The “Relatively” Easy Way to Forecast Long-Term Returns
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 Class||Average Forecast (per annum)|
|US 10-year bonds||2%–2.5%|
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?
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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.
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