Asset Allocation Review - Mississippi Workshop/2017... · James W. Van Heuit . Capital Market...

Asset Allocation Review

PERS Board Education

March 28,2017

James W. Van Heuit Capital Market Research Group

William C. Howard, CFA Denver Fund Sponsor Consulting

John P. Jackson, CFA Chicago Fund Sponsor Consulting

1 PERS Asset Allocation Review Knowledge. Experience. Integrity.

Agenda

● Building Blocks of Asset Class Returns – Components of returns – Contributions to investment forecasts

● Economic Outlook – Historical, current and prospective conditions – Implications for asset market forecasts

● Asset Class Forecasts – Equity – Fixed Income

● Asset Allocation Analysis – Alternative asset mix construction – Expected performance – Range of performance expectations

Topics for Discussion


Building blocks

● Investment markets are complex

● It is advantageous for the forecasting process to break markets down into “building blocks”

● Risk Premia Building Blocks – Investments span the risk spectrum from very safe Treasury bills to volatile emerging markets equity – Theoretically, investors should require more compensation in terms of higher returns in order to invest in riskier

markets – Forecasts are based on historical return “spreads” across the range of risky assets

● Economic and Financial Building Blocks – Generally speaking, investments are either debt or equity

– Investors are either lenders or owners – Investors are compensated for their contributions to economic activity (e.g., businesses, governments,

mortgage borrowers) – Economic and financial building blocks look at the sources of funds to compensate investors

– Revenues to pay government bond investors – Cash flow to pay interest to corporate bondholders and dividends to shareholders – Reinvestment to promote profit growth

– Forecasts are based on the opportunities available to generate cash flow and how much investors are willing to pay to receive these cash flows

Contributors to Return


Asset Class Returns

Risk Premia Building Blocks

● Investors require greater return for taking greater levels of risk: “risk premia”

● Risk premia have varied widely historically – In some periods, e.g., during and immediately after the financial crisis, equities returned less than bonds – What are the “right” levels for risk premia? How should they change through time?

● Treasury bills provide “risk-free” returns – If purchased and held to maturity the return is known in advance – The U.S. government is not going to default

● Bond risk premia – Term Risk: More time to maturity means greater uncertainty – Credit Risk: Higher probability of default means more uncertainty for future interest payments, and the

repayment of principal – The additional risk means that bonds need to offer a higher return than Treasury bills

● Equity risk premia – Stocks pay dividends which are not fixed in advance like bond interest rate payments – Stock values can fluctuate substantially, more widely than most bonds – The additional risk means that stocks need to offer a higher return than bonds

Building Blocks


Asset Class Returns

● For 30 years the S&P 500 has averaged a 6.33% return premium over 3-month Treasury bills

● The highest return premium was 14.5% at the peak of the tech bubble

● The lowest return premium was -6.4% at the nadir of the financial crisis

● The forecast should be somewhere in between these extremes, but it is unclear where – The historical time period is decisive in determining the forecast

Risk Premia Building Blocks

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

(10)

(5)

0

5

10

15

20

for 30 Years Ended December 31, 2016Rolling 40 Quarter Excess Return Relative To CE Fed 3 Mo Bill

Exc

ess

Ret

urn

US Eq S&P 500 US Eq S&P 500 Average

6.33


Asset Class Returns

Economic and Financial Building Blocks

● Economic factors play an important role – GDP growth and its underlying components – Inflation and its underlying components – These values tend to move up and down together

– More growth leads to more inflation – Less growth leads to less inflation

● Treasury bills are still “risk-free” returns – Yields depend on inflation over their brief time to maturity – Investors normally want a positive after-inflation “real” return

● Projected bond returns will be high if investors anticipate high growth and inflation – Bond investors also want a positive real rate of return – Credit spreads will be low if growth reduces the probability of corporate default

● Projected equity returns will be higher if investors anticipate high growth and inflation – Higher economic growth rates generally mean higher profits, dividends and capital appreciation

● Still, uncertainty over “right” levels of real bond and stock returns fluctuate as conditions change over time

● Investors still require greater return for taking greater levels of risk

Building Blocks


Economic Outlook

● Real Gross Domestic Product (GDP) Growth and Consumer Price Inflation (CPI) are forecast

● Callan forecasts are based on forecasts provided by the Federal Reserve and the International Monetary Fund (IMF) – Forecasts are country-specific for non-US markets – Aggregated non-US forecasts are weighted averages using World ex USA and Emerging Markets index

weights

● Forecasts are intertwined – GDP and inflation tend to rise and fall together

● Forecasts form a starting point for projections – GDP forecasts provide a very rough estimate of future earnings growth – Inflation forecasts provide an approximate path for short-term yields – Inflation is added to the real return forecasts for equity and fixed income

Role of Economic Variables


Economic Outlook

● Employment compensation as a percentage of national income has been falling for decades

● Falling compensation limits consumption which can limit economic growth

Employment Compensation Contribution to Gross Domestic Income (GDI)


Economic Outlook

● Corporate profits have been growing as a percentage of national income

● The impact of higher levels of corporate profits depends on how profits are used

Corporate Profits Contribution to Gross Domestic Income


Economic Outlook

● Gross private domestic nonresidential investment measures investments by companies

● While profits have been growing, investments by firms have been trending downward

● Investments increase productivity which leads to higher levels of economic growth

Private Domestic Investment Contribution to Gross Domestic Product


Economic Outlook

● Gross private domestic personal consumption expenditures measures the total amount of what consumers pay to live their daily lives

● Personal consumption expenditures as a percentage of GDP have experienced limited growth since over the most recent 15 years

Personal Consumption Expenditures Contribution to GDP


Economic Outlook

● Real GDP growth rebounded dramatically after the Global Financial Crisis

● Growth since the GFC has been lower than over previous long-term periods

● Growth is likely to be more muted going forward

Developed Markets Real GDP Growth

*

Source: International Monetary Fund


Economic Outlook

● Consumer price inflation fell in the aftermath of the Global Financial Crisis

● It has been a low levels since in spite of monetary and fiscal stimulus designed to increase it

● There are recent indications that inflation in the US is starting to pick up

Developed Markets Consumer Price Inflation

Source: International Monetary Fund


Economic Outlook The Federal Reserve Dot Chart

5 — — 5

4.25 — — 4.25 4.00 — — 4.00 3.75 — • • — 3.75 3.50 — • • — 3.50 3.25 — • •• — 3.25 3.00 — •• •••• •••••••• — 3.00 2.75 — •• •••••• — 2.75 2.50 — •• ••• • — 2.50 2.25 — •• •• — 2.25 2.00 — • ••• • — 2.00 1.75 — ••••• — 1.75 1.50 — •••• • — 1.50 1.25 — •••••• — 1.25 1.00 — •••• — 1.00 0.75 — •• • • — 0.75 0.50 — ••••••••••••••••• — 0.50 0.25 — — 0.25 0.00 — — 0.00

2016 2017 2018 2019 Longer run

Target fed funds rate at year-end (December projections)

Each shaded circle indicates the value of an individual participant’s judgment of the midpoint of the target federal funds rate at the end of the specified calendar year and over the longer run. The number in each column represents the lower bound of an 0.25 percentage point range.


Economic Outlook U.S. Treasury Yield Curves

Source: Federal Reserve and Callan


Economic Outlook U.S. Treasury Yield Curves


Economic Outlook Trailing P/E for the S&P 500

Trailing earnings as reported for the fiscal year; includes negative earnings from 1998 onward. Source: Standard & Poor’s and Callan

0

5

10

15

20

25

30

35

40

45

54 58 62 66 70 74 78 82 86 90 94 98 02 06 10 14

Pric

e/E

arni

ngs

Rat

io

Price to Earnings Ratio for S&P 500 (1954 - 2016)

S&P 500 P/E Ratio Long-Run Average

+ 2 Std. Dev.

- 2 Std. Dev.


Economic Outlook

● 2% to 2.5% for the US – Higher growth rate than the post financial crisis time period but lower than the last half century average – Factors which could lead to upper end of forecast

– Strong labor market – Expansive fiscal policies of the incoming administration – Restrictive trade policies

– Factors which could lead to lower end of forecast – Tighter monetary policy, unexpectedly high interest rates or both – Congressional resistance to the fiscal policies of the incoming administration – Strong dollar

● 1.5% to 2.0% for Developed Non-US Markets – Lower than the US due to concerns about political, fiscal and monetary policy as well as the banking system – Factors which could lead to upper end of forecast

– Additional stimulative monetary policies – Controlled growth of government budget deficits – Reduced levels of austerity – Improvements in bank balance sheets – Reduced unemployment

– Factors which could lead to lower end of forecast – Political uncertainty – Trade issues – Declining health of the financial sector

GDP Growth Forecasts


Economic Outlook

● 4% to 5% for Emerging Markets – Absolute size of many emerging economies (primarily China and India) limits growth to below historical values – Growth rates still substantially exceed those of the developed markets – Factors which could lead to upper end of forecast

– Improving export markets – Expanding internal demand

– Factors which could lead to lower end of forecast – Domestic government policies – Developed market trade restrictions

GDP Growth Forecasts


Economic Outlook

● 2% to 2.5% for the US – Headline values ticking up but still less than 1.75% while core inflation has been above 2% since late 2015 – Factors which could lead to upper end of forecast

– Rising energy prices – Tight labor markets – Fiscal stimulus – Declining dollar drives up import prices

– Factors which could lead to lower end of forecast – Poor overseas economic performance strengthens the dollar – Competitive labor market keeps wages in check – The Fed implements tight monetary policy

● 1.75% to 2.25% for Developed Non-US Markets – Inflation is starting to tick up but is very low in largest economies – Factors which could lead to upper end of forecast

– More expansive fiscal policies – Faster economic growth

– Factors which could lead to lower end of forecast – Opportunities for additional fiscal and monetary stimulus are limited – Slack in European labor markets

Inflation Forecasts


Economic Outlook

● 2.5% to 3.5% for Emerging Markets – Future inflation is uncertain – Path of prices depends on government policies, relative currency strength, trade policies, the balance of

internal supply and demand, and commodity prices

Inflation Forecasts


Equity Forecasts

● Fundamental Relationship

● Forecast capital appreciation depends on projected future earnings – Long-term earnings tend to correspond to long-term GDP growth

– Weak short-term relationship – Relationship more robust in developed than emerging markets economies

– Investors will pay more for stocks with better future earnings potential – Prices don’t depend on historical or current earnings

● Forecast income also depends on projected future earnings – Income is related to earnings via the payout ratio – Income also influenced by

– Prospects for future corporate investments – Interest rates

● Valuations have limited impact on forecasts – Average P/Es over different market cycles differ markedly

– Oil Boycott – Tech Bubble – Global Financial Crisis

– Capital market projections only impacted when markets reach extreme valuations

Overview

Equity Return = Capital Appreciation + Income


Equity Forecasts

● Return = 6.85%, Risk = 18.25%

● Broad US equity is represented by the Russell 3000 index

● Earnings growth likely to be moderate – Earnings growth is likely to be higher than it has been since 2014 – Stronger GDP growth than would have been the case without more expansive economic policies – GDP growth still likely to lag its longer-term average

● Dividend yield consistent with recent history – Payout ratios close to historical norms – Yields have been stable for 20 years in the face of changing interest rates

● Any additional return from share buybacks likely offset by dilution from additional issuance

Broad US Equity


Equity Forecasts

● Return = 7.00%, Risk = 21.00%

● Global ex US equity is represented by the MSCI All-Country World ex USA index

● Earnings growth likely to be moderate – Improving outlook for developed markets economies but from a low starting point – Emerging market growth declining but still substantial – Significant uncertainty in future economic policies

● Relatively high dividend yields will support returns – Developed markets yields are measurably higher than those in the US

– High even relative to history – Dividends to make up differences in capital appreciations between US and developed non-US markets

– Emerging markets yields not as high as in developed markets but still higher than in US

Global ex US Equity


Fixed Income Forecasts

● Fundamental Relationship

● Forecast capital appreciation depends on projected future interest rates – Inflation – Central bank policy – Credit conditions

● Income = yield

● Roll return reflects capital appreciation from declines in yields as bonds move toward maturity with upward sloping yield curves

Overview

Bond Return = Capital Appreciation + Income + Roll Return


Fixed Income Forecasts

● Return = 3.00%, Risk = 3.75%

● Broad US fixed income is represented by the Bloomberg Barclays Aggregate index

● Interest rates expected to rise – Most of the increase is expected over the next 3 years – Our path is consistent with that forecast by the Fed

● Yield curve expected to flatten – Yield curve currently steep – Long rates are still expected to increase but not as much as short rates

● Higher yields expected to be earned over most of the forecast horizon

● Capital losses expected as yields increase in early years – Losses consistent with moderate duration

– Historically about 5 but currently closer to 6 – Little impact from changing credit spreads

● Roll return expected to decline – Current steep yield curve provides relatively high roll return – Flatter curve will reduce its contribution to total return

Broad US Fixed Income


Return and Risk Projections 10-Year Time Horizon

PROJECTED RETURN PROJECTED RISK

Asset Class Index1-Year

Arithmetic10-Year

Geometric* RealStandard Deviation

Projected Yield

EquitiesBroad Domestic Equity Russell 3000 8.30% 6.85% 4.60% 18.25% 2.00%Large Cap S&P 500 8.05% 6.75% 4.50% 17.40% 2.10%Small/Mid Cap Russell 2500 9.30% 7.00% 4.75% 22.60% 1.55%Global ex-US Equity MSCI ACWI ex USA 8.95% 7.00% 4.75% 21.00% 3.10%International Equity MSCI World ex USA 8.45% 6.75% 4.50% 19.70% 3.25%Emerging Markets Equity MSCI Emerging Markets 10.50% 7.00% 4.75% 27.45% 2.65%

Fixed IncomeShort Duration Bloomberg Barclays 1-3 Yr G/C 2.60% 2.60% 0.35% 2.10% 2.85%Domestic Fixed Bloomberg Barclays Aggregate 3.05% 3.00% 0.75% 3.75% 3.50%Long Duration Bloomberg Barclays Long G/C 3.75% 3.20% 0.95% 10.90% 4.50%TIPS Bloomberg Barclays TIPS 3.10% 3.00% 0.75% 5.25% 3.35%High Yield Bloomberg Barclays High Yield 5.20% 4.75% 2.50% 10.35% 7.75%Non-US Fixed Bloomberg Barclays Glbl Agg xUSD 1.80% 1.40% -0.85% 9.20% 2.50%Emerging Market Debt EMBI Global Diversified 4.85% 4.50% 2.25% 9.60% 5.75%

OtherReal Estate Callan Real Estate Database 6.90% 5.75% 3.50% 16.35% 4.75%Private Equity TR Post Venture Capital 12.45% 7.35% 5.10% 32.90% 0.00%Hedge Funds Callan Hedge FoF Database 5.35% 5.05% 2.80% 9.15% 2.25%Commodities Bloomberg Commodity 4.25% 2.65% 0.40% 18.30% 2.25%Cash Equivalents 90-Day T-Bill 2.25% 2.25% 0.00% 0.90% 2.25%

Inflation CPI-U 2.25% 1.50%

* Geometric returns are derived from arithmetic returns and the associated risk (standard deviation).


Correlations

● Low correlations reduce portfolio risk

Diversification

Correlation Matrix 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 191 Broad Domestic Equity 1.002 Large Cap 1.00 1.003 Small/Mid Cap 0.97 0.94 1.004 Global ex-US Equity 0.87 0.87 0.84 1.005 International Equity 0.84 0.84 0.80 0.99 1.006 Emerging Markets Equity 0.87 0.86 0.85 0.94 0.87 1.007 Short Duration -0.25 -0.24 -0.27 -0.27 -0.25 -0.29 1.008 Domestic Fixed -0.11 -0.10 -0.14 -0.13 -0.11 -0.16 0.87 1.009 Long Duration 0.13 0.14 0.12 0.10 0.12 0.07 0.73 0.93 1.0010 TIPS -0.05 -0.05 -0.08 -0.05 -0.03 -0.09 0.53 0.60 0.53 1.0011 High Yield 0.64 0.64 0.61 0.63 0.61 0.62 -0.14 0.02 0.22 0.06 1.0012 Non-US Fixed 0.01 0.05 -0.10 0.01 0.06 -0.09 0.48 0.51 0.54 0.34 0.12 1.0013 EMD 0.57 0.57 0.56 0.58 0.55 0.58 -0.04 0.10 0.16 0.18 0.60 0.01 1.0014 Real Estate 0.73 0.73 0.71 0.68 0.66 0.65 -0.17 -0.03 0.19 0.00 0.56 -0.05 0.44 1.0015 Private Equity 0.95 0.95 0.92 0.93 0.90 0.91 -0.26 -0.20 0.02 -0.11 0.64 -0.06 0.57 0.72 1.0016 Hedge Funds 0.80 0.80 0.77 0.76 0.73 0.76 -0.13 0.08 0.30 0.08 0.57 -0.08 0.54 0.61 0.78 1.0017 Commodities 0.15 0.15 0.15 0.16 0.16 0.16 -0.22 -0.10 -0.04 0.12 0.10 0.05 0.19 0.20 0.18 0.21 1.0018 Cash Equivalents -0.04 -0.03 -0.08 -0.04 -0.01 -0.10 0.30 0.10 -0.05 0.07 -0.11 -0.09 -0.07 -0.06 0.00 -0.07 0.07 1.0019 Inflation -0.01 -0.02 0.02 0.01 0.00 0.03 -0.20 -0.28 -0.29 0.18 0.07 -0.15 0.00 0.10 0.06 0.20 0.40 0.00 1.00


Asset Mixes

● The current and target mixes are expected to return just under 6.6%

● The alternative asset mixes have the lowest risks for their targeted rates of return (“optimal”) – Mix returns range from 6% to 7% in 0.25% increments – There is a 1% minimum for cash but all of the other asset classes are unconstrained

● The current and target mixes have allocations, returns and risks between mixes 3 and 4

Current and Range of Alternative Asset Mixes


Range of Returns

● The exhibit above shows the range forecast returns for any given year in the 10-year horizon – The center dotted line is the median asset value while the bottom of the bar is the 95th percentile – The range is created by 5,000 simulations based on the returns, risks and correlations shown earlier

● The positions and sizes of the bars depend on forecasted asset class performances

● Asset mixes are below a 50% probability of achieving the 7.75% return goal in any one year

● All of the asset mixes have more than a 5% probability of a double digit one-year loss

Any Single Year in the Next Decade

Current Target M ix 1 M ix 2 M ix 3 M ix 4 M ix 5(30%)(20%)(10%)

0%10%20%30%40%50%

of R

etur

n (%

)A

nnua

l Rat

es

Average

5th Percentile25th PercentileM edian75th Percentile95th Percentile

Prob > 7.75%

6.84%

36.14%17.98%

6.74%(3.65%)

(16.71%)

47.5%

6.86%

36.32%18.01%

6.82%(3.69%)

(16.78%)

47.6%

6.16%

28.15%14.68%

6.08%(1.94%)

(12.26%)

44.3%

6.45%

31.29%16.00%

6.33%(2.53%)

(13.89%)

45.8%

6.74%

34.55%17.43%

6.68%(3.24%)

(15.65%)

47.1%

7.05%

38.35%18.95%

7.06%(4.05%)

(17.86%)

48.3%

7.38%

42.79%20.80%

7.43%(5.00%)

(20.21%)

49.3%

7.75%48 48 44 46 47 48 49


Range of Returns

● The ten-year ranges of return result from continuing the 5,000 simulations for a full 10 years

● The median return is lower over ten years than over any one year due to “volatility drag”

● The probability of achieving the return target falls to about 40% for the current, target and mix 3

● The annualized range of returns is compressed over 10 years relative to one year – Very good or poor returns in any one year are unlikely in other years diluting the extreme outcomes – There is still more than a 5% probability of a negative annualized return over the entire time period

10 Years, Annualized

Current Target M ix 1 M ix 2 M ix 3 M ix 4 M ix 5(30%)(20%)(10%)

0%10%20%30%40%50%

of R

etur

n (%

)A

nnua

l Rat

es

Average


Prob > 7.75%

6.57%

15.28%9.98%6.53%3.21%

(1.46%)

40.8%

6.58%

15.31%10.02%

6.56%3.21%

(1.49%)

41.0%

6.00%

12.55%8.62%5.98%3.47%

(0.16%)

32.3%

6.25%

13.60%9.18%6.22%3.40%

(0.59%)

36.5%

6.50%

14.74%9.75%6.47%3.31%

(1.15%)

39.8%

6.75%

16.01%10.38%

6.70%3.21%

(1.75%)

42.7%

7.00%

17.45%11.12%

6.93%2.99%

(2.45%)

45.1%

7.75%41 41 32 36 40 43 45


Range of Returns

● The exhibit above is based on the same data as the prior exhibits but with unannualized returns

● Over the next ten years the assets would be expected to grow by from about 80% to 95% in the median outcomes if cash flows are not considered

● Double digit nominal cumulative losses are possible in poor markets. – Not only are these absolute losses but they also represent considerable underperformance relative to the

expected returns

10 Years, Cumulative

Current Target M ix 1 M ix 2 M ix 3 M ix 4 M ix 5(100%)

0%

100%

200%

300%

400%

500%

Cum

ulat

ive

Rat

es o

f Ret

urn

(%)


314.4%158.8%

88.3%37.2%

(13.7%)

315.6%159.9%

88.8%37.1%

(14.0%)

226.2%128.7%

78.8%40.6%(1.6%)

257.8%140.6%

82.8%39.7%(5.8%)

295.4%153.4%

87.1%38.6%

(10.9%)

341.6%168.5%

91.3%37.1%

(16.2%)

399.4%186.9%

95.5%34.3%

(22.0%)


Disclaimers

This report is for informational purposes only and should not be construed as legal or tax advice on any matter. Any decision you make on the basis of this content is your sole responsibility. You should consult with legal and tax advisers before applying any of this information to your particular situation.

This report may consist of statements of opinion, which are made as of the date they are expressed and are not statements of fact.

Reference to or inclusion in this report of any product, service or entity should not be construed as a recommendation, approval, affiliation or endorsement of such product, service or entity by Callan.

Past performance is no guarantee of future results.

The statements made herein may include forward-looking statements regarding future results. The forward-looking statements herein: (i) are best estimations consistent with the information available as of the date hereof and (ii) involve known and unknown risks and uncertainties such that actual results may differ materially from these statements. There is no obligation to update or alter any forward-looking statement, whether as a result of new information, future events or otherwise. Undue reliance should not be placed on forward-looking statements.

Asset Allocation Review - Mississippi Workshop/2017... · James W. Van Heuit . Capital Market...

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