# Total return forecasts for major asset classes

As financial markets collapse, the relative attractiveness of expected returns increases. Deciding when, if at all, investors will be able to capture these forecasts in the real world is up for debate, but the winds seem to favor relatively higher long-term returns.

Using the average of three models to estimate future performance suggests that several markets look relatively attractive relative to their past history. For example, emerging market equities are expected to generate an annualized total return of 7.8% over the long term, more than double the 10-year return. The difference translates to a deviation of 4.1 percentage points in favor of the expected return (as shown in the table below via the top row in the box highlighted in green on the right).

In fact, there is quite a bit of green in the chart above in the Spread column. This implies that the markets are valued to deliver relatively higher results compared to their respective 10-year performance.

One notable exception is the Global Market Index (GMI), an unmanaged market-weighted portfolio that holds all major asset classes (except cash). The GMI’s weighted average expected return is 5.1% annualized, slightly below the benchmark’s 6.4% annualized return over the past decade (and down slightly from the month’s estimate). last). This is a sign that investors should remain cautious about earnings projections for multi-asset class portfolios over the past 10 years.

GMI represents a theoretical benchmark of the optimal portfolio for the average investor with an infinite time horizon. Based on this, GMI is useful as a starting point for asset allocation research and portfolio design. GMI’s track record suggests that the performance of this passive benchmark is competitive with most active asset allocation strategies overall, especially after adjusting for risk, trading costs and taxes .

Keep in mind that all of the above forecasts are likely to be incorrect to some extent, although GMI’s projections should be more reliable when compared to the estimates for individual asset classes presented in the table above. In contrast, forecasts for specific market components (US equities, commodities, etc.) are subject to greater volatility and tracking error than forecast aggregation into the GMI estimate, a process that can reduce some of the errors over time.

For a historical perspective on how GMI’s realized total return has evolved over time, consider the history of the benchmark on a 10-year rolling annualized basis. The chart below compares GMI’s performance against the equivalent for US stocks and US bonds over the past month. GMI’s current 10-year yield (green line) is a solid 6.1%. Although this has fallen from recent levels, it is still above the current long-term projection.

10-year annualized returns

Here is a brief summary of how forecasts are generated:

**BB:** The Building Block model uses historical returns as a proxy to estimate the future. The sample period used begins in January 1998 (the earliest date available for all asset classes listed above). The procedure involves calculating the risk premium for each asset class, calculating the annualized return, and then adding an expected risk-free rate to generate a total return forecast. For the expected risk-free rate, we use the latest 10-year TIPS (Treasury Inflation Protected Security) yield. This return is considered a market estimate of a real risk-free (inflation-adjusted) return for a “safe” asset – *this “risk-free” rate is also used for all the models described below.* Note that the BB model used here is (loosely) based on a methodology originally described by Ibbotson Associates (a division of Morningstar).

**Equalizer: **The Equilibrium model reverses the engineering of expected return through risk. Rather than trying to predict return directly, this model relies on the somewhat more reliable framework of using risk measures to estimate future performance. The process is relatively robust in that it is slightly easier to predict risk than to project return. The three entries:

* An estimate of the market price of expected risk for the entire portfolio, defined as the Sharpe ratio, which is the ratio of risk premia to volatility (standard deviation). Note: “portfolio” here and throughout is defined as GMI

* The expected volatility (standard deviation) of each asset (market components of GMI)

* The expected correlation for each asset relative to the portfolio (GMI)

This model for estimating equilibrium returns was originally described in a 1974 paper by Professor Bill Sharpe. For a summary, see Gary Brinson’s explanation in Chapter 3 of The Portable MBA in Investment. I also review the model in my book Dynamic Asset Allocation. Note that this methodology initially estimates a risk premium, then adds an expected risk-free rate to arrive at the total return forecast. The expected risk-free rate is described in BB above.

**AD:** This methodology is identical to the equilibrium model (EQ) described above *with one exception:* forecasts are adjusted for short-term momentum and longer-term mean reversion factors. Momentum is defined as the current price relative to the moving average of the last 12 months. The average reversion factor is estimated as the current price relative to the moving average of the last 60 months (5 years). Equilibrium forecasts are adjusted for current prices relative to 12-month and 60-month moving averages. If current prices are above (below) moving averages, estimates of unadjusted risk premia are decreased (increased). The adjustment formula simply takes the inverse of the average of the current price to the two moving averages. For example: if the current price of an asset class is 10% above its 12-month moving average and 20% above its 60-month moving average, the unadjusted forecast is reduced by 15% (the average of 10% and 20%). The logic here is that when prices are relatively high relative to recent history, equilibrium forecasts are reduced. On the other hand, when prices are relatively low compared to recent history, the equilibrium forecast is raised.

**Avg:** This column is a simple average of the three forecasts for each line (asset class)

**10 years of retirement:** For a perspective on real returns, this column shows the 10-year annualized total return for the asset classes up to the current target month.

**Spread:** Average forecast of the model minus yield over 10 years.