The S&P 500’s historical annual return has been 10.2% from 1956 to 2020. However, according to J.P. Morgan’s long-term capital market assumptions (See Figure 1), US large-cap equity returns will be 4.1% over the next 10 to 15 years, with investment-grade bond returns projected at 2.8% and cash at 1.3%—all well below the long-term historical average. The figure shows select long-term capital market assumptions. The lower assumptions are driven largely by the current global economic environment and projections for stunted future global growth. Other institutions have expressed doubt that double-digit returns for financial assets are sustainable after a 13-year bull market for both stocks and bonds.
Capital market assumptions (CMAs) used in models, asset allocation, and financial planning models influence all the approaches listed above. If the difference between the historical averages and CMAs were small (a few basis points), it would not matter as much as the difference that most firms project today. However, the differences between the long-term averages and the forward-looking projections are quite large. The inputs used in the various models determine the return expectations, income levels, and risk required to achieve client goals over a determined time horizon. Relying on flawed CMAs may lead to overestimating returns, falling short of investor expectations, or being forced to extend time horizons to achieve results.
Wealth advisors need to expand their playbook beyond traditional stock and bond allocations to help clients achieve their long-term goals. Private equity may provide higher returns, private credit provides alternative sources of income, and hedge funds have historically delivered diversification relative to traditional investments. J.P. Morgan projects a private equity illiquidity premium of 400 basis points over the next 10 to 15 years.
Asset Allocation Considerations
The world has changed a great deal since Markowitz’s paper was published, both in the number of asset classes and the availability of those asset classes. The additional asset classes serve as valuable diversification tools, because globalization by definition means that markets are more interconnected today. The challenge, of course, is optimizing the number of asset classes in the appropriate weight and using current capital market assumptions to provide realistic expectations around returns and risks.
To determine the optimal combination of asset classes, advisors use some form of MVO modeling, where the critical inputs are returns, risk, and correlation of the underlying asset classes. Many models use long-term historical data. But what if future results do not mirror past results? What if returns are lower and risks and correlations are higher? How can investors achieve their long-term goals?
As previously discussed, the current capital market assumptions suggest that it will be much harder to achieve targeted returns and sufficient diversification using only traditional investments. Alternative investments may be valuable tools in addressing the challenges in the current environment. Private equity provides the opportunity for higher returns, private credit provides an alternative source of income, and certain hedge fund strategies provide diversification relative to traditional investments.
Let’s divide alternative investments into hedge fund strategies (equity-hedged, event-driven, relative value, macro, and multi-strategy) and private markets (private equity, private credit, and real assets). These versatile strategies can be valuable tools for wealth advisors in building more sophisticated and durable portfolios for HNW investors. In this challenging environment, HNW investors are demanding access to these once-elusive investments.