When developing a long-term investment strategy, investors conduct strategic asset allocation (SAA) to seek out the portfolio that provides the most effective balance between risk and return. SAA relies on coherent forecasts – for instance, capital market assumptions – of long-term investment expectations and variability. Such forecasts are frequently presented in the usual framework of mean-variance of expected returns, volatilities and correlations:
- Expected return: Average annual return in the long run
- Volatility: The standard deviation of annual returns
- Correlation: How closely are the returns of various investments linked?
Investors trust in JPMorgan’s Long-Term Capital Market Assumptions (LTCMA) to support the strategic asset allocation used to construct optimal portfolios. JPMorgan’s team of greater than 50 economists and analysts revises its forecasts annually to include latest information from the markets, policymakers and the economy.
For 2021, JPMorgan’s forecasts try and abstract from the short-term challenges and take into consideration the lasting consequences of the COVID-19 crisis, particularly the impact of policy measures to combat the pandemic. Surprisingly, JPMorgan expects “very few” lasting consequences for economic activity worldwide. In fact, its growth forecasts are very just like those before COVID.
For the U.S., JPMorgan expects equity market returns to fall to 4.1% over the subsequent 10 to fifteen years from 5.6% last yr. This decline largely reflects the impact of valuation normalization. For fixed income, JPMorgan’s forecast assumes three phases for Treasuries: two years of stable yields, followed by three years of capital depreciation and eventually a return to equilibrium. As a result, expected 10-year Treasury yields fall from 2.76% to 1.54%. And with a healthy and well-capitalized banking sector, JPMorgan believes the present cycle is unlikely to trigger a credit-disrupting crisis, especially given the prevailing support from the U.S. Federal Reserve.
Over the investment horizon, JPMorgan expects modest economic growth and constrained returns across many asset classes. However, the firm stays optimistic that investors can achieve acceptable returns with flexible and precise portfolio management without increasing portfolio risk to an unacceptable level.
Against this background, investors should compare the optimized portfolios presented here with their existing allocations – and their personal market forecast – and adjust accordingly.
method
Using the Portfolio Visualizer online suite of portfolio evaluation tools, I created an “efficient frontier” of portfolios based on the JPMorgan 2021 LTCMA for eight canonical asset classes and their corresponding Vanguard tickers:
- US Intermediate Bonds (VFITX)
- US investment grade corporate bonds (VWESX)
- US high yield bonds (VWEHX)
- Emerging Market Government Bonds (VGAVX)
- US Large Cap Stocks (VFINX)
- US Small Cap Stocks (VSMAX)
- EAFE shares (VTMGX)
- Emerging Markets Equities (VEMAX)
An efficient frontier tracks the expected returns of optimized portfolios, or those that supply the very best expected return, over a variety of risk points. I also create the portfolio with the very best Sharpe ratio, defined because the expected portfolio return exceeding the portfolio volatility.
Using JPMorgan’s LTCMA and Portfolio Visualizer’s Efficient Frontier tool, 4 optimal portfolios were identified:
- Maximum Sharpe ratio: Maximize the Sharpe Ratio
- Conservative risk: Meet the volatility of a 35%/65% equity-bond portfolio
- Moderate risk: Meet the volatility of a 65%/35% equity-bond portfolio
- Aggressive risk: Achieve the volatility of a 100% equity portfolio
The long-term capital market assumptions for the eight canonical asset classes are as follows:
Long-term capital market assumptions
| Exp Ret | tape | |
| VFIT | 1.54% | 2.83% |
| VWESX | 2.69% | 6.22% |
| VWEHX | 5.13% | 8.33% |
| VGAVX | 5.57% | 8.82% |
| VFINX | 5.13% | 14.80% |
| VSMAX | 6.33% | 19.44% |
| VTMGX | 7.80% | 16.92% |
| VEMAX | 9.19% | 21.14% |
Source: JPMorgan
I used historical correlations between the eight asset classes.
Results
The asset allocation for the 4 optimal portfolios is as follows:
Optimal portfolios
| Exp | tape | VFIT | VWESX | VWEHX | VGAVX | VFINX | VSMAX | VTMGX | VEMAX | |
| Max Sharpe | 2.51% | 2.81% | 76.80% | 17.39% | 5.81% | |||||
| Conservative | 4.84% | 7.11% | 18.96% | 23.41% | 50.79% | 6.84% | ||||
| Moderate | 6.25% | 10.27% | 75.03% | 15.71% | 9.26% | |||||
| Aggressive | 7.60% | 14.69% | 33.88% | 25.61% | 40.51% |
These results show that an investor with moderate risk affinity can expect a median return of 6.25% over the subsequent 10 to fifteen years.
Notably, domestic large-cap and small-cap stocks and investment-grade bonds are absent from any of the 4 optimal portfolios. This is because of the numerous headwinds created by valuation normalization: In the United States, long cycles of equity market outperformance followed by long cycles of underperformance will not be unusual.
Also notable is the diversifying role that intermediate-term Treasuries proceed to play within the lower-risk portfolios. Portfolio Visualizer shows a correlation of -0.16 between Treasuries and large-cap stocks. A “balanced” portfolio for high-risk investors, however, consists of non-US stocks and Treasuries. JPMorgan’s projections suggest that such a portfolio could generate average returns of over 7.5% over the long run. For example, the aggressive portfolio matches the S&P 500 by way of risk, but improves expected returns by almost 2.5 percentage points!
The Max Sharpe Ratio portfolio has a Sharpe ratio of 0.88, but generates an expected return that might not be appropriate for some investors. The other three portfolios have Sharpe ratios between 0.515 and 0.675.
These basic portfolios include the key public asset classes which can be the constructing blocks of most mutual funds and exchange-traded funds (ETFs). Alternative investments resembling hedge funds and commodities will not be included. JPMorgan believes that rates of interest will remain “low for longer” and that opportunities for alpha, income and diversification in traditional investments will shrink. This could make alternative investments a lovely proposition because they’ve a low correlation with traditional investments and may generate higher returns.
Conclusions
These optimal portfolios are suitable for long-term investors with different risk appetites who measure risk by return variability. Investors who use other risk measures – resembling Sortino or minimal downdraft – might obtain different results.
Even though equity markets are at historic highs and bond yields are at generational lows, it remains to be possible to construct robust portfolios with reasonable return expectations. Prudent investors may consider aligning their long-term asset allocations with these optimal portfolios.
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Photo credit: ©Getty Images / cosmin4000
