Share Term Papers Cfa

The “Relatively” Easy Way to Forecast Long-Term Returns

By Andrew Perrins

Posted In: Drivers of Value

Long-term returns are relatively easy to forecast.

Short-term returns are dominated by randomness, but long-term forecasts for most asset classes can, in part, be derived mathematically (give or take some arguing about the assumptions).

But why bother with long-term return expectations — for example, 10-year forecasts? For most multi-asset managers or tactical asset allocators, 10 years is an eternity. Investment managers are judged on much shorter time frames.

For asset owners or asset managers compiling a strategic asset allocation, however, long-term forecasts are relevant and necessary. When combined with estimates for risk and correlation, these forecasts allow investors to fine-tune their long-term benchmarks and consider trade-offs between asset classes to enhance the implied risk and return profile of the fund.

In the following table, I have aggregated the results from three major asset managers — JP Morgan, Northern Trust, and BNY Mellon — that publish their long-term return forecasts for major asset classes. Here are the average expected returns:


Average Long-Term Return Forecasts

Asset ClassAverage Forecast (per annum)
US inflation2%–2.5%
US cash2%–2.5%
US 10-year bonds2%–2.5%
Commodities2%–3%
Hedge funds4%–5%
US equities6%–7%
Global equities6%–8%
Private equity8%–9%

 


Let’s think about how these estimates are derived and whether they are realistic.

Fixed-income securities are the obvious starting point. If we buy a 10-year Treasury today with a redemption yield of 2.5% and hold it to redemption, we know that the return will be 2.5% per annum (assuming that the US government doesn’t default).

The Return from US Equities

Now, let’s consider US equities. The simplest expression of the truly long-term return from US equities follows a classical formula, as described by Richard Grinold and Kenneth Kroner:

Long-term return from equities = Dividend yield + Inflation + Real earnings growth

Long-term return from equities = 2.0% + 2.25% + 2.25% = 6.5%

So, at first glance, if you believe the assumptions — that inflation will be around 2.25% and that dividends will grow pretty much in line with long-run GDP expectations — then the forecast above is reasonable. What’s not to like? Let’s unwrap this in more detail.

First, should we adjust for buybacks? In reality, the payback to long-term (buy and hold) investors will be both in dividends and in capital return from share buybacks. It’s reasonable to assume that substituting buybacks for dividends makes no substantive difference to total long-term returns, although some of the publications linked in this post explore the building blocks behind this in impressive detail.

Second, is it reasonable to assume that dividend growth (or earnings growth) will keep pace with the real economy? Can the profit share of GDP hold at its current level? A recent report from McKinsey & Company is forecasting that more competitive world markets will trigger a 20% fall in global profit share by 2025.

Also, even if profit share holds near to recent highs, can the companies that currently make up the index maintain their own profit share as new players and technologies emerge? My personal expectation is that earnings growth will not match real GDP growth in the long run. You may have your own view.

Third is the question of equity market valuation. If we are considering a finite time horizon (let’s say 10 years), then our formula above only holds if the dividend yield remains constant. If it is likely to change, we need to make a valuation adjustment.

It is for this reason that the estimate of long-term US equity returns from our fourth research publication is starkly different from those above. Rob Arnott’s team at Research Affiliates forecasts that, over the next 10 years, the valuation of the US equity market (as measured by the Shiller CAPE ratio) will revert halfway back to its long-term average. This implies a valuation adjustment of 2.4% per annum. When added to a dividend yield of 2% and their estimate of dividend growth of 1.4% per annum, this gives a prospective 10-year total return from US equities of just 1.0% per annum.

Whom do you believe?

Visit Savvy Investorfor other articles on long-term return forecasts or asset allocation.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©iStockphoto.com/Jorgenmac

Andrew Perrins

Andrew Perrins is CEO and co-founder of Savvy Investor, a professional network for institutional investors, which curates pension and investment research and white papers from around the web. After qualifying as an Actuary in 1987, Perrins worked as Director of Global Asset Allocation for Abbey Life and Chase Manhattan Bank.

The Chartered Financial Analyst (CFA) is one of the more frequently sought after designations for investment professionals. However, becoming a CFA charter holder is not for the faint-hearted nor the uninterested. The journey to becoming a CFA charter holder is long, and it tests not only your knowledge of the subject, but also your endurance, diligence and will. According to the CFA Institute, the current program is best described as a self-study, distance-learning program that takes a generalist approach to investment analysis, valuation and portfolio management, and emphasizes the highest ethical and professional standards. 

The CFA program consists of three exams: CFA Level I, Level II and Level III. As a CFA candidate, you are required to pass each of these exams and you must meet certain work requirements as set out by the CFA Institute. In 2016 the passing rate for the Level I exam was 43%.

The curriculum for each of these three levels is designed to test you on a broad array of skills considered to be most relevant for the investment profession. In this article we will focus on the CFA Level I exam.

Exam Structure

The exam is a six-hour exam, broken into a morning and afternoon session, each being three hours long.  The exam consists of 240 multiple-choice questions: 120 questions in the morning session and 120 questions in the afternoon session.  All of the multiple-choice questions are free standing (i.e., they are not dependent on each other). For each question, there are three possible choices provided. The questions are crafted intelligently, such that the incorrect choices reflect common mistakes in calculation or logic. So, you have to be very careful while selecting the right choice.

Exam Curriculum

The exam focuses on basic knowledge and comprehension of tools and concepts of investment valuation and portfolio management. The curriculum consists of 10 topics that are grouped into four areas, specifically: ethical and professional standards, investment tools, asset classes, and portfolio management and wealth planning.

The following table provides the weights of these topics and broad areas for the Level I exam.

Topic AreaLevel I
Ethical and Professional Standards (total)15
Investment Tools (total)50
Corporate Finance7
Economics10
Financial Reporting and Analysis20
Quantitative Methods12
Asset Classes (total)30
Alternative Investments4
Derivatives5
Equity Investments10
Fixed Income10
Portfolio Management and Wealth Planning (total)7
Total100

Let's take a brief look at each of these 10 topics.

Ethics and Professional Standards

This section covers the code of ethics, professional standards and the Global Investment Performance Standards (GIPS). This is a very important section and you will be asked approximately 36 questions on the subject. The Institute itself takes this section very seriously. If you score low or close to the minimum passing score on all other topics, then your score on ethics could determine whether you pass or fail. One advantage with studying ethics well is that it also helps with your Level II and III exam preparation.

Quantitative Methods

While ethics is more scenario-oriented and easy to follow, this section could be intimidating for some students. You don't need a Ph.D. in mathematics to do well in quants, but having a stats background will certainly be helpful. You can expect around 28 to 30 questions related to quants. The topics covered are geared toward providing you the knowledge of analytical tools that are essential for material on fixed income, equities and portfolio management. The key topics covered are: time value of money, performance measurement, statistics and probability basics, sampling and hypothesis testing and correlation and linear regression analysis. 

Economics

The economics section tests your knowledge on basic micro and macroeconomic concepts. If you studied economics in college, then you will find this material very familiar. Without a background in economics, this material can be challenging, especially macroeconomics, which employs the use of graphs and x and y curves to illustrate concepts related to the economy. Economics comprises 10% of the syllabus.

Financial Reporting and Analysis

This is probably the largest section on the exam, with 20% of the questions being on this topic. Reporting and analysis are also weighted about the same for the Level II course, so it's important to spend enough time studying this area to build a solid foundation for subsequent exams. You will be asked to interpret the three financial statements (balance sheet, income statement and cash flow statement), know the ratios and many other advanced concepts such as revenue recognition, inventory analysis, long-term assets and taxes. Since the exam is a global exam, it does not cover local accounting practices. The focus is more on widely accepted standards such as U.S. GAAP and IFRS.

Corporate Finance

After financial reporting and analysis comes corporate finance. This is a short section with only an 7% weightage. The key topics include agency problems related to agency-principal relationship, capital budgeting, cost of capital, leverage and working capital management.

Portfolio Management

The Level I exam only introduces you to the basics of portfolio management. The important concepts are Modern Portfolio Theory and the Capital Asset Pricing Model. There will be about 17 questions in this section. This section acts as a preparation for Levels II and III, where the focus is more on the application of all your knowledge on portfolio management.

Equity Investments

You can expect about 10% of questions to be on equities. The curriculum for equities covers equity markets and instruments, and tools and techniques for valuing companies. The majority of the questions will be focused on valuing and analyzing companies.

Fixed Income

After equities, the exam deals with fixed income markets and its instruments. You are required to understand the characteristics of various fixed income securities and how to price them. Some important concepts are the yield measures and duration and convexity. This section also discusses structured products such as mortgage-backed securities and collateralized mortgage obligations, among others. Fixed Income comprises 10% of the exam.

Derivatives

Similar to portfolio management, derivatives are only introduced in Level I. You will be tested on the basics of futures, forwards, swaps, options and hedging techniques using these derivatives. This section only has a 5% weightage, that's about 12 questions.

Alternative Investments

This section focuses on alternative investments including real estate, private equity, venture capital, hedge funds, closely held companies, distressed securities and commodities. There will be about seven to eight questions from this section and will be more conceptual in nature. There is special consideration to commodity investments, so get familiar with concepts such as backwardation and contango.

The Bottom Line

Overall, the CFA Level I exam is well-balanced, with a wide spectrum of topics. Some topics may require proportionally more time to study than others; however, what's important is to plan your studies and stay with the plan. Best of luck on the exam!

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