Strategic Asset Allocation

Q: Why does the study exclude convertible bonds? Some research suggests that adding convertible bonds to a mixed portfolio can improve the efficient frontier

A: Our SAA analysis focuses on asset classes included in our Tactical Asset Allocation and for which we have consensus return assumptions from major asset managers. Convertible bonds don’t meet both criteria. However, they can potentially improve the efficient frontier. For a tailored SAA that includes convertible bonds or other assets, we can create custom assumptions. Please contact us for more information.

Q: How does your process avoid simply following market consensus? Since consensus is often already priced in, how do you ensure your approach adds value?

A: Investing alongside consensus doesn’t guarantee outperformance, but in this context, the consensus adds unique value. First, the return expectations we use are forward-looking, not historical. They reflect asset managers’ long-term views on factors like economic growth and inflation, which already differ from a ‘market consensus’ based on past returns. Second, financial markets tend to focus on short-term developments, while our consensus of long-term return assumptions may not be fully priced in.

Q: Can the outperformance of SAA decisions versus passive allocations be a unique selling point?

A: We are currently building a track record to compare the performance of using consensus expected returns in SAA decisions against a strategy that relies on past performance to estimate future returns.

Q: Is your SAA optimization based on target returns in EUR? Were expected returns for foreign currencies adjusted for FX hedging costs?

A: In short, we haven’t adjusted expected returns for FX hedging costs, and here’s why:

Our reports adopt a global investor perspective, reflecting our diverse audience. While we are Europe-based and serve primarily European clients, we also have a global readership. Most of the benchmarks we use are dollar-denominated, with EMU and Japan equity/bonds comprising a smaller share. Additionally, many index constituents are multinational companies with global operations, meaning FX hedging practices vary.

Our Tactical Asset Allocation report includes an FX allocation, replicating an active currency overlay strategy. The Strategic FX allocation reflects major currencies’ share in global FX transactions, based on WTO and BIS data, offering a robust global view.

For clients seeking tailored SAA solutions, we can incorporate FX hedging costs and adjust expected returns accordingly. Please contact us if you’d like to explore this further.

Q: Will you use consensus expected correlations and volatility in SAA to align with expected returns, instead of historical data?

A: No, many asset managers don’t provide long-term expectations for cross-asset correlations and volatility, so the sample size would be limited. Additionally, correlations and volatility tend to mean-revert, making historical averages a better predictor for future trends.

Q: What statistics or studies support your assumption of 10% real estate in the SAA?

A: The 10% midpoint for listed real estate is based on several factors:

Real estate is a key global asset class, though illiquid and considered an alternative investment. It serves as an inflation hedge, with rents typically indexed and values rising in line with inflation. However, leverage reduces its appeal, making it more correlated with bonds.

Given its equity and bond-like characteristics, listed real estate is attractive in a diversified portfolio. We expect long-term inflation pressures, driven by factors like aging populations and energy transitions, which would make real estate, along with gold and commodities, more appealing as inflation hedges.

To our knowledge, no academic studies define the optimal real estate allocation band.

Q: How do you handle varying input frequencies from asset managers? (e.g., yearly vs. quarterly)? Are they given equal or weighted importance?

A: For each Expected Returns (Capital Market Assumptions) report, we consider the forecast currency, whether it’s nominal or real, and the time horizon. We base our report on the peer group with the most commonly reported currency.

We include reports from the past five quarters, as around 70% are annual and 30% quarterly. While trends within a year are sometimes observed (e.g., expected returns moving up or down), differences are typically smaller than 0.25%.

Given that asset allocation isn’t high-frequency trading, these trends provide a solid foundation for investment committee discussions. For more frequent responses, you can use custom building blocks, such as Real Earnings Growth, Dividend Yield, Inflation, and Valuation/PE, to adjust for time lags or align with your desired frequency.

Q: Given the wide range of 49 firms used to define target returns, would it make sense to adjust for variables such as client volume, track record, expertise, assets under management, and team size/capabilities?

A: Adjusting for factors like client volume, track record, expertise, and assets under management could add precision, and it's something worth exploring. However, we choose equal weighting for two main reasons:

1. Simplicity: Adjusting for these factors would introduce complexity and reduce clarity.
2. Goal alignment: Our primary aim is to move beyond relying solely on past returns. We believe that using the average of expected returns from major asset managers offers more valuable insights, as it incorporates not only past performance but also considerations like valuations and the long-term outlook for growth and inflation.

Q: Why use an equally weighted basket of US, EU, JP, and EM stocks for 'global stocks' instead of a capitalization-weighted index like the MSCI World?

A: Given the long-term horizon, we prefer an equally weighted approach because market cap weightings:

• Reduce diversification, as seen with the US making up around 70% of the MSCI World.
• Increase exposure to overvalued stocks, as they tend to have higher prices and valuations. Historically, today's stock leaders with the highest market caps often lose their position over time, making them less attractive for long-term investors.