity ... not to rely only on mean‐variance analysis when constructing portfolios. ... horizons. For](https://reader031.fdocuments.in/reader031/viewer/2022030815/5b24cb327f8b9a10578b4b1e/html5/thumbnails/24.jpg)
proportiontoourassumedlong‐termearningsgrowthrateforUSlarge‐capitalizationstocks(1.53%)toyieldanassumednon‐USdevelopedmarketsearningsgrowthrateof0.81%.Fordevelopedmarkets,ourassumedbuildingblocksareasfollows: 1.96% Inflation 2.94% CurrentDividendYield 0.81% AdjustedCompoundAverageRealEarningsGrowth WemeasureexpectedP/Ereversionhalfwaytolong‐termmean: ShillerP/E Current 17.8
Long‐TermAverage 13.410 AnnualReversionEffect ‐1.41%(halfwaytolong‐termaverage)
Thisapproachyieldsanexpectedcompoundreturnfordeveloped‐marketsNon‐USLarge‐CapitalizationEquitiesof4.29%,apremiumof2.12%relativetoourcalculationofUSLarge‐CapEquityusingsimilarbuild‐upmethodology.
USLarge‐CapBuild‐up 2.17% Non‐USDevelopedBuild‐up 4.29% Non‐USDevelopedPremium +1.06%(assumeshalfofUSLarge‐Capapproach) USLarge‐CapAssumedReturn4.48% Non‐USDevelopedPremium +1.06% ReturnAssumption 5.54%Ouremergingmarketsequityapproachisdetailedbelow.Theassumedcompoundreturnis6.56%.Developedmarketscurrentlycomprise75%,andemergingmarkets25%,ofthenon‐UStotalequitymarketcapitalization.Applyingthoseweightstoourdevelopedandemergingmarketsassumptionsyieldsanon‐USlarge‐capitalizationcompoundreturnassumptionof5.80%. 10OverthelongestcommonperiodforwhichwehavebothUS(S&P500)andDevelopedNon‐US(MSCIEAFE)earningsseries(since1995),EAFEhastradedatanaveragevaluationlevelapproximately78%oftheleveloftheS&P500.Weapplythisfractiontoourassumptionforthelong‐termP/EofUSlarge‐capitalizationstockstoarriveatourassumedlong‐termaveragevaluationleveltowhichweexpectnon‐USlarge‐capitalizationstockstorevert.
23
![Page 25: 2018 Capital Market Assumptions - Sellwood Consulting LLC · Emerging Markets Equity ... not to rely only on mean‐variance analysis when constructing portfolios. ... horizons. For](https://reader031.fdocuments.in/reader031/viewer/2022030815/5b24cb327f8b9a10578b4b1e/html5/thumbnails/25.jpg)
Non‐USSmall‐CapEquityModeled:Non‐USSmall‐CapitalizationEquities,DevelopedandEmerging
CompoundReturn:6.05%ArithmeticAverageReturn:9.50%
Risk:28.00%
Asfarbackaswehavereliablepricedata(1994),non‐USsmall‐capstockshaveoutperformednon‐USlarge‐capstocksby0.45%peryear.ToourNon‐USLarge‐CapEquityassumption,weaddamoreconservativecompoundreturnpremiumof0.25%.Thisyieldsacompoundreturnassumptionof6.05%.Givenverylimiteddatafornon‐USsmall‐capequities,wearenotinclinedtomakeavaluationadjustmentbasedonreversiontoanaverage.EmergingMarketsEquity
Modeled:EmergingMarketsEquityCompoundReturn:6.56%
ArithmeticAverageReturn:10.30%Risk:29.25%
OurreturnassumptionforEmergingMarketsEquityisconstructedwithabuildingblocksapproach,butwithanadditionaladjustmenttothelong‐termearningsgrowthbuildingblock,givenlimiteddatahistoryforemergingmarketsstocks.OverthelongestcommonperiodforwhichwehavebothUS(S&P500Index)andemerging(MSCIEMIndex)marketsearnings(1995),emergingmarketearningshavegrownat3.08timestherateofUSlarge‐capitalizationstocks.Goingforward,wedonotexpectthisextraordinarygrowthratetocontinueindefinitelyandhavecutthelong‐termratioinhalfto1.54.Weapplythisproportiontoourassumedlong‐termearningsgrowthrateforUSlarge‐capitalizationstockstoyieldanassumedemergingmarketsearningsgrowthrateof2.35%.Ourassumedbuildingblocksareasfollows:
1.96% Inflation 2.21% CurrentDividendYield 2.35% AdjustedCompoundAverageRealEarningsGrowth(reducedby50%)
WemeasureexpectedP/Ereversionhalfwaytolong‐termmean:
ShillerP/E Current 15.0
Long‐TermAverage 14.411
11Since1995,thelongestdataseriesavailablefornon‐USmarketearnings,theaverageShillerP/Eratioforemergingmarketshasbeen18.6.Wenotethattheperiodsince1995hasgloballybeenaperiodofhighervaluationsthanhavehistoricallybeenexperienced.Forthisreason,wedonotassumethatemergingmarketsearningswillreverttotherelativelyhighlevel–instead,weassumethatemergingmarketswillcommandanaverageP/Eratio1.00higherthandevelopednon‐USmarketswill.
24
![Page 26: 2018 Capital Market Assumptions - Sellwood Consulting LLC · Emerging Markets Equity ... not to rely only on mean‐variance analysis when constructing portfolios. ... horizons. For](https://reader031.fdocuments.in/reader031/viewer/2022030815/5b24cb327f8b9a10578b4b1e/html5/thumbnails/26.jpg)
Annualreversioneffect‐0.20% (halfwaytolong‐termaverage)AddingthisP/Ereversionmeasuretotheotherbuildingblocksyieldsanexpectedcompoundreturnof6.32%,a4.15%premiumoversimilarlycalculatedUSLarge‐CapEquity:
USLarge‐CapBuild‐up 2.17% EmergingMarketsBuild‐up 6.32% EmergingMarketsPremium +4.15%AddinghalfofthispremiumtoourassumptionforUSLarge‐CapEquityyields6.56%: USLarge‐CapAssumedReturn4.48% EmergingMarketsPremium +2.08% ReturnAssumption 6.56%Non‐USEquity
Modeled:Non‐USEquities,AllRegions&CapitalizationsCompoundReturn:5.83%
ArithmeticAverageReturn:8.30%Risk:23.75%
OurreturnassumptionforNon‐USEquityisintendedtomodeltheentireNon‐USequitymarket.Itassumesthecurrentweightingoflarge‐capandsmall‐capmarketsequitiesintheinternationalequitymarket–86%large‐capand14%small‐cap12.TheseweightsareappliedtotheunderlyingNon‐USLarge‐CapEquityandNon‐USSmall‐CapEquityassumptions.Thisweightingyieldsacompoundreturnassumptionof5.83%:
(86%x5.80%)+(14%x6.05%)=5.83%.
12MSCI,MorningstarDirect
25
![Page 27: 2018 Capital Market Assumptions - Sellwood Consulting LLC · Emerging Markets Equity ... not to rely only on mean‐variance analysis when constructing portfolios. ... horizons. For](https://reader031.fdocuments.in/reader031/viewer/2022030815/5b24cb327f8b9a10578b4b1e/html5/thumbnails/27.jpg)
ALTERNATIVESAlternativeassetsshareacommonelementofnoteasilybeingmodeledwithpublic‐marketindexproxies.Aswell,wearemorereluctanttorelyontheirlong‐termhistory,givengrowthinassetsallocatedtosuchstrategiesoverthelastseveraldecadesandthedynamicnatureofstrategiesemployed.Instead,weemployabuild‐upapproachtoidentifyandmodeltheirsourcesofreturn.RealEstate
Modeled:Public(USEquityREITs)andOpen‐EndedPrivateCoreRealEstateCompoundReturn:4.57%
ArithmeticAverageReturn:6.20%Risk:19.00%
Ourexpectedreturnreflectsgoing‐incapratesforpublicequityandcoreprivaterealestate.ForpublicequityREITs,wecalculatethecurrentcaprate,definedasincomedividedbyprice,oftheFTSENAREITAllEquityREITSIndex:3.85%.ThefollowingchartdepictstheinverseofthecapratefortheequityREITbenchmark:itshistoricalprice‐to‐incomeratio.Thepresentlowcaprateisexplainedbyhighvaluationsrelativetotheindex’sownhistory.
OurcaprateassumptionforcoreprivaterealestateisbasedontheUrbanLandInstituteconsensusestimateoftheNCREIFcapitalizationrateasofDecember31,2017:5.30%incompoundterms.13Thiscapratereflectscurrentincomereturnonanunleveredbasisandexcludescapitalappreciation.
13 UrbanLandInstitute.http://uli.org/research/centers‐initiatives/center‐for‐capital‐markets/barometers‐forecast‐and‐data/uli‐real‐estate‐consensus‐forecast/
0.0
5.0
10.0
15.0
20.0
25.0
30.0
35.0
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
2015
2017
NAREITAllEquityREITSValuation:Price/12‐MonthTrailingIncome
Price/Income AveragePrice/Income
26
![Page 28: 2018 Capital Market Assumptions - Sellwood Consulting LLC · Emerging Markets Equity ... not to rely only on mean‐variance analysis when constructing portfolios. ... horizons. For](https://reader031.fdocuments.in/reader031/viewer/2022030815/5b24cb327f8b9a10578b4b1e/html5/thumbnails/28.jpg)
Averagingthesetwocapratesyieldsareturnassumptionof4.57%.Wenotethattheprimarydriverofreturnforcorerealestateoverthelongtermhasbeenincome,notappreciation.ForequityREITS,inrealtermssince1973,historicalpriceappreciationhasaveraged0.33%peryear,andincomehasaveraged3.24%peryear.DiversifiedInflation‐Related
Modeled:Diversifiedportfoliocontaining1/3each:RealEstate,Commodities,andUSTIPSCompoundReturn:3.65%
ArithmeticAverageReturn:4.60%Risk:14.50%
Weassumeadiversifiedportfoliocontaining1/3eachinUSTIPS,RealEstate,andCommodities.TheUSTIPScomponentissimplyourexpectedreturnforUSTIPS,asoutlinedabove:2.12%,incompoundterms.TheRealEstatecomponentisourRealEstateAssumption:4.57%incompoundterms.FortheCommoditiescomponent,webuildamodelassumingthatcommodityreturncanbedecomposedintothreesources:collateralreinvestmentyield,commodityspotreturn,androllyield.Weassume0%forrollyield,knowingthatithasbeenpositiveandnegativeovervarioushistoricalperiods,asthebuyingandsellingbalancebetweencommodityinvestorsandcommodityconsumershasshifted.Overthelastdecade,rollyieldhasbeennegative.Forspotreturn,wecalculateaseriesofthelast10yearsofrealpricesfortheBloombergCommodityIndexandassumethatthecurrentrealpriceoftheindexwillreverthalfwaytoits10‐yearaverage,inevenincrementsoverthenext10years.ThecurrentrealspotpricefortheBloombergCommodityIndexis85.9,andits10‐yearaveragerealpriceis139.2.Revertinghalfwaytothisaveragerealpriceimpliesacompoundrealspotreturnof2.47%peryear.Insummary,fortheCommoditiescomponent: Collateral: 1.79%(ourassumednominalreturnforCashEquivalents) Spotreturn: 2.47%(halfwaytolong‐termaverage) Rollyield: 0.00% Commodityreturn: 4.26%FortheDiversifiedInflation‐Relatedassumption,weassumeacompoundreturnof:
1/3(TIPS)+1/3(RealEstate)+1/3(Commodities)=1/3(2.12%)+1/3(4.57%)+1/3(4.26%)=3.65%
27
![Page 29: 2018 Capital Market Assumptions - Sellwood Consulting LLC · Emerging Markets Equity ... not to rely only on mean‐variance analysis when constructing portfolios. ... horizons. For](https://reader031.fdocuments.in/reader031/viewer/2022030815/5b24cb327f8b9a10578b4b1e/html5/thumbnails/29.jpg)
MarketableAlternativesModeled:HedgeFundsofFunds,GlobalGTAA,&Daily‐ValuedAlternativeStrategies
CompoundReturn:4.12%ArithmeticAverageReturn:4.80%
Risk:11.75%Weassumeadiversifiedportfoliothatwilltendtoapproximatethefollowingmarketexposuresovertime: 30%USEquity 30%Non‐USEquity 20%CoreFixedIncome 20%Non‐CoreFixedIncomeWeightingthoseassumptionsaccordinglyresultsinacompoundreturnassumptionof4.12%.Thisapproachdoesnotexplicitlyreflecttheuseofleverageinmarketablealternativesstrategies.Alternativesvehiclesthatemployleveragecanearnhigherreturns,butduetothemechanicsofperformance‐basedfeeschedules,alsosubtracthigherfeesfromthosereturns.Giventhatourassumptionsetisintendedtobepassiveinnatureandnotreflectactivemanagement,forhedgefunds,weareassuminganindustryaveragehedgefundoffunds.Non‐MarketableAlternatives
Modeled:VentureCapital,PrivateEquity,&DistressedCredit,inLockupVehiclesCompoundReturn:6.52%
ArithmeticAverageReturn:10.30%Risk:29.75%
Weassumeadiversifiedportfoliothatwilltendtoapproximatethefollowingmarketexposuresovertime,plusapremiumforilliquidity: 50%USEquity 50%Non‐CoreFixedIncome +3.00%illiquidity/leveragepremiumWeightingthoseassumptionsaccordinglyresultsinacompoundreturnassumptionof6.52%.Giventhatourassumptionsetisintendedtobepassiveinnatureandnotreflectactivemanagement,weareassuminganindustry‐averageactivemanagerorcollectionofactivemanagers.
28
![Page 30: 2018 Capital Market Assumptions - Sellwood Consulting LLC · Emerging Markets Equity ... not to rely only on mean‐variance analysis when constructing portfolios. ... horizons. For](https://reader031.fdocuments.in/reader031/viewer/2022030815/5b24cb327f8b9a10578b4b1e/html5/thumbnails/30.jpg)
RISKOurriskassumptionsaremostlyderivedfromhistory,butwehaveenhancedhistoricalmetricswithqualitativeoverlaysinseveralassetcategories.Foreachassetcategory,webeganbyexaminingthefollowinghistoricalannualreturns:Inflation USCPICashEquivalents 91‐DayT‐BillsLow‐DurationFixedIncome BloombergBarclays1‐3YearGovernment/CreditCoreFixedIncome BloombergBarclaysUSAggregateCorePlusFixedIncome 80%CoreFixedIncome,20%Non‐CoreFixedIncomeNon‐CoreFixedIncome 50%MLHighYieldMasterII,50%JPMorganEMBIbackto1994;
100%MLHighYieldMasterIIbefore1994Long‐DurationFixedIncome BloombergBarclaysLongGovernment/CreditTIPS BloombergBarclaysUSTIPSShort‐TermTIPS BloombergBarclaysUS0‐5YearTIPSUSEquity Russell3000backto1979;S&P500before1979USLarge‐CapEquity Russell1000backto1979;S&P500before1979USSmall‐CapEquity Russell2000Non‐USEquity MSCIACWIexUSIMIbackto1994;MSCIEAFEbefore1994Non‐USLarge‐CapEquity MSCIACWIexUSbackto2001;MSCIEAFEbefore2001Non‐USSmall‐CapEquity MSCIACWIexUSSmallCapEmergingMarketsEquity MSCIEmergingMarketsRealEstate FTSENAREIT,NCREIFProperty,andNCREIFODCE(separately)DiversifiedInflation‐Related 1/3each:FTSENAREIT,BloombergBarclaysUSTIPS,Bloomberg
CommodityMarketableAlternatives HFRIFundofFunds;and30%ourUSEquityseries,30%ourNon‐US
Equityseries,20%ourCoreFixedIncomeseries,and20%ourNon‐CoreFixedIncomeseries(separately)
Non‐MarketableAlternatives Averageof2xourUSEquityseriesand2xourNon‐CoreFixedIncomeseries
Ineachcase,wecalculatedthelongest‐termstandarddeviationofreturnspossibleforthecategory.Then,wecalculatedthestandarddeviationofannualreturnsoverthelasttenyears.Theaverageofthesetwofiguresrepresentsourbase‐caseriskassumption.Next,weexaminedtheworstannualreturnforeachproxyindex,goingbackasfaraspossibleintohistory.Weassumedthisreturnastheworst‐casescenario.Insomecases,thenormalreturndistributionimpliedbyourreturnandriskassumptionssuggestedthattheactualworst‐casescenariohadlessthana2%probability(1in50years)ofoccurring.Becauseweareuncomfortableassumingthatobservedrealityisunlikely,weadjustedourriskassumptionupwarduntiltheworst‐casescenariohadatleasta2%probabilityofoccurringunderourassumednormalreturndistribution.Toperformthisprobabilityanalysisforprivaterealestate,weexaminedrollingtwo‐
29
![Page 31: 2018 Capital Market Assumptions - Sellwood Consulting LLC · Emerging Markets Equity ... not to rely only on mean‐variance analysis when constructing portfolios. ... horizons. For](https://reader031.fdocuments.in/reader031/viewer/2022030815/5b24cb327f8b9a10578b4b1e/html5/thumbnails/31.jpg)
yearperiodstoaccountforthefactthatdeclines,asmeasuredbyappraisalsandilliquidity,occurmoreslowlythaninpublicmarkets.Finally,basedonthisanalysisandourqualitativeassessmentofthequalityandlongevityofourreturndata,wemadeseveralqualitativeadjustments,wherenoted.Theresultsofthisriskanalysisfollow.Thefollowingtabledepictsactualstandarddeviationsofannualreturn,measuredinthelongterm(asfarbackashistorywillallow),forthelasttenyears,andtheaverageofthosetwofigures.AddingorsubtractingourqualitativeadjustmentresultsintheRiskAssumptionatthefarright.
LongestTerm 10Years Average
QualitativeAdjustment
RiskAssumption(Rounded)
Inflation 4.90% 0.91% 2.90% 0.00% 3.00%CashEquivalents 3.30% 0.44% 1.87% ‐0.75% 1.00%Low‐DurationFixedIncome 4.61% 1.51% 3.06% 0.00% 3.00%CoreFixedIncome 6.80% 2.99% 4.90% 0.00% 5.00%Core‐PlusFixedIncome 5.27% 4.40% 4.84% 0.50% 5.25%Non‐CoreFixedIncome 12.57% 15.68% 14.13% 0.00% 14.25%Long‐DurationFixedIncome 10.91% 9.42% 10.17% 0.00% 10.25%TIPS 6.00% 6.58% 6.29% 0.00% 6.25%Short‐TermTIPS 3.76% 3.77% 3.77% 0.00% 3.75%USEquity 17.10% 19.79% 18.44% 0.25% 18.75%USLarge‐CapEquity 17.16% 19.78% 18.47% 0.25% 18.75%USSmall‐CapEquity 18.90% 20.94% 19.92% 0.00% 20.00%Non‐USEquity 22.64% 24.66% 23.65% 0.00% 23.75%Non‐USLarge‐CapEquity 22.16% 24.10% 23.13% 0.00% 23.25%Non‐USSmall‐CapEquity 25.41% 30.60% 28.01% 0.00% 28.00%EmergingMarketsEquity 33.76% 35.37% 34.57% ‐5.25% 29.25%RealEstate 18.66% 19.33% 19.00% 0.00% 19.00%DiversifiedInflation‐Related 12.26% 14.56% 13.41% 1.00% 14.50%MarketableAlternatives 9.76% 9.44% 9.60% 2.26% 11.75%Non‐MarketableAlternatives 26.61% 32.66% 29.64% 0.00% 29.75%
StandardDeviationofReturns
30
![Page 32: 2018 Capital Market Assumptions - Sellwood Consulting LLC · Emerging Markets Equity ... not to rely only on mean‐variance analysis when constructing portfolios. ... horizons. For](https://reader031.fdocuments.in/reader031/viewer/2022030815/5b24cb327f8b9a10578b4b1e/html5/thumbnails/32.jpg)
Thefollowingtableexaminestheprobabilityoftheactualexperiencedworstcaseoccurringunderourassumednormaldistributionofreturns,asimpliedbyourexpectedreturnandstandarddeviationofreturns,afteraccountingforqualitativeadjustmentstorisk.Wemeasuretheactualworst‐casescenarioin“sigmas,”orstandarddeviationsfromourassumedmeanreturn.Measuringthisway,weask,“Howlikelywastheactualexperiencedworstcase,accordingtothedistributionparameterswehaveassumed?”Wehavequalitativelyadjustedseveralassetclassestoensurethattheprobabilityoftheactuallyexperiencedworstcaseisalwaysgreaterthan2%,meaningweassumethattheexperiencedworstcasehasatleastaone‐in‐fifty‐yearchanceofhappeningunderourassumptions.Wehavemadesimilaradjustmentsforassetclasseswithlimitedreturnhistory,toensurethatourassumptionsimplythattheactualobservedworstcasewasatleasta3%probability(roughly,one‐in‐30‐yearchanceofhappening).Whenmakingqualitativeadjustmentstomeetthesecriteria,weadjustthenumbersonlyenoughtomeetthesecriteria.
ActualWorstCase,in
SigmasfromAssumption
ImpliedProbabilityofActualWorstCaseOccurring
CashEquivalents 0.02% (2011) 1.59 11.3%Low‐DurationFixedIncome 0.55% (1994) 0.67 50.3%CoreFixedIncome ‐2.92% (1994) 1.15 25.2%Core‐PlusFI ‐4.26% (1994) 1.31 19.1%Non‐CoreFixedIncome ‐18.86% (2008) 1.58 11.3%Long‐DurationFixedIncome ‐8.83% (2013) 1.16 24.6%TIPS ‐8.61% (2013) 1.74 8.3%Short‐TermTIPS ‐2.03% (2008) 1.16 24.5%USEquity ‐37.31% (2008) 2.32 2.0%USLarge‐CapEquity ‐37.60% (2008) 2.33 2.0%USSmall‐CapEquity ‐33.79% (2008) 2.00 4.5%Non‐USEquity ‐45.99% (2008) 2.30 2.2%Non‐USLarge‐CapEquity ‐45.24% (2008) 2.31 2.1%Non‐USSmall‐CapEquity ‐50.01% (2008) 2.12 3.4%EmergingMarketsEquity ‐53.33% (2008) 2.17 3.0%RealEstate ‐37.34% (1974) 2.29 2.2%DiversifiedInflation‐Related ‐28.61% (2008) 2.31 2.1%MarketableAlternatives ‐21.37% (2008) 2.20 2.7%Non‐MarketableAlternatives ‐56.17% (2008) 2.24 2.5%
AlternatebenchmarksforRealEstateandNon‐MarketableAlternatives:NCREIFProperty(2Years) ‐22.23% (2008‐9) 1.50 13.4%NCREIFODCE(2Years) ‐36.79% (2008‐9) 2.26 2.4%MarketableAlternatives(build‐up) ‐27.71% (2008) 2.74 0.6%
WorstYear
31
![Page 33: 2018 Capital Market Assumptions - Sellwood Consulting LLC · Emerging Markets Equity ... not to rely only on mean‐variance analysis when constructing portfolios. ... horizons. For](https://reader031.fdocuments.in/reader031/viewer/2022030815/5b24cb327f8b9a10578b4b1e/html5/thumbnails/33.jpg)
OurqualitativeadjustmentstoRiskwereasfollows:CashEquivalents(‐0.75%)
Whilethelong‐termstandarddeviationofreturnstocashhasbeengreaterthan3%,thatvolatilitywasexperiencedathigherlevelsofcashreturn.Webelieveitisunlikelyforthedistributionofreturnstocashequivalentstobeaswideashistoricallyobserved,givenitscurrentlowlevelofreturn.Wequalitativelyadjusttherisktocashequivalentsdownwardby75basispoints.
Core‐PlusFixedIncome(+0.50%)
Whilebecauseofdiversificationeffectslong‐termvolatilityforourmodeledCore‐PlusserieshasbeenlowerthanthatforCoreFixedIncome,recent(last10years)volatilityhasbeenapproximately50%higher.Ourmodestadjustmentacknowledgesthattheriskierelementsinherentinplussectorsprovideawiderdistributionofreturns,regardlessoftheirmeasuredyear‐over‐yearvolatility.
USEquity,USLarge‐CapEquity,DiversifiedInflation‐Related(+0.25%,+0.25%,+1.00%)
Thesecategorieswereadjustedupwardtomaketheiractualworst‐caseexperiencegreaterthana2%probabilityofoccurringundertheassumeddistribution.
EmergingMarketsEquity(‐5.25%)
Giventhelimitedhistoryforapublic‐marketproxyforeachassetclass,wearereluctanttorelytooheavilyonhistoricallymeasuredvolatility.Assuch,weadjustedtheriskdownwardsuchthattheassetclass’sactualworstcase(2008)representsanapproximately3%probabilityofoccurrenceundertheassumeddistribution.
MarketableAlternatives(+2.26%)
Thisadjustmentaveragesourtwoapproachesformodelingthehistoryforthisassetcategory.Theupwardadjustmentmakestheriskassumptionhalfwaybetweenthehistoricallymeasuredvolatilityofeachapproach(HFRIFundofFundsIndex,andbuild‐upapproach).
32
![Page 34: 2018 Capital Market Assumptions - Sellwood Consulting LLC · Emerging Markets Equity ... not to rely only on mean‐variance analysis when constructing portfolios. ... horizons. For](https://reader031.fdocuments.in/reader031/viewer/2022030815/5b24cb327f8b9a10578b4b1e/html5/thumbnails/34.jpg)
CORRELATIONCOEFFICIENTSOurforward‐lookingcorrelationassumptionsaremostlyderivedfromlong‐termhistorybutemphasizetherecentpast.Ourprocessfirstidentifiesareasonableproxyforeachassetcategory,typicallyanindexthatrepresentstheassetclass.Forseveralassetclasses,wehaveusedourjudgmenttoconstructaproxyreturnstreamfortheassetclassthateitherhasalongerhistoryforevaluation,ortoconstructamarketableproxyforanon‐marketableasset.Ourcorrelationassumptionsarebasedonthesereturnstreams:Inflation USCPICashEquivalents 91‐DayT‐BillsLow‐DurationFixedIncome BloombergBarclays1‐3YearGovernment/CreditCoreFixedIncome BloombergBarclaysUSAggregateCorePlusFixedIncome 80%CoreFixedIncome,20%Non‐CoreFixedIncomeNon‐CoreFixedIncome 50%MLHighYieldMasterII,50%JPMorganEMBIbackto1994;
100%MLHighYieldMasterIIbefore1994Long‐DurationFixedIncome BloombergBarclaysLongGovernment/CreditTIPS BloombergBarclaysUSTIPSShort‐TermTIPS BloombergBarclaysUS0‐5YearTIPSUSEquity Russell3000backto1979;S&P500before1979USLarge‐CapEquity Russell1000backto1979;S&P500before1979USSmall‐CapEquity Russell2000Non‐USEquity MSCIACWIexUSIMIbackto1994;MSCIEAFEbefore1994Non‐USLarge‐CapEquity MSCIACWIexUSbackto2001;MSCIEAFEbefore2001Non‐USSmall‐CapEquity MSCIACWIexUSSmallCapEmergingMarketsEquity MSCIEmergingMarketsRealEstate FTSENAREIT,NCREIF,andNCREIFODCEMarketableAlternatives HFRIFundofFundsDiversifiedInflation‐Related 1/3each:FTSENAREIT,BloombergBarclaysUSTIPS,Bloomberg
CommodityNon‐MarketableAlternatives Averageof2xtheNon‐CoreFixedIncomeseriesand2xtheUS
EquityseriesUsingthosestreams,weconstructedacorrelationmatrixthattakesthesimpleaverageoffourothercorrelationmatrices–constructedwith3years,5years,and10yearsofdata,andonewithasmuchdataaspossiblegoingbacktoeachseries’inception.Averagingthesefourmeasuresgivesacknowledgementtothelong‐termhistorywhileemphasizingtherecentpast,whencorrelationshavebeenhigherthanlong‐termhistoryhasdelivered.Thisapproachisthereforeconservativeinassumingthediversificationbenefitthatwillappearfromcorrelationinourmodeling.Wequalitativelyadjustedonlytherealestatecorrelationcoefficients,becauseoftheirilliquidity.OurassumedcoefficientsforrealestateaveragethecalculatedcoefficientsforpublicREITsandprivaterealestate.
33
![Page 35: 2018 Capital Market Assumptions - Sellwood Consulting LLC · Emerging Markets Equity ... not to rely only on mean‐variance analysis when constructing portfolios. ... horizons. For](https://reader031.fdocuments.in/reader031/viewer/2022030815/5b24cb327f8b9a10578b4b1e/html5/thumbnails/35.jpg)
Finally,weranourcalculatedcorrelationcoefficientsthroughtheIbbotsonstatisticalcorrelationmatrixtester,whichmadeslightadjustmentstoensurethatthematrixispositivesemi‐definite.Ourassumedreturncorrelationmatrixfollows:
Inflation
CashEquivalents
Low‐DurationFixedIncome
CoreFixedIncome
Core‐PlusFixedIncome
Non‐CoreFixedIncome
Long‐DurationFixedIncome
TIPS
STTIPS
USEquity
USLarge‐CapEquity
USSmall‐CapEquity
Non‐USEquity
Non‐USLarge‐CapEquity
Non‐USSmall‐CapEquity
EmergingMarketsEquity
RealEstate
DiversifiedInflation‐Related
MarketableAlternatives
Non‐MarketableAlternatives
Inflation
1.00
0.08
0.01
‐0.11
0.00
0.22
‐0.19
0.03
0.23
0.11
0.11
0.12
0.13
0.12
0.15
0.13
0.00
0.19
0.16
0.16
CashEquivalents
0.08
1.00
0.17
0.09
0.07
0.02
0.08
0.08
0.11
‐0.01
‐0.01
‐0.01
0.06
0.06
0.05
0.11
0.00
0.13
0.03
0.00
Low‐DurationFixedIncome
0.01
0.17
1.00
0.80
0.72
0.30
0.62
0.66
0.63
‐0.15
‐0.13
‐0.21
0.04
0.04
0.03
0.16
0.24
0.35
‐0.10
0.01
CoreFixedIncome
‐0.11
0.09
0.80
1.00
0.92
0.43
0.94
0.80
0.54
‐0.08
‐0.06
‐0.17
0.09
0.09
0.09
0.17
0.41
0.41
‐0.03
0.11
Core‐PlusFixedIncome
0.00
0.07
0.72
0.92
1.00
0.74
0.87
0.83
0.63
0.20
0.22
0.10
0.39
0.39
0.38
0.46
0.56
0.61
0.22
0.43
Non‐CoreFixedIncome
0.22
0.02
0.30
0.43
0.74
1.00
0.42
0.55
0.53
0.62
0.63
0.53
0.77
0.77
0.74
0.78
0.59
0.73
0.58
0.83
Long‐DurationFixedIncome
‐0.19
0.08
0.62
0.94
0.87
0.42
1.00
0.74
0.41
‐0.04
‐0.03
‐0.12
0.10
0.10
0.09
0.16
0.45
0.40
‐0.01
0.13
TIPS
0.03
0.08
0.66
0.80
0.83
0.55
0.74
1.00
0.83
0.05
0.07
‐0.02
0.26
0.26
0.27
0.36
0.41
0.58
0.11
0.25
STTIPS
0.23
0.11
0.63
0.54
0.63
0.53
0.41
0.83
1.00
0.12
0.13
0.05
0.32
0.32
0.33
0.43
0.31
0.63
0.18
0.29
USEquity
0.11
‐0.01
‐0.15
‐0.08
0.20
0.62
‐0.04
0.05
0.12
1.00
1.00
0.90
0.83
0.83
0.78
0.69
0.59
0.56
0.73
0.95
USLarge‐CapEquity
0.11
‐0.01
‐0.13
‐0.06
0.22
0.63
‐0.03
0.07
0.13
1.00
1.00
0.88
0.83
0.84
0.78
0.69
0.59
0.56
0.73
0.95
USSm
all‐CapEquity
0.12
‐0.01
‐0.21
‐0.17
0.10
0.53
‐0.12
‐0.02
0.05
0.90
0.88
1.00
0.70
0.70
0.68
0.56
0.55
0.51
0.69
0.85
Non‐USEquity
0.13
0.06
0.04
0.09
0.39
0.77
0.10
0.26
0.32
0.83
0.83
0.70
1.00
1.00
0.97
0.89
0.52
0.64
0.76
0.88
Non‐USLarge‐CapEquity
0.12
0.06
0.04
0.09
0.39
0.77
0.10
0.26
0.32
0.83
0.84
0.70
1.00
1.00
0.95
0.89
0.52
0.64
0.75
0.89
Non‐USSm
all‐CapEquity
0.15
0.05
0.03
0.09
0.38
0.74
0.09
0.27
0.33
0.78
0.78
0.68
0.97
0.95
1.00
0.86
0.50
0.63
0.76
0.84
EmergingMarketsEquity
0.13
0.11
0.16
0.17
0.46
0.78
0.16
0.36
0.43
0.69
0.69
0.56
0.89
0.89
0.86
1.00
0.49
0.67
0.64
0.79
RealEstate
0.00
0.00
0.24
0.41
0.56
0.59
0.45
0.41
0.31
0.59
0.59
0.55
0.52
0.52
0.50
0.49
1.00
0.77
0.35
0.64
DiversifiedInflation‐Related
0.19
0.13
0.35
0.41
0.61
0.73
0.40
0.58
0.63
0.56
0.56
0.51
0.64
0.64
0.63
0.67
0.77
1.00
0.43
0.68
MarketableAlternatives
0.16
0.03
‐0.10
‐0.03
0.22
0.58
‐0.01
0.11
0.18
0.73
0.73
0.69
0.76
0.75
0.76
0.64
0.35
0.43
1.00
0.74
Non‐MarketableAlternatives
0.16
0.00
0.01
0.11
0.43
0.83
0.13
0.25
0.29
0.95
0.95
0.85
0.88
0.89
0.84
0.79
0.64
0.68
0.74
1.00
SellwoodConsulting2018CorrelationCoefficientAssumptions
34
![Page 36: 2018 Capital Market Assumptions - Sellwood Consulting LLC · Emerging Markets Equity ... not to rely only on mean‐variance analysis when constructing portfolios. ... horizons. For](https://reader031.fdocuments.in/reader031/viewer/2022030815/5b24cb327f8b9a10578b4b1e/html5/thumbnails/36.jpg)
APPENDIX:SOURCESWearegratefultoseveralsourcesforouranalysis.Theywere:FRED,TheSt.LouisFedFederalReserveEconomicData
https://fred.stlouisfed.org/
FTSENAREIThttps://www.reit.com/data‐research/reit‐indexes/ftse‐nareit‐us‐real‐estate‐index‐historical‐values‐returnshttp://www.ftse.com/products/indices/russell‐us
ProfessorAswathDamodaran,SternSchoolofBusiness http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/implpr.html
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2581517
ResearchAffiliateshttp://www.researchaffiliates.com
Blackrock http://www.blackrock.com
PIMCO http://www.pimco.com
Standard&Poors http://www.standardandpoors.com
UrbanLandInstitutehttp://uli.org/research/centers‐initiatives/center‐for‐capital‐markets/barometers‐forecast‐and‐data/uli‐real‐estate‐consensus‐forecast/
MorganStanleyCapitalInternationalhttp://www.msci.com/
Moodyshttps://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_151031https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_154805
ProfessorRobertShillerhttp://www.econ.yale.edu/~shiller/data.htm
Vanguardhttps://personal.vanguard.com/pdf/s338.pdf
ThisworkislicensedunderaCreativeCommonsAttribution‐NoDerivatives4.0InternationalLicense.Toviewacopyofthislicense,visithttp://creativecommons.org/licenses/by‐nd/4.0/.
35