In the current environment, when structuring equity portfolios clients should consider:

  • Our most recent Secular Outlook indicates low expected returns for equity markets, with a skew to downside risks
  • Clients should consider allocating capital to diversifying strategies and increasing diversity within their existing matching, credit and equity portfolios
  • In equity portfolios, we believe clients should possibly:
    • Reduce allocations to traditional core, active long-only strategies
    • Increase allocations to long/short hedge funds
    • Increase allocations to private equity strategies
    • Increase use of highly active managers
    • Increase use of smart beta

Medium-term outlook

In our 2015 Secular Outlook, our view on expected medium-term equity returns was relatively cautious. Our central outlook considers the likelihood of three different scenarios, and points to an expected equity return that is both lower than history, and much lower than many would regard as normal. Put simply, we think the achievable returns from equities going forward may be lower than the required returns for many asset owners. Downside risks to this central outlook remain elevated, as we emphasized last year.

Importantly, over the medium term we believe a bad outcome is twice as likely as a good one, given starting conditions. The bad outcome scenario is consistent with a very significant equity market drawdown within a five-year period — and a much worse outcome than we experienced in 2015.

Below, we show the cyclically adjusted price/earnings ratio, which indicates U.S. stock market valuations are somewhat rich relative to history. While this is partially explained by the current low rate environment, when we consider alternate valuation models, we also find that global equities are richly priced.

In our view, this highlights the need for investors to ensure their exposure to growth assets, such as equities and credit, is appropriate, given the low-return, forward-looking environment we may face.

Figure 1. S&P 500 cyclically adjusted price/earnings ratio

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Past performance is not indicative of future results.
Source: Thomson Reuters

Improving diversity

A reduced reliance on the equity risk premium in client portfolios is our outlook’s first potential implication. We believe increased portfolio diversity is a key and impactful lever to improve risk-adjusted returns given the low expectations for equities. Increased allocations to diversifying strategies, including liquid alternatives and real assets, is key to this end.

We believe clients can also improve diversity within existing allocations:

  • Better diversity within the “matching” portfolio: introducing STRIPs, Treasury futures, swaps, high-quality credit bonds
  • Better diversity within the credit portfolio: introducing more alternative credit (loans, asset-backed securities, illiquid credit)
  • Better diversity within the equity portfolio (discussed below)

Adding downside protection

The tolerance for volatility or below-average returns depends on the asset owner’s specific conditions such as funding status, time horizon and beliefs. Still, when considering medium-term allocations, we believe an important question is: How big of a hit can you take along the way? For asset owners that have low tolerance for heightened volatility, we believe that option protection can also be considered, at the right cost.

Diversity within the equity portfolio

Growth assets are likely to remain heavily represented by equity, even with greater diversity. However, improvements to the equity portfolio can increase the diversity of return drivers, and hence, risk-adjusted returns. In a low-return equity market, additional returns from other drivers such as skill or illiquidity can potentially become even more valuable. There are several tools to increase exposure to the skill and illiquidity premia within equity portfolios:

  • For clients with a home bias, moving to a fully global portfolio
  • Reduced allocations to traditional core or benchmark-hugging active, long-only strategies
  • Increased allocations to long/short equity strategies
  • Increased allocations to private equity strategies
  • Increased use of highly active long-only managers (concentrated/high active share managers)
  • Increased use of smart beta as a way to access systematic skill premium (accessing skill without the use of traditional active managers): Smart beta can also be used to control costs, which become even more important in a low-return environment

Figure 2. Standard vs. Suggested Equity Portfolio Structure and Premia Exposure

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Individual client ability to access these tools will vary with governance budget and the size of assets within the equity portfolio. Clients with more limited governance budgets may wish to consider outsourcing arrangements for nontraditional investments.

A diverse equity portfolio structure that uses the building blocks we’ve discussed strives to provide better access to different return drivers and potentially improve portfolio diversity and risk characteristics. We believe this may provide better long-term risk-adjusted returns than standard existing equity portfolio structures. We feel it is a particularly attractive time to adjust portfolios to a more diverse structure, given our low medium-term equity market return expectations.

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