Insights from Horizon Actuarial’s Research

It leans on research conducted in the US by Horizon Actuarial. Each year, they survey 42 investment firms that share their capital market assumptions — the expected returns for various asset classes. The result of the survey is an aggregated view of these assumptions that can give investors insights into how to manage risk in their portfolios.

The report outlines the circumstances for the change in the efficient frontier, the optimal allocation to maximise returns given the risk taken. If you are below this theoretical frontier, it means that you aren’t being properly compensated for the risk that you are taking on in your portfolio.

Understanding the Efficient Frontier

The efficient frontier is a professional term and theoretical concept that is not something usually considered by individual investors. However, the concept may provide some insights into how we should think about risk and return. Additionally, as the efficient frontier is used by professional investors it governs the decisions that many asset managers make when positioning their portfolios.

The efficient frontier informs the moves of these institutional investors that galumph around the market. Even if individual investors have no interest in asset classes that may be the current flavour of the month, such as bonds, it will impact returns.

The Shift Since 2010

For most of the decade following 2010, expected long-term returns across asset classes were low. We entered the era of ‘TINA’ – There Is No Alternative. Cash and bond returns were dismal. Many investors saw no point of investing in any other asset class than equities. Monetary stimulus and risk premiums bottomed out in 2021 and many investors started searching for riskier assets due to low return expectations.

This was a time where private equity and small-cap equity strategies saw inflows. The long-term outlook for returns now looks quite different than it did over the last decade. The efficient frontier has shifted higher, but this shift has not been uniform.

Less risky assets like cash and bonds have become more attractive which allows investors to take on less risk to meet the return targets for their portfolios. In turn, there’s been less demand for riskier assets like small cap shares and private equity.

Optimising for a 7% Return

The report illustrates this point by creating two optimal portfolios assuming a typical 7% nominal return target using expected returns from 2021 and 2023. For this portfolio, private equity was capped at 40% to reflect a reasonable liquidity risk profile.

What we see in 2021 is that the optimal allocation to core bonds was 0%. The rest of the portfolio was allocated to ‘risky’ assets across equity, credit, and real estate.

What we see now, two years later, is that the rise in bond yields has resulted in an increase of the optimal allocation to core bonds to 45%. This is pulling allocation away from those riskier assets like private equity.

Minimising risk to maximise return – the optimal levels
Source: Pitchbook Quantitative Perspective report Q4 2023

The Risk Premium

The risk premium is an academic concept. It is useful to understand and add context to your own investment decision making. As investors, we exchange risk for returns. The risk, in this instance, is volatility — how much an investment bounces around.

The more volatile the investment, the more return that an investor should expect. Shares change in price more than cash but will have higher returns over the long-term. However, the volatility that is experienced while holding the security is also a function of the risk of permanently losing your investment.

US Treasury Bonds are considered risk-free because there is no risk that investors will not receive their funds back. This is because a government that issues these bonds in their own currency also controls the printing of money. Need to pay a loan and don’t have the cash? Print it.

Unlike government bonds, a corporate bond carries default risk. Even the safest company in the world still has a risk of default. The difference between a government bond and a corporate bond represents the additional return from taking on that risk.

Shares have higher expected returns. Investors take on more risk with the expectation that they will be compensated. The higher return expectation is called the equity risk premium — the return earned on top of the risk-free rate.

Valuation and Risk

The price of risk is important. It is easy to go back and look at the historic equity risk premium, but that doesn’t necessarily reflect the risk you’re taking on today.

The value of a share is the future cash flows that are generated by the company. Higher valuation levels typically mean lower dividend yields and thus, lower expected future returns — in other words, a lower equity risk premium.

Despite our natural tendency to fall victim to recency bias, a rising market decreases expected future returns. A rising market becomes riskier when share prices have gone up — not less risky.

Currently, we see the Australian market as overvalued. Does this mean that investors should shift their allocation to asset classes with higher risk premiums, such as bonds?

Strategic vs Tactical Asset Allocation

Investors often grapple with the push and pull between strategic and tactical asset allocation. Strategic asset allocation is your long-term target. It defines your goal, calculates your required rate of return, and then allocates assets to get that return.

Tactical asset allocation is a short-term deviation from that strategic target made based on current market conditions — for example, increasing exposure to core bonds due to attractive risk premiums.

Making a tactical asset allocation decision should not be done lightly. Regardless of the rationale, it is still a form of market timing.

The Role of Cash

In many cases, tactical allocation involves cash. An average investor is more likely to move funds between cash and shares or ETFs than between listed property and infrastructure.

This is an underrated aspect of cash. Having some cash in your portfolio allows you to take advantage of opportunities. Just like an emergency fund ensures you don’t have to sell shares at the wrong time, cash allows you to buy shares when they’re on sale.

This, in itself, is an investing lesson worth remembering.