The views expressed are those of the author at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.
1. Shop for value
2. Tilt broad equity exposure away from the US
3. Include defensive equities as a specific allocation
4. Lean less on passive equity strategies
5. Look beyond traditional “buyout” models in private equity
6. Take a more flexible approach to fixed income
7. Allocate to fixed income “complements”
8. Increase exposure to inflation-sensitive assets/strategies
9. Take advantage of thematic and opportunistic investments
10. Don’t let asset class silos limit the opportunity set
Many asset owners, from public and private pensions to endowments and foundations, find themselves between a rock and a hard place. Their return targets are high but current capital market returns expectations are well below the results of recent years — as in the case of our Investment Strategy group’s intermediate (10-year) capital market assumptions (Figure 1). As shown at the bottom of the table, these returns could mean substantially weaker outcomes for traditional asset mixes.
I first wrote about this return gap several years ago, noting the challenge of “bridging” it with a single strategy and proposing instead that asset owners consider a series of “stepping stones” — incremental investment ideas that may help put a portfolio on a path forward. In this paper, I offer updated stepping stones. Once again, these ideas are not linear — they can be combined in different ways, depending on the asset owner’s particular objectives. They are not riskless either, but my view is that the aggregate risk impact of implementing these relatively modest steps should be tolerable at the total portfolio level.
After a long stretch of market leadership for growth stocks, I expect value stocks to outperform over the next decade, particularly because there has historically been strong cyclicality to the performance of the two styles. Figure 2 compares the trailing 10-year relative performance of value and growth (x-axis) to the forward 10-year relative performance of value and growth (y-axis), using data back to 1978. What we see is that a 10-year period of growth outperformance has never been followed by a second one (i.e., no data points in the lower left quadrant). More pointedly, when growth has beaten value over the trailing period, value hasn’t just outperformed growth over the forward period, it has done so by a wide margin — more than 2.5% (green oval).
Statisticians could rightly point out that 1) the history is quite limited and 2) I am using overlapping data. But I think the data is sufficient to support the argument for mean reversion, and often very powerful mean reversion, of value after growth outperforms. I’d also note that Fama-French data, which goes back to 1926 (using a simpler definition of value), shows a similar result.
In terms of what a shift to value could mean from an allocation standpoint, asset owners may need to ensure that value managers are back to their core approach. (Some may have shifted toward a GARP-y approach [growth at a reasonable price] amid the challenging environment of the past five to 10 years.) Thinking about stock versus sector exposure is also important; the expression of a value approach comes not just from relative opportunities within sectors but also opportunities across sectors. Our Director of Derivatives, Gordy Lawrence, pointed out that in the years since value last led the market, the size of some sectors has shifted dramatically, especially in the US. As technology has ballooned, finance and energy have contracted, for example. A little money moving out of technology and into more value-oriented sectors could have a disproportionate effect — a 1% outflow from the technology sector could be a 2% inflow into the finance sector.
Finally, in assessing managers, asset owners should be cautious about the “value trap” temptation. As the cycle turns, it may well be that the deepest of deep value companies — including companies that may not ultimately survive — could have the most dramatic rallies. In that case, a core value portfolio might underperform in the near term, but may still be the best choice for the long term.
One risk to my view is the idea that “technology trumps all.” In other words, if it turns out that technology companies are able to capture the lion’s share of the economic gains from their innovations (rather than those gains being shared broadly across the economy), then we could see growth continue to dominate value. But that scenario would create even greater distortion in the market cap of technology companies versus the rest of the world, something I see as unlikely.
Since the post-GFC trough in February 2009, US equities have compounded at 17% per year for more than 13 years — roughly twice what we’ve seen from non-US developed market equities. During this period, US equities have had extremely strong fundamentals, but I think we are due for some mean reversion over time. Our capital market assumptions (CMAs) favor non-US equities by a healthy margin (Figure 3). Looking at the components of our CMAs, it’s notable that we’re not assuming the US is going to grow more slowly than the rest of the world; we actually assume that faster earnings growth will continue. But we do assume a degree of valuation reversion in the US. We also expect some dividend and currency advantage for non-US equities. With this in mind, I’d note that tilting toward non-US equities is a relatively simple strategic allocation change to implement and one that could have a meaningful return impact, with the additional potential for an alpha advantage in less efficient markets.
The risk to this view is that markets that have suffered through long-term economic challenges, including Japan and Europe, don’t move in the right direction. (Perhaps their economies are fundamentally “broken” in some way.) That’s not my base case, but it is a risk.
To demonstrate the potential benefit of defensive investing, Figure 4 illustrates a hypothetical strategy that captures 95% of the return of the S&P 500 in up months but only 85% in down months. Not surprisingly, the strategy adds value when the S&P 500 falls, including during bear markets (shaded areas). But it also holds its own in bull markets, when it might be expected to struggle. After all, even in a bull market there are ups and downs, and a strategy that can limit downside can leverage the power of compounding to improve results over time.
Our Fundamental Factor team has pointed out that asset owners with a traditional equity portfolio (growth, value, core) may miss out on factors related to defensiveness, such as price stability (e.g., low volatility) and earnings stability. One idea for filling this gap is “compounders” — equity strategies focused on companies with high and stable free-cash-flow yield and the potential to grow modestly but steadily over time, all in the pursuit of high-single-digit or low-double-digit returns. This category includes portfolio managers we think of as “core compounders,” based on the way they pick companies, as well as listed infrastructure and listed real estate strategies.
If our CMAs (discussed earlier) prove correct, high-single-digit or low-double-digit returns would represent significant alpha in the next decade. In addition, valuation could be a tailwind for some defensive approaches, given the category’s weak COVID-era performance. Some of these strategies (e.g., listed infrastructure) may also offer the benefit of inflation hedging, which could add to the appeal in the current environment. Lastly, it is possible that in some scenarios, fixed income will be a less effective hedge against an equity market sell-off than it has been historically, which could make defensive equities all the more attractive.
Risks to my view include the possibility that we are seeing a secular shift away from the “slow and steady” mindset and that the market remains focused on high growth at any cost. But as discussed, I think it is more likely that we’re at an inflection point away from growth outperforming all else in the market.
Lower capital market assumptions may argue for greater reliance on idiosyncratic alpha. Of course, there is no guarantee there will be more alpha available in the market just because investors need it, but historically there has been real cyclicality in alpha generation, as shown in Figure 5, and I think we may be on an upswing.
Active equity managers have faced a number of headwinds recently, including the strong outperformance of a handful of mega-cap stocks, which active managers tend to underweight in their effort to build diversified portfolios of stocks that fit their philosophy and process. But that headwind may abate if the market is indeed shifting away from its growth focus. This and other market inflections (e.g., tighter central bank policy) could translate to higher volatility and more dispersion, opening the door for active managers to find attractive opportunities.
The key risk to my view would be the possibility that market efficiency proves more of a trend than a cycle. But I believe human beings are prone to making mistakes that active managers can take advantage of. I also think that active managers have become more creative with fee structures, which may allow asset owners to shift some exposure from passive to active without a dramatic increase in costs. Finally, while asset owners selecting active strategies tend to focus on less efficient markets, there are compelling ways to approach more efficient markets, such as US large-cap equities (which constitute a substantial share of global market cap). For example, it may be worth considering managers using highly idiosyncratic strategies to pursue unique betas (such as strong brands or publicly-listed infrastructure) or strategies (such as factor-based approaches) that seek to make market betas more efficient via portfolio construction.
For those using private equity to help close a return gap, I think there’s a case for looking beyond the traditional buyout model. In my experience, asset owners who invest in private equity tend to expect a return premium of about 3% relative to public equities. Figure 6 shows what that looks like as a multiple of public equity returns. For example, if the public market were to return 14% (next-to-last column), an asset owner might be looking for a 17% net return from the private market. Assuming a two and 20 fee1, that requires a 23% gross (that is, before fees) return or a 1.7x multiple of the public market. While that might sound high, it may be attainable for private equity managers given the variety of tools at their disposal, including leverage. But the math becomes more challenging at lower public market returns. A public market return of 4% (second column) implies an 11% gross return in private equity, for a multiple of 2.7x.
I continue to believe that the private market offers inefficiencies and should remain an arrow in an asset owner’s quiver. But given our modest CMAs, I worry that for managers of broad buyout strategies who are paying a premium to take public companies private, the math in Figure 6 may be challenging. With this in mind, I think it is an interesting time to consider niche-y areas of private equity (e.g., sector-focused strategies or late-stage growth strategies) — especially those where private capital is in great demand and investors may be more likely to earn a premium.
The risk here is that there are greater opportunities for financial engineering in today’s world and that private equity managers will find new ways to create value, even in the core buyout space.
Historically, it might have been enough to hold a single fixed income portfolio in order to pursue income, a healthy return, diversification, and liquidity. But today I think there is a strong case for using two buckets — one for income and return and the other for diversification and liquidity (Figure 7).
For the income/return-seeking bucket, the focus will likely be on credit. This could include direct investment in sectors like high yield and emerging market debt, but investors may instead include diversified or opportunistic credit strategies that rotate across different sectors according to their attractiveness. Total return strategies, fixed income hedge funds, and private credit may also play a role.
The diversification/ liquidity-seeking bucket might look like today’s “core bond” portfolios; it could skew more conservative to focus solely on government bonds or it could aim for capital efficiency and use futures to get duration exposure. There may also be a role for hedging strategies beyond fixed income, including using options or other derivatives to compensate for some of the diversification benefit that traditional fixed income may not offer in an inflationary environment.
The risk when it comes to the merits of this disaggregated approach to fixed income is that there is a rate shock that makes yields compelling again (i.e., back to the levels yields were at prior to the global financial crisis), in which case a traditional aggregate approach might suffice.
Historically, the current yield of core bonds has been a good predictor of future returns (Figure 8). Today, that suggests a forward 10-year return in the neighborhood of 3%. Credit may well play a role in boosting returns, but spreads are currently tight in some areas, including high yield. In this environment, investors who follow the flexible approach described in the previous stepping stone idea may want to lean more heavily on the income/ return-seeking bucket. Within that bucket, they may want to prioritize fixed income complements, such as private credit, absolute return and total-return hedge funds, and strategies focused on bank loans, convertible bonds, and CLOs, all of which may do well if rates rise further. This would mean taking on more risk, but at a total portfolio level, I think the impact would be modest.
The risks to my view here would include a period of deflation (which would call for more duration in a portfolio, not less) or a credit crisis with lasting impact.
Based on the US breakeven curve (Figure 9), the market is expecting inflation of about 4% over the next few years, 3% over 10 years, and 2.5% over 30 years — significant increases in the context of recent history, which I don’t believe are fully reflected in most portfolios.
Asset owners may want to consider adding to commodities, given their track record of strong performance in inflationary regimes, as well as other real assets and some of the previously mentioned fixed income assets that could benefit from rising rates (e.g., bank loans and convertible bonds). Commodities may offer an additional benefit: They have historically tended to perform well in periods when stocks and bonds were selling off.
It’s also worth bearing in mind that climate change and the government policy reaction to climate change (e.g., carbon taxes) are likely to prove inflationary. Given that climate change is an investable theme, it may have a role in an inflation-hedging allocation.
The risk here would of course be that deflationary forces prevail and we end up with slower growth and less demand. But at the margin, I think inflation risks skew to the upside and I would position portfolios accordingly. Given the strong performance of commodities thus far in 2022, some may wonder whether they’ve missed the opportunity to add exposure, but I believe that more than a decade of weak capital investment in commodity production should be positive for the asset class in the medium term. Our commodities team also notes that the market’s term structure is favorable, with many commodities offering a positive roll yield that may compensate investors for bearing risk.
I define thematic investing as trying to capture structural trends that will change the world over a period of five to 10 years (or more) in ways the market hasn’t fully recognized. Today, fintech, energy infrastructure, and emerging market development are among the themes I’m most excited about.
Opportunistic investing is about taking advantage of market dislocations or negative investor sentiment, which can create massive tailwinds when fundamentals (and sentiment) inflect — a process that often plays out over a shorter cycle (three to five years) than thematic. Opportunistic investors seek to “monetize” a longer time horizon by being a liquidity provider when the market is shying away from a region, asset class, or approach. Given that there is ample liquidity today, I see fewer of these opportunities at the moment, but Japan may fit the bill and China could soon as well.
Both thematic and opportunistic investments can benefit from tailwinds that aren’t reliant on the business cycle or economic growth, which means they are less dependent on the state of the broad capital markets and may add some diversification to a portfolio. Success factors include identifying the right themes or opportunities and then finding the related securities that are most attractive at any given point in the cycle.
Risks to this view include the possibility that the themes or opportunities don’t play out as expected and the broad market does better than some of these niche-y ideas.
Putting on my governance hat, I think some asset owners find it challenging to tap into pockets of higher return potential because their investment teams or their portfolios have clearly defined silos and it can be hard to allocate to areas that fall in between (Figure 10). For example, convertible bonds might be too equity-like for a bond portfolio or too bond-like for an equity portfolio. And “hybrid” strategies (e.g., hedge funds that can invest in both public and private markets) may not have a natural home in a portfolio (my colleague, Cara Lafond, wrote about this topic recently).
To take advantage of these ideas, asset owners may need to pull down the artificial walls between different asset types. The risk may be that we are in a world where there are better opportunities within silos than between them, but I think it is more likely that some attractive market niches will be underinvested and therefore have the potential for additional returns relative to broad markets.
Asset owners can seek to improve returns by choosing stepping stone ideas that are in sync with their investment beliefs and priorities. Ideally, the steps should build on the existing expertise of the in-house staff and/or consultant. Asset owners should choose steps that can be explained logically to constituents, and they should have enough conviction to avoid being pressured to shift out of them if they don’t work immediately.
The current market backdrop is without question a challenging one, and there is no quick fix and no single “bridge” that will get asset owners where they need to go. But there are effective steps that can be taken. The task at hand is to choose which to take first and then to manage the process of implementation. We would welcome the opportunity to discuss how our research and multi-asset resources can be deployed to help work through these decisions.
1Many private equity strategies charge an annual fee that is 2% of investors’ capital plus 20% of realized gains when investments are sold.
IMPORTANT DISCLOSURES: CAPITAL MARKET ASSUMPTIONS
Equities
General — Assumed market returns are based on the Investment Strategy Group’s expectations for future dividend yield, earnings growth, and valuation change. Assumed volatility and correlations are based on historical analysis of the representative indices. Indices used are as follows:
US large cap equities — S&P 500
US small cap equities — Russell 2000
Non-US equities — MSCI EAFE
DM equities — MSCI World
EM equities — MSCI EM
Bonds
General — Assumed risk and correlations based on historical analysis of the representative indices.
High-quality sovereign bonds – Return assumptions are based on starting yields and the expectation that yields move toward our estimate of a terminal interest rate over the time period. Using these inputs and the duration of the respective bill, note, or bond, we then calculate the income and capital gains/losses associated with these changes. We assume zero downward adjustment for downgrades and defaults for high-quality sovereign bonds.
Credit risk premia — For non-sovereign and corporate bonds, excess return assumptions are estimated. The excess return assumption is a function of excess spread, a downward adjustment for downgrades and losses, and reversion to median spread levels. The excess spread is readily observable in market pricing. The downward adjustment for downgrades and defaults is based on our proprietary research and the long-term historical experience. Indices used are as follows:
Core bonds — Bloomberg US Aggregate Bond
US long bonds — Bloomberg US Long Govt/Credit
US high-yield bonds — Bloomberg US Corporate High Yield
Non-US bonds (hedged) — Bloomberg Global Aggregate exUSD Bond (hedged)
Emerging market (EM) debt — JPMorgan EMBI Global (i.e., USD denominated)
Currencies
Return assumptions are shown for unhedged currency exposure, unless stated otherwise.
Hedged — Hedged currency return assumptions are based on current and forward-looking estimates for interest-rate differentials.
Unhedged — Unhedged currency return assumptions are formulated based on forward-looking estimates of real carry returns, normalization of real exchange rates, and an adjustment for productivity growth.
General
Period — Intermediate capital market assumptions are based on a period of approximately 10 years. If we developed expectations for different time periods, results shown would differ, perhaps significantly. Additionally, assumed annualized performance and results shown do not represent assumed performance for shorter periods (such as the one-year period) within the 10-year period, nor do they reflect our views of what we think may happen in other time periods besides the 10-year period. The annualized return represents our cumulative 10-year performance expectations annualized. The assumed returns shown do not reflect the potential for fluctuations and periods of negative performance.
This analysis is provided for illustrative purposes only. This material is not intended to constitute investment advice or an offer to sell, or the solicitation of an offer to purchase shares, strategies, or other securities. References to future returns are not promises or even estimates of actual returns a client may achieve. This material relies on assumptions that are based on historical performance and our expectations of the future. These return assumptions are forward-looking, hypothetical, and are not representative of any actual portfolio, or the results that an actual portfolio may achieve. Note that asset-class assumptions are market or beta only (i.e., they ignore the impact of active management, transaction costs, management fees, etc.).
The expectations of future outcomes are based on subjective inputs (i.e., strategist/analyst judgment) and are subject to change without notice. As such, this analysis is subject to numerous limitations and biases and the use of alternative assumptions would yield different results. Expected return estimates are subject to uncertainty and error. Future occurrences and results will differ, perhaps significantly, from those reflected in the assumptions. ACTUAL RESULTS MAY DIFFER SIGNIFICANTLY AND AN INVESTMENT CAN LOSE VALUE. Indices are unmanaged and used for illustrative purposes only. Investments cannot be made directly into an index.
This illustration does not consider transaction costs, management fees, or other expenses. It also does not consider liquidity (unless otherwise stated), or the impact associated with actual trading. These elements, among others, associated with actual investing would impact the assumed returns and risks, and results would likely be lower (returns) and higher (risk).
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