Better long-term returns ahead

Gregory van Inwegen
Global Head of Quantitative Research and Asset Allocation, Citi Investment Management
Paisan Limratanamongkol
Head of Quantitative Research and Asset Allocation, Citi Investment Management

2022 saw valuations fall across asset classes. This points to potentially higher returns over the coming decade, according to our proprietary methodology.

Key takeaways

Our strategic asset allocation methodology predicts higher returns over the decade

Meanwhile, many investors are sitting on excess cash in their portfolios

History suggests this is likely to prove a costly mistake over time

Our Investment Philosophy calls for fully invested, globally diversified portfolios throughout economic cycles

Being an investor was very tough in 2022. A rare simultaneous selloff across many risk assets and the highest quality government bonds meant diversification failed for a time. Put simply, there was almost nowhere to hide, as the final column in Figure 1 shows. However, this cloud has a long-term silver lining. The broad-based declines have driven many asset valuations down to levels that imply more rewarding future returns, according to our proprietary strategic asset allocation methodology.

Adaptative Valuation Strategies (AVS) looks out over a ten-year horizon. It uses current asset class valuations to produce annualized return forecasts or “Strategic Return Estimates” (SRE) for the decade ahead. This is based on the insight that lower current valuations have given way to higher returns over time, whereas higher valuations have been followed by lower returns. It then allocates to each asset class according to its outlook for returns.

For Global Equities, AVS has an SRE of 10.0% out to 2033 – Figure 1. Within this, Emerging Market Equities – shares from economies such as China, India and Brazil – have an SRE of 13.6%. Developed Market Equities – shares from economies such as the US, most of Europe and Japan – have an SRE of 9.5%. For context, the SRE for Global Equities in the middle of 2022 was 8.3%.

Cheaper bond valuations also point to higher returns. Investment-Grade Fixed Income – which includes bonds from the most creditworthy sovereign and corporate issuers – now has an SRE of 4.6%. This is up from 3.4% in mid-2022, mainly due to interest rate hikes which pushed bond yields up globally. Despite selling off alongside equities in 2022, this asset class has been less correlated to equities over time, helping investors to build diversified portfolios. 

The SRE for High-Yield (HY) Fixed Income – bonds issued by less creditworthy corporate borrowers – has increased to 7.4%. Similarly, the SRE for Emerging Market Fixed Income – bonds issued by emerging country governments and companies – has increased to 7.8%. The SRE for Cash has risen to 3.4%, meanwhile.

In alternative asset classes, the SRE for Hedge Funds has risen to 9.5%. As at the mid-year stage, Private Equity remains the asset class with the highest SRE at 18.6%. This SRE is derived from small-cap public equity valuations, which are at historically cheap levels. By contrast, the SRE for Real Estate has only edged up to 10.6%.

Having been the top performing asset class in 2022, Commodities are not expected to do so well over the next ten years. Indeed, its SRE of 2.4% is the lowest of the ten asset classes that AVS addresses, even below Cash. 

 
 
 
Figure 1. AVS’ long-term outlook for asset classes
  2023 SRE * 2022 Mid-Year SRE 2022 return
Global Equities 10.0% 8.3%  
Global Fixed Income 5.1%  3.7%  
Developed Market Equities 9.5% 8.0% -19.22%
Emerging Market Equities 13.6% 10.5% -30.86%
Investment-Grade Fixed Income 4.6% 3.4% -14.57%
High-Yield Fixed Income 7.4% 5.2% -12.35%
Emerging Market Fixed Income 7.8% 6.0% -23.32%
Cash 3.4% 1.5% 1.42%
Hedge Funds  9.5% 6.5% -6.68%
Private Equity  18.6% 15.7% -15.50%
Real Estate  10.6% 9.4% -27.89%
Commodities  2.4% 2.0% 17.65%
Source: Citi Global Wealth Investments Global Asset Allocation team.

2023 SREs are based on data as of 31 Oct 2022. Global Equity consists of Developed and Emerging Market Equity. Global Fixed Income consists of Investment-Grade, High-Yield and Emerging Market Fixed Income. Strategic Return Estimates are in US dollars; all estimates are expressions of opinion, are subject to change without notice and are not intended to be a guarantee of future events. Strategic Return Estimates are no guarantee of future performance. Citi Private Bank Global Asset Allocation Team. SREs for Mid-Year 2022 are based on data as of 30 Apr 2022. Returns estimated in US dollars. Strategic Return Estimates (SRE) based on indices are Citi Private Bank’s forecast of returns for specific asset classes (to which the index belongs) over a 10-year time horizon. Indices are used to proxy for each asset class. The forecast for each specific asset class is made using a proprietary methodology that is appropriate for that asset class. Equity asset classes utilize a proprietary forecasting methodology based on the assumption that equity valuations revert to their long-term trend over time. The methodology is built around specific valuation measures that require several stages of calculation. Assumptions on the projected growth of earnings and dividends are additionally applied to calculate the SRE of the equity asset class. Fixed Income asset class forecasts use a proprietary forecasting methodology that is based on current yield levels. Other asset classes utilize other specific forecasting methodologies. Each SRE does not reflect the deduction of client advisory fees and/or transaction expenses. Past performance is not indicative of future results. Future rates of return cannot be predicted with certainty. The actual rate of return on investments can vary widely. This includes the potential loss of principal on your investment. It is not possible to invest directly in an index. SRE information shown above is hypothetical, not the actual performance of any client account. Hypothetical information reflects the application of a model methodology and selection of securities in hindsight. No hypothetical record can completely account for the impact of financial risk in actual trading. See Glossary for definitions.

* AVS SRE methodology was enhanced in 2022 and mid-year SREs reported reflect this enhancement.

The perils of hoarding cash

The turmoil in 2022 has left many investors in a highly cautious mode. A common reaction we encounter is holding large amounts of cash, perhaps as much as one-third of a total portfolio, with equal proportions in equities and fixed income. And in fact, certain financial professionals, influenced by clients’ behavior, may be tempted to recommend such an allocation in the wake of market shocks. How would such an allocation have performed over time compared to one created by AVS?

Figure 2 shows an AVS Global US dollar allocation at Risk Level 3. This is intended for an investor seeking modest capital appreciation and capital preservation. Given this investor’s moderate appetite for risk, some allocation to alternative and illiquid asset classes are suitable. 

The bottom two rows in Figure 2 show the hypothetical performance of these two allocations over the past 37 years. Over the entire period, the AVS Risk Level 3 allocation would have outperformed the cash-heavy allocation portfolio by an annualized 2.3%. Hypothetically in dollar amounts, an initial investment of $1 million would have become $7.5 million for the Level 3 allocation, while the “cash-heavy” allocation would have grown to just $3 million. That said, its volatility is also lower, at 5.5% versus 9.0%. However, this is less risk than an investor at Risk Level 3 could take. As a result, they are inappropriately sacrificing performance potential by having too little risk exposure.

At moments of crisis, a cash-heavy approach has tended to outperform, but this can come at great cost. For example, consider these two sets of allocations in August 2008, just before the major selloff in risk assets – Figure 3. By the subsequent market lows seven months later (March 2009), the cash-heavy approach would have declined only by 17%, compared to 27% for the AVS Risk Level 3 allocation. However, after this point, both began to recover and reached breakeven in 20 and 13 months respectively. Thus, the AVS Risk Level 3 allocation recovered much faster than the cash-heavy allocation. Ten years later, the cash-heavy allocation would have returned only 21%, compared to 50% for the AVS Risk Level 3 allocation.

 
 
 
Figure 2. Global multi-asset class diversification vs a cash-heavy allocation since 1985
31 Dec 1985 to 31 Oct 2022 AVS Risk Level 3 allocation Cash-heavy allocation
Developed Market Equity 27% 34%
Emerging Market Equity 5%
Investment-Grade Fixed Income 33% 33%
High-Yield Fixed Incomes 3%
Emerging Market Fixed Income 3%  
Cash 2% 33%
Hedge Funds 12%  
Private Equity 10%  
Real Estate 5%  
Commodities 0%  
Annualized mean return 6.2% 3.9%
Annualized volatility 9.0% 5.5%
Source: Citi Global Wealth Investments Global Asset Allocation team, as of 31 Oct 2022.

The performance of the AVS Global USD Risk Level 3 and the cash-heavy portfolio was calculated on an asset class level using indices to proxy for each asset class.

1 Net performance results for both portfolios reflect a deduction of 2.5% maximum fee that can be charged in connection with advisory services that covers advisory fees and transaction costs. Individuals cannot directly invest in an index. The performance is for illustrative purposes only.

2 These are preliminary asset allocations for 2023. All performance information shown above is hypothetical, not the actual performance of any client account. Hypothetical information reflects the application of a model methodology and selection of securities in hindsight. No hypothetical record can completely account for the impact of financial risk in actual trading. For example, there are numerous factors related to the equities, fixed income or commodities markets in general which cannot be and have not been accounted for in the preparation of hypothetical performance information, all of which can affect actual performance. The returns shown above are for indices and do not represent the result of actual trading of investable assets/securities. The asset classes used to populate the allocation model may underperform their respective indices and lead to lower performance than the model anticipates.

 

 
Figure 3: Global multi-asset diversification vs cash-heavy allocation after the Global Financial Crisis

Cumulative return after GFC 2008
Source: Citi Global Wealth Investments Global Asset Allocation team, as of 31 Oct 2022.

The performance of the AVS Global USD Risk Level 3 and the cash-heavy portfolio was calculated on an asset class level using indices to proxy for each asset class.

1 Net performance results for both portfolios reflect a deduction of 2.5% maximum fee that can be charged in connection with advisory services that covers advisory fees and transaction costs. Individuals cannot directly invest in an index. The performance is for illustrative purposes only.

2 These are preliminary asset allocations for 2023. All performance information shown above is hypothetical, not the actual performance of any client account. Hypothetical information reflects the application of a model methodology and selection of securities in hindsight. No hypothetical record can completely account for the impact of financial risk in actual trading. For example, there are numerous factors related to the equities, fixed income or commodities markets in general which cannot be and have not been accounted for in the preparation of hypothetical performance information, all of which can affect actual performance. The returns shown above are for indices and do not represent the result of actual trading of investable assets/ securities. The asset classes used to populate the allocation model may underperform their respective indices and lead to lower performance than the model anticipates.

What to do now? 

Forecast 10-year returns have risen across all asset classes, albeit in some cases more than others. Nevertheless, many investors are sitting on excess cash, whose outlook has also improved from very low to modest levels. Our Investment Philosophy suggests this will prove an expensive mistake over time. We advocate fully invested, globally diversified portfolios for the long term, aligned to an appropriate strategic asset allocation.

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