capital market assumptions - d6g93j3kwyclp.cloudfront.net · CONSULTING RESEARCH GROUP ... we...

At CAPTRUST, we believe setting realistic capital market assumptions

leads to more prudent asset allocation decisions for corporate

defined benefit plans and private investors alike and to a more

successful investment experience overall. In developing our new

assumptions, we expect monetary policy, rather than fiscal policy or

fundamental factors such as corporate earnings, will continue to drive

the performance of capital markets. Given these circumstances, we

suggest that now is the time for investors to reassess their portfolio

return expectations.

The financial literature has taught us

that risk and return are related and that

optimized portfolios seek to produce

the highest expected return per unit

of risk. But what returns are realistic

to expect in a post-financial-crisis

environment characterized by slower

economic growth, historically low

interest rates, and subdued inflation?

Formulating risk and return assumptions

for the various asset classes that

comprise capital markets offers

investors a guide to the probable range

of investment performance over a

given period. These assumptions can

then guide the asset allocation and

risk levels that should be chosen to

meet investment goals. For instance, if

equities are expected to deliver higher

returns in the forward period than

they have in the previous period, can

equity allocations be lowered without

sacrificing performance?

SUMMARY

CONSULTING RESEARCH GROUP | POSITION PAPER

www.captrustadvisors.com

capital market assumptions Seeking Opportunities in a More Challenging Environment

April 2013

2

CAPTRUST FINANCIAL ADVISORS


Overall, our new return forecasts are generally lower than our prior

forecasts, primarily due to a lower starting point across each asset class.

Historically low interest rates are driving more subdued fixed income

returns, while slower economic growth adversely impacts equity returns.

Despite lower return forecasts, we remain generally constructive on capital

markets. Going forward, however, investors will need to be more selective

with their asset allocation decisions.

Our forecast covers a full market cycle, which is typically five to seven years. We look at four

principal themes that guide our current thinking in formulating capital market assumptions.

1) Slower economic growth: Economic improvement following financial crises tends to

be shallower than in other recoveries. In recent years, growth has been held back by several

factors, including corporate and household deleveraging, but signs of progress are evident.

As shown in Figure 1, the household and financial sectors have made considerable strides

in reducing their debt burdens; debt-to-Gross Domestic Product (GDP) ratios for both of

these sectors are at decade lows. The corporate sector has made less progress on this issue,

but high cash levels on corporate balance sheets provide support. Given balance sheet

strength and cheap financing rates, we are less concerned about corporate indebtedness.

capital market assumptions Seeking Opportunities in a More Challenging Environment

GUIDING THEMES

Figure 1: Debt Outstanding by Sector as a Percentage of U.S. GDP, 1965–2012

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3CAPITAL MARKET ASSUMPTIONS — Seeking Opportunities in a More Challenging Environment

In contrast to private sector deleveraging, government debt

as a percentage of GDP continues to increase at a rapid

pace and is currently at historic highs. Academic research

suggests that a high debt-to-GDP ratio can have a materially

negative effect on a country’s economic growth.1 The fiscal

tightening that is necessary to address this issue, likely

through tax increases and spending cuts, could be a drag on

U.S. economic growth.

The key question over the forecast horizon is whether a

recovery in the U.S. private sector can offset contraction

in the government sector. Within the private sector,

homebuilding is beginning to recover and should provide

a tailwind for economic growth. In the early years of our

forecast, fiscal contraction is expected to offset better

growth prospects in the private sector. However, in the later

years of our forecast, assuming the government debt-to-

GDP ratio is reduced to a sustainable level, both the public

and private sectors could contribute to economic growth.

The International Monetary Fund (IMF) forecasts that U.S.

GDP growth will gradually return to its long-term trend

over the forecast horizon. Sluggish growth may be partially

attributed to shorter-term issues such as uncertainty about

the U.S. deleveraging process over the next year and the

European sovereign debt crisis. As clarity emerges on

these issues, business and consumer confidence will

likely improve. However, structural issues related to the

financial crisis such as longer-term debt reduction and a

persistently high unemployment rate may also impact

growth. Demographic factors such as an aging U.S.

population could also play a role, as the pace of labor force

growth slows. Some observers, such as the Congressional

Budget Office, are concerned that these structural factors

could impair the longer-term U.S. growth rate, although the

evidence is unclear at this point.2

2) Low interest rates: As shown in Figure 2, U.S.

interest rates have steadily fallen over the past 30 years

to historically low levels. The Federal Reserve expects to

keep short-term interest rates at the present low levels for

several more years, depending on the pace of improvement

in the labor market and the overall economy’s trajectory.

Interest rates could gradually rise toward equilibrium

levels in the latter part of our forecast horizon.

continued on page 4


Figure 2: U.S. 10-Year Government Bond Yields, 1975–2013

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September 1981: 15.32%

May 1984: 13.41%

January 2000: 6.66%

December 2008: 2.42%

January 2013: 1.98%

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continued from page 3

While the Fed is expected to keep short-term rates

anchored in the near term, it has less direct control over

longer-term rates. Many investors are concerned that

longer-term interest rates can only go higher from today’s

historically low levels. As discussed later in this report, we

expect subdued returns in fixed income as interest rates

begin to rise.

However, low interest rates can have a favorable impact on

other aspects of the economy, including the deleveraging

process. In recent years, households and businesses have

refinanced their debt at significantly lower rates, which

reduces their future debt service cost.

3) Monetary policy: With fiscal policy constrained in

the developed world, monetary policy is a critical asset

class return determinant. Central bank actions not

only influence interest rates but also investor behavior

as evidenced by strong flows into higher-yielding asset

classes over the past year. According to Lipper, U.S. high

yield bond funds saw $29 billion of inflows in 2012, just

below the record inflows posted in 2003 and 2009. In

some cases, such as with global equities, monetary policy

could distort asset prices as investors pay less attention to

corporate earnings and other fundamental factors. Central

banks’ ability to successfully unwind their accommodative

policies will also have a significant impact on asset prices,

although this is more likely to be a factor in the latter part

of the forecast horizon.

4) Inflation: U.S. inflation, as measured by the

Consumer Price Index (CPI) (Figure 3), has been well-

contained in recent years due to sluggish GDP growth

and considerable slack in the economy. This scenario has

kept wage growth at low levels. We expect inflation to

remain subdued in the near term but pick up in the later

years of our forecast due to the impact of accommodative

monetary policy and stronger economic growth.

Some observers are concerned that the aggressive steps

taken by central banks could eventually lead to higher

inflation. The Fed’s balance sheet has expanded significantly

following the financial crisis, driven by its purchases of

U.S. Treasurys and mortgage-backed securities. The Fed’s

balance sheet should continue to expand in the near term

and could reach $4 trillion by the end of 2013 based on

the current pace of asset purchases. The European Central

Bank has embarked on a similar program in response to that

region’s sovereign debt crisis.

The U.S. money multiplier, which measures the amount

of commercial bank money that can be created by a given

unit of central bank money, remains at a historically low

level (Figure 4), which dilutes the impact of monetary

policy. A contraction in bank lending due to tighter lending

standards and lower loan demand is the main driver behind

this trend. As the money multiplier normalizes due to a

pickup in bank lending, we will likely see higher inflation

during the later years of our forecast horizon.


These four themes could have a

significant impact on asset class

results during our forecast horizon.

The balance between private sector

growth and public sector deleveraging

is a significant swing factor in our

forecasts. Market observers who are

pessimistic on U.S. growth often

cite the drag from fiscal contraction

as a primary reason. The future path

of interest rates is meaningful to

our forecasts, particularly for fixed

income. If longer-term rates stay low

for an extended period, this could be

supportive for fixed income returns.

In contrast, if rates normalize faster

than expected due to acceleration

in economic growth, fixed income

returns could be adversely impacted.

Accommodative monetary policy

could lead to higher than expected

inflation, with adverse effects on a

number of asset classes, particularly

fixed income. In that scenario, hard

assets such as commodities and real

estate could become relatively more

attractive as they have historically

acted as hedges against inflation risk.

continued on page 6


Figure 3: U.S. Consumer Price Index, 1950–2012

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We divide our full market cycle forecast horizon into two periods:

• Years 1-3: continuation of slow GDP growth, low interest rates, and modest inflation

• Years 4-7: gradual acceleration of GDP growth leading to higher interest rates and inflation

Please note that our forecasts are at the asset class level only; we do not forecast the excess returns

derived from the use of active management.

As shown in Figure 5, our new return forecasts are lower than our prior forecasts across nearly every asset

class. When developing capital market assumptions, the starting point for each asset class is an important

consideration since it historically has a high correlation with future returns. Historically low interest rates

drive our more subdued fixed income returns, most notably in rate-sensitive subsectors such as long-term

Treasurys and core fixed income. Slower economic growth is filtering into corporate profits, which drives

our equity returns lower. Equity valuations have rebounded following the financial crisis, which suggests a

lower probability of multiple expansion (investors paying a higher price per unit of earnings) going forward.

OVERVIEW OF NEW ASSUMPTIONS

Asset Class Prior Return New Return Prior Risk New Risk

U.S. GDP Growth — 2.5% — —

U.S. Inflation 3.0% 2.6% — —

Cash 1.5% 1.2% 0.5% 0.5%

Long-term U.S. Treasury — 1.8% — 12.1%

Core Fixed Income 5.0% 2.5% 5.1% 5.5%

U.S. Investment Grade Corporate 5.8% 3.6% 6.9% 6.1%

Long Duration Corporate — 5.0% — 11.3%

U.S. High Yield Corporate 6.1% 7.0% 9.7% 15.0%

Emerging Market Debt — 5.8% — 13.0%

U.S. Municipal Debt 5.8% 2.7% 4.9% 4.9%

U.S. Large-cap Equity 8.1% 7.0% 15.3% 17.4%

U.S. Mid-cap Equity 9.3% 7.5% 18.5% 20.6%

U.S. Small-cap Equity 9.5% 7.3% 22.9% 22.5%

International Equity — Developed 9.3% 7.6% 19.3% 25.0%

International Equity — Emerging 12.0% 9.3% 28.0% 27.2%

Private Equity 13.0% 10.0% 26.5% 28.8%

U.S. Public Real Estate 7.4% 7.2% 15.9% 22.8%

U.S. Private Real Estate 9.0% 6.2% 18.9% 12.5%

Commodities 8.6% 6.0% 21.0% 19.7%

Hedge Fund of Funds (Diversified) 8.5% 4.0% 5.5% 5.0%

Figure 5: Comparison of New and Prior Capital Market Assumptions

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continued on page 8

You’ll see that our new risk forecasts are higher than our prior risk forecasts across most

asset classes. We use standard deviation as one risk metric, which measures the possible

divergence of the actual return for an asset class from its expected return. Note that for

our portfolio construction processes, we view permanent capital impairment or loss of

capital as the single most important risk measurement. Our standard deviation forecasts

in Figure 6 are based on historical trends with more weight placed on recent periods. For

nearly all asset classes, standard deviations in the most recent five-year period are higher

than over the prior 20 years. The deleveraging process and other repercussions from the

financial crisis have driven increased volatility in economic growth and asset prices. The

trend of increased volatility is expected to continue in the coming years.


Historical Standard Deviation Difference Standard

Deviation

Asset Class 20 Years 10 Years 5 Years 5 Yr – 20 Yr Forecast

Cash 0.6% 0.5% 0.5% -0.1% 0.5%

Long-term U.S. Treasury 9.8% 11.3% 12.9% 3.1% 12.1%

Core Fixed Income 3.7% 3.6% 3.5% -0.2% 5.5%

U.S. Investment Grade Corporate 5.3% 5.7% 6.4% 1.1% 6.1%

Long Duration Corporate 8.8% 10.6% 12.1% 3.3% 11.3%

U.S. High Yield Corporate 8.9% 10.9% 13.5% 4.6% 15.0%

Emerging Market Debt — 9.1% 10.4% 1.4% 13.0%

U.S. Municipal Debt 4.4% 4.6% 5.0% 0.6% 4.9%

U.S. Large-cap Equity 14.9% 15.7% 18.2% 3.3% 17.4%

U.S. Mid-cap Equity 16.7% 18.3% 21.9% 5.2% 20.6%

U.S. Small-cap Equity 19.5% 20.7% 23.5% 4.0% 22.5%

International Equity — Developed 17.0% 18.8% 22.3% 5.3% 25.0%

International Equity — Emerging 24.0% 24.1% 28.3% 4.3% 27.2%

Private Equity 11.0% 10.9% 11.5% 0.5% 28.8%

U.S. Public Real Estate 19.8% 25.1% 31.7% 11.8% 22.8%

U.S. Private Real Estate 4.9% 6.2% 7.7% 2.8% 12.5%

Commodities 15.3% 18.2% 21.1% 5.8% 19.7%

Hedge Fund of Funds (Diversified) 4.0% 4.3% 5.4% 1.3% 5.0%

Figure 6: Standard Deviation Forecasts

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Expected risk-adjusted returns for each asset class based

on the Sharpe ratio, which divides CAPTRUST’s expected

return by our expected standard deviation, are displayed in

Figure 7. Sharpe ratio is a helpful measure since it allows for

comparison across asset classes. For example, although hedge

fund of funds have a low expected return of 4%, risk-adjusted

returns are more favorable. In contrast, private equity has both

a high expected return and standard deviation, which leads to

a lower Sharpe ratio. Within fixed income, our analysis reveals

that credit-sensitive subsectors are more attractive than rate-

sensitive areas. Equities generally screen near the average level

among the asset classes in our capital market assumptions.

Sharpe ratio is a

helpful measure

since it allows for

comparison across

asset classes.

Figure 7: Risk-Adjusted Returns

Hedge Fund of Funds (Diversified)

Long-Term U.S. Treasury

0.0

Sharpe Ratio

U.S. Private Real Estate

U.S. Investment Grade Corp

U.S. High Yield Corporate

Emerging Market Debt

Long Duration Corporate

U.S. Large-Cap Equity

U.S. Municipal Debt

U.S. Mid-Cap Equity

Private Equity

International Equity—Emerging

U.S. Small-Cap Equity

U.S. Public Real Estate

International Equity—Developed

Commodities

0.1 0.2 0.3 0.4 0.5 0.6

Core Fixed Income

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continued on page 10

Our correlation forecasts (Figure 8) are derived from the same methodology as our risk

assumptions. Correlations among and within asset classes have generally increased in

recent periods as macroeconomic issues and central bank actions drive markets. Given

this trend, we place more weight on recent periods when developing correlation forecasts.


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Cash 1.00 -0.02 -0.01 -0.12 -0.15 -0.17 -0.14 -0.11 -0.06 -0.08 -0.09 -0.04 -0.01 0.06 -0.11 0.28 0.04 0.08

Long-Term Treasury -0.02 1.00 0.78 0.46 0.56 -0.25 0.11 0.29 -0.28 -0.31 -0.33 -0.27 -0.27 -0.53 -0.16 0.03 -0.22 -0.34

Core Fixed Income -0.01 0.78 1.00 0.84 0.81 0.22 0.57 0.49 0.07 0.06 -0.02 0.14 0.11 -0.33 0.16 -0.13 0.08 -0.01

U.S. Investment Grade Corporate -0.12 0.46 0.84 1.00 0.95 0.58 0.78 0.56 0.36 0.38 0.28 0.46 0.42 0.11 0.37 -0.19 0.31 0.35

Long Duration Corporate -0.15 0.56 0.81 0.95 1.00 0.52 0.72 0.49 0.31 0.33 0.25 0.40 0.37 0.07 0.35 -0.14 0.24 0.27

U.S. High Yield Corporate -0.17 -0.25 0.22 0.58 0.52 1.00 0.78 0.35 0.72 0.78 0.72 0.73 0.73 0.65 0.73 -0.07 0.48 0.64

Emerging Market Debt -0.14 0.11 0.57 0.78 0.72 0.78 1.00 0.43 0.63 0.66 0.58 0.70 0.71 0.55 0.61 -0.04 0.51 0.53

U.S. Municipal Debt -0.11 0.29 0.49 0.56 0.49 0.35 0.43 1.00 0.12 0.16 0.08 0.12 0.11 0.01 0.19 -0.19 -0.05 0.20

U.S. Large-Cap Equity -0.06 -0.28 0.07 0.36 0.31 0.72 0.63 0.12 1.00 0.96 0.91 0.89 0.81 0.82 0.75 0.23 0.52 0.62

U.S. Mid-Cap Equity -0.08 -0.31 0.06 0.38 0.33 0.78 0.66 0.16 0.96 1.00 0.96 0.87 0.83 0.83 0.80 0.18 0.55 0.67

U.S. Small-Cap Equity -0.09 -0.33 -0.02 0.28 0.25 0.72 0.58 0.08 0.91 0.96 1.00 0.81 0.77 0.77 0.80 0.19 0.46 0.56

International Equity—Developed -0.04 -0.27 0.14 0.46 0.40 0.73 0.70 0.12 0.89 0.87 0.81 1.00 0.88 0.76 0.69 0.13 0.62 0.67

International Equity—Emerging -0.01 -0.27 0.11 0.42 0.37 0.73 0.71 0.11 0.81 0.83 0.77 0.88 1.00 0.72 0.60 0.04 0.65 0.70

Private Equity 0.06 -0.53 -0.33 0.11 0.07 0.65 0.55 0.01 0.82 0.83 0.77 0.76 0.72 1.00 0.61 0.50 0.64 0.87

U.S. Public Real Estate -0.11 -0.16 0.16 0.37 0.35 0.73 0.61 0.19 0.75 0.80 0.80 0.69 0.60 0.61 1.00 0.23 0.37 0.37

U.S. Private Real Estate 0.28 0.03 -0.13 -0.19 -0.14 -0.07 -0.04 -0.19 0.23 0.18 0.19 0.13 0.04 0.50 0.23 1.00 0.30 0.28

Commodities 0.04 -0.22 0.08 0.31 0.24 0.48 0.51 -0.05 0.52 0.55 0.46 0.62 0.65 0.64 0.37 0.30 1.00 0.65

Hedge Fund of Funds 0.08 -0.34 -0.01 0.35 0.27 0.64 0.53 0.20 0.62 0.67 0.56 0.67 0.70 0.87 0.37 0.28 0.65 1.00

Figure 8: Correlation Matrix

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GDP and Inflation

Dividing the full market cycle into two periods, as

discussed earlier, forms the basis for our long-term 2.5%

U.S. GDP growth forecast. In years one through three,

the impact of deleveraging is expected to keep GDP

growth below its long-term average. In years four through

seven, fiscal contraction becomes less of a drag and GDP

growth accelerates.

In a similar fashion, the expectation for a slow growth

period followed by a stronger one underpins our 2.6%

U.S. inflation forecast. In years one through three, the

money multiplier stays below its long-term average and

considerable slack remains in the economy, particularly

in the labor market, keeping inflation contained. In years

four through seven, inflation rises due to the impact of

central banks’ accommodative monetary policies and a

tighter labor market.

Gradual recoveries in GDP growth and inflation have a

significant impact on our equity return forecasts, as these

conditions lead to lower earnings growth compared to

historical averages. Inflation expectations normally have a

negative correlation with fixed income returns. If inflation

remains well controlled, this could be supportive for fixed

income. In contrast, hard assets such as commodities and

real estate tend to perform well in inflationary environments.

Fixed Income

The current yield is the starting point for our fixed income

forecasts as it has been a reasonable proxy for forward fixed

income returns with a correlation of 0.90 (see Figure 9). With

the 10-Year Treasury yield hovering around 2%, this could

signal subdued fixed income returns in future years. Fixed

income returns have diminished over time as interest rates

approach the nominal “zero bound,” a term reflecting that

in unadjusted terms, bond yields cannot move below zero.

ASSET CLASS METHODOLOGY AND IMPLICATIONS

Figure 9: 30-Year U.S. Treasury Yield vs. Barclay’s U.S. Aggregate Index, 1977–2012

1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2004 2006 2008 20102002 2012

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The biggest risk for fixed income returns is a sharp rise in interest rates,

but several factors could prevent this scenario. Despite accommodative

monetary policy from central banks, risks to global growth remain a concern,

which could lead to a more gradual increase in interest rates. In addition,

demographic factors in the U.S. and a lack of viable substitutes for U.S.

Treasurys as a safe haven asset could provide support even as rates rise.

Our cash and long-term U.S. Treasury forecasts incorporate insights from

the forward yield curve, which represents market participants’ expectations

for future interest rates. The forward curve suggests a gradual rise in interest

rates over the coming years. For long-term U.S. Treasurys, we also factor in

the potential for principal loss in a rising rate environment. We examined

prior periods of rising interest rates to gauge the likely path of future returns,

which showed that Treasurys are more vulnerable to losses than other fixed

income subsectors.

For the remaining fixed income subsectors, we use the current yield as the

starting point and then make adjustments for expected spread tightening,

which could aid returns. U.S. investment grade and high yield spreads have

tightened significantly over the past few years albeit from elevated levels

during the financial crisis. In some cases, spreads could eventually reach

their pre-crisis lows due to improved fundamentals and investor appetite for

yield in the current low rate environment.

For high yield debt, the expected default rate is also incorporated into our

return forecast. U.S. high yield default rates have improved for several years

but are expected to gradually increase going forward. Default rates are

unlikely to rise sharply in the near term due to ample liquidity that provides

refinancing opportunities for companies.

Equities

We use three building blocks to develop equity return forecasts: dividend

yield, expected earnings growth, and the impact from valuation changes. Our

estimates for each return component are illustrated in Figure 10. The sum of

current dividends and earnings growth is a reasonable proxy for forward equity

returns with a correlation of 0.60. This measurement is currently about 6.5%,

which is slightly below our 7.0% return forecast for large-cap U.S. equities.

Despite accommodative

monetary policy from

central banks, risks to

global growth remain

a concern, which could

lead to a more gradual

increase in interest rates.


12




Dividend yields should be supported by a high level of cash on corporate balance sheets and a focus

on returning more capital to shareholders through actions including share buybacks. In a slow-growth

environment, yield has become an increasingly important component of total returns for equities.

During our forecast horizon, earnings growth for large-cap U.S. earnings is expected to be significantly

lower than its historical average of 8% as companies face revenue pressure and less flexibility to further

reduce costs. Earnings growth of 4.9% for large-cap U.S. equities is projected to be roughly in line with

our expectation for accelerated U.S. GDP growth in the latter part of our forecast horizon, with modestly

higher earnings growth for mid- and small-cap firms. In international equities, earnings growth in the

emerging markets should outpace the developed markets due to a better fiscal position and favorable

demographics. However, emerging market growth may be lower than in previous periods as China

transitions to a more sustainable growth rate.

U.S. Large-Cap U.S. Mid-Cap U.S. Small-Cap International Developed

International Emerging

Dividend Yield 2.1% 1.8% 1.6% 3.2% 2.8%

Earnings Growth 4.9% 5.7% 5.7% 3.5% 6.5%

Valuation Impact – – – 0.9% –

Total Return 7.0% 7.5% 7.3% 7.6% 9.3%

Figure 10: Equity Building Blocks

Figure 11: S&P P/E Ratio on 10-Year Normalized EPS, 1925–2012

30%

20%

10%

45%

0%

40%

5%

15%

1925 1930 1935 1940 1950 1960 1970 1980 1990 20001945 1955 1965 1975 1985 1995 2005 2010

25%

35%

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PT

RU

ST

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Average = 17.4%



For most equity categories, we do not model any valuation

impact. Figure 11 depicts the S&P 500 price-to-earnings

(P/E) based on the average of the prior 10 years of

earnings (inflation adjusted). This metric was developed by

economist Robert Shiller and is referred to as the “Shiller

P/E ratio.” Many observers consider it a more stable measure

of valuation that has relevance for long-term equity returns

since it extends over one or two business cycles.

While below its prior peaks, the current Shiller P/E is

higher than it has been 70% of the time since 1926. Long-

term expected returns normally decline as the starting

level of valuation increases.

We forecast a positive valuation impact for international

developed equities, as they are trading at a historically low

valuation level. Concerns about the European sovereign debt

crisis are now likely reflected in the market, so a favorable

resolution in the coming years could lead to modest multiple

expansion. While Europe’s growth outlook remains weak,

financial conditions have recently improved due to the more

aggressive steps taken by the European Central Bank.

Commodities

Nominal global GDP growth is used as a reasonable proxy

for commodity returns. As with equities, slower global

economic growth (as shown in Figure 12) leads to lower

commodity returns compared to our prior forecast. In

particular, the transition of China’s economy to a more

sustainable growth level could impact commodity returns.

China accounts for a large percentage of global demand in

many commodities, so changes in its growth trajectory can

be meaningful. Although commodity returns are forecast

to be lower than those of equities, commodities could be a

useful hedge against higher-than-expected inflation.


Figure 12: Global Nominal GDP Growth (%), 1981–2011

10%

8%

4%

14%

0%

12%

2%

6%

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1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2004 2006 2008 20102002

14




Private Equity

To derive private equity returns, we add an illiquidity premium to our U.S. large-cap equity

forecast. Investors expect to be compensated for the illiquidity risk that is inherent in private

equity, so it has both the highest expected return and highest expected risk of all the asset

classes in our forecast. The excess return of private equity has diminished in recent years

following strong returns in the pre-crisis period. The dispersion of individual manager returns is

wide within private equity, so manager selection is important to fully capture the benefit of this

asset class. Our private equity forecast is based on a broad index and does not incorporate the

benefits of individual manager skill.

Real Estate

For public real estate (REITs), we use the same three building blocks as equities (dividend

yield, earnings growth, and valuation impact). Solid dividend yields and earnings growth

are partially offset by multiple contraction, as valuations are above their historical level.

Commercial real estate fundamentals remain favorable, with high occupancy levels and

continued increases in rent.

Hedge Fund of Funds

Figure 13 displays a multi-factor model

used to identify the components of hedge

fund returns. The model is driven by the

cash forecast, which leads to a subdued

return expectation for the broad hedge

fund-of-funds category. We expect the

environment to remain challenging for

hedge funds due to historically high

correlations both within and among asset

classes. However, hedge funds provide

higher risk-adjusted returns than some

asset classes. As with private equity,

hedge fund returns are characterized by

a large amount of dispersion so manager

selection is crucial for this asset class.

Factor Model *Current Weight

Avg. Weight 2003–present

S&P 500 Total Return Index 5.5% -6.2%

Russell 2000 Total Return Index 3.1% 8.8%

MSCI EAFE Net Total Return Index 15.1% 13.5%

MSCI Emerging Markets Total Return Index 11.0% 13.3%

USD-EUR Spot Rate 6.6% 3.3%

One-Month USD LIBOR 65.3% 70.6%

Total (excludes USD-EUR spot rate) 100.0% 100.0%

Figure 13: Hedge Fund Factor Model

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*as of November 2012


Despite lower return forecasts across most asset classes, we remain

generally constructive on capital markets. Following a multi-decade

bull market in fixed income and facing the prospect of rising interest

rates, it may be tempting for investors to abandon this asset class.

However, we continue to believe that fixed income has an important

role to play in client portfolios. It has historically been a less volatile

asset class and provided a cushion during times of economic stress.

Nevertheless, we expect subdued returns for fixed income going

forward, so investors will need to be more selective with their asset

allocation decisions in this area. While economic growth prospects are

not robust, traditionally riskier assets such as equities could still provide

solid returns over the forecast horizon. Accommodative monetary policy

provides an incentive for investors to move away from lower-yielding

asset classes. Equities do not appear inexpensive on an absolute basis,

but they do look compelling relative to fixed income—subject to one’s

risk tolerance and time horizon. We are less constructive on commodity

returns due to slower global growth, although they could still play a role

in portfolios as an inflation hedge. Real estate currently has perhaps the

best fundamentals of any asset class due to favorable supply/demand

dynamics, although valuation metrics appear full. Alternative assets

such as private equity and hedge funds can benefit from individual

manager skill and are often less correlated with traditional asset classes.

If correlations, both within and between asset classes, return to more

normalized levels, this could provide a more favorable environment for

hedge fund strategies to add value. n

CONCLUSION

Sources:1 Reinhart, Carmen M., and Kenneth S. Rogoff. “Growth in a Time of Debt.” American Economic Review 100.2 (2010): 577.2 Congressional Budget Office. An Update to the Budget and Economic Outlook: Fiscal Years 2012 to 2022. August 2012, pp 40-41.




With over 25 years

of continuous

focus, learning, and

reinvestment, we have

developed compelling

resources and expertise

that we can translate

into effective advice for

our clients.

The opinions expressed in this report are subject to change without notice. This material has been prepared or is distributed

solely for informational purposes and is not tax or legal advice. This is not a solicitation or an offer to buy any security or

instrument or to participate in any trading strategy. The information and statistics in this report are from sources believed

to be reliable, but are not warranted by CAPTRUST Financial Advisors to be accurate or complete. The analyses are based

on hypothetical scenarios using various assumptions as detailed in each example and are not intended to illustrate the

experience of any particular investor or plan participant.

All Publication Rights Reserved. No portion of the information contained in this publication may be reproduced in any form

without the permission of CAPTRUST: 919.870.6822

© 2013 CAPTRUST Financial Advisors. Member FINRA/SIPC.

Hunter Brackett, CFASenior Manager CAPTRUST Consulting Research Group

ABOUT THE AUTHOR:

Hunter joined CAPTRUST in 2012 and works in the Investment Research

division, where he focuses on strategic and tactical asset allocation for client

portfolios. Prior to joining CAPTRUST, Hunter served with firms such as

NCM Capital where he managed the firm’s financial sector exposure across

all equity portfolios for their institutional and high-net-worth clients. He

was also an Associate, Large/Mid-Cap Banks at Lehman Brothers, Equity

Research Division, and an International Corporate Banking Associate at First

Union Corporation. Hunter is a graduate of Washington and Lee University

with a BA in economics, received his MBA from UNC Kenan-Flagler

Business School, and holds a CFA® designation.

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