3 active steps to enhance portfolio returnsContributor Jeff Geller
What a world we live in. Never in the history of financial markets have the four major developed market currencies—the dollar, euro, pound sterling, and yen—delivered a “risk free” rate as close to zero. At the same time, moving out on the risk curve into sectors such as core fixed income does not offer many inspiring opportunities for return.
Quantitative easing (QE) by central banks, intended to stimulate growth and raise inflation expectations, has acted more as a steroid than a medicine—pumping up equity valuations by nearly 200% (as measured by the S&P 500 from March 9, 2009 through year-end 2015), but proving less potent in boosting underlying growth or raising core inflation to meet central bank targets.
What does this mean for the returns of a static 60/40 portfolio over the long term? Our 10- to 15-year estimates suggest below average beta (or index) returns relative to the past. We believe that, in such an environment, active alpha generation—through careful manager selection, dynamic asset allocation and prudent implementation—is more important than ever.
A downshift in long-term return expectations
Each year J.P. Morgan Asset Management publishes its Long-Term Capital Market Assumptions, 10- to 15-year annualized return and risk estimates for roughly 50 major global asset classes. Our 2016 assumption for a static 60% U.S. equity (S&P 500)/40% fixed income (Barclays Aggregate Index) asset allocation is now down to 6.4% annualized. This is a direct reflection of a quicker than expected run-up in equity prices (flattening the trajectory of long-term returns), as well as anticipation of a continued moderate growth, low interest rate environment. Our 6.4% annualized number is well below the whopping 11.9% return the same static 60/40 portfolio delivered for the period March 2009 through December 2015, and, as seen in the chart, over 100bps lower than our assumptions ten years ago.
Pulling the right levers—with care
This lower return environment may be a sobering new world for investors, but we believe there are important levers that investors can pull to confront the static 60/40 return challenge.
- Select proven active managers. Especially when index returns are under pressure, careful manager assessment is crucial to outperforming the index—or finding alpha. We recommend looking for long tenured managers that have a proven track record for generating alpha over various stages of the business cycle—early, middle or late. Because a manager’s style has been in favor over a recent, limited period does not mean the manager can deliver value over the long term.
- Be flexible in managing allocations. Investors can stay reasonably within their risk profile while adding a dynamic asset allocation overlay to an existing strategic allocation. Given the return challenges going forward, investors should consider tactical asset allocation as a way to capture market dislocations within and among equity, fixed income and alternative asset classes. We believe asset allocation flexibility can improve total and risk adjusted returns and help manage downside risk and total portfolio volatility. A good example of such flexibility in today’s market environment is the use of a higher quality high yield portfolio as an equity substitute, since the yield component can create a smoother total return ride.
- Make prudent use of leverage. Leverage is often misunderstood; it can be used to manage risk or to generate return. The use of exchange traded futures on indices such as the S&P 500 or the Eurostoxx 50 can be an efficient way to add and remove beta (or market) risk from your portfolio, based on tactical asset allocation views. In many asset classes, it is more economical to use futures to tactically trade risk vs. bearing the transaction costs of buying and selling individual stocks or bonds. Additionally, Treasury futures can be used to quickly add or remove duration to manage interest rate risk and equity exposure.
While the 60/40 static asset allocation has outperformed investor expectations coming out of the financial crisis, driven by an unprecedented liquidity environment, there are reasons to believe that some of those returns have been borrowed from future returns. In this new challenging environment we encourage investors to be open to flexible tactical asset allocation, have a process for determining consistent manager alpha potential, allocate to alternative markets if possible, and finally, consider introducing leverage, where appropriate, to make their cash work harder.
Opinions and statements of market trends that are based on current market conditions constitute our judgment and are subject to change without notice. These views described may not be suitable for all investors. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations. Past performance is no guarantee of future results. JPMAM Long Term Capital Market Assumptions: Given the complex risk-reward trade-offs involved, we advise clients to rely on judgment as well as quantitative optimization approaches in setting strategic allocations. Please note that all information shown is based on qualitative analysis. Exclusive reliance on the above is not advised. This information is not intended as a recommendation to invest in any particular asset class or strategy or as a promise of future performance. Note that these asset class and strategy assumptions are passive only–they do not consider the impact of active management. References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Assumptions, opinions and estimates are provided for illustrative purposes only.
J.P. Morgan Asset Management is the marketing name for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide.