Risk Premia Forecasts: Major Asset Classes - March 2021

The expected risk premium for the Global Market Index (GMI) ticked higher last month, although it remains well below the trailing realized performance for the benchmark. Nonetheless, GMI’s projected 5.6% annualized return for the index over the “risk-free” rate is above the previous estimate and the year-earlier forecast.

GMI is an unmanaged, market-value-weighted portfolio that holds all the major asset classes (except cash) and represents a theoretical benchmark of the “optimal” portfolio. Using standard finance theory as a guide, this portfolio is considered the best choice for the average investor with an infinite time horizon. Accordingly, GMI is useful as a baseline to begin research on asset allocation and portfolio design. GMI’s history suggests that this benchmark portfolio tends to be competitive with efforts to beat it, especially after adjusting for risk and trading costs.

Using recent market activity to adjust the benchmark’s outlook cuts the forward estimate substantially. For example, modifying the numbers to incorporate short-term momentum and medium-term mean-reversion market factors (defined below) reduces GMI’s ex ante risk premium to an annualized 4.7%.

All forecasts are wrong in some degree, but GMI projections are expected to be comparatively reliable vs. the estimates for the individual asset classes that are used to generate the benchmark’s forecast. Predictions for the individual market components are subject to greater uncertainty vs. aggregating the forecasts into the GMI outlook — a process that may cancel out some of the errors in the underlying market estimates.

For historical context, here’s a chart of rolling 10-year annualized risk premia for GMI, US stocks (Russell 3000), and US Bonds (Bloomberg Aggregate Bond) through last month. Note that GMI’s realized 10-year risk-premium performance (red line) in recent history has been relatively steady, ticking fractionally lower last month to an annualized 6.8% for the trailing decade. The current forecast for GMI suggests that investors should manage expectations down for multi-asset-class strategies relative to results in recent years.

1 2 3 4
View single page >> |

Disclosures: None.

How did you like this article? Let us know so we can better customize your reading experience.

Comments

Leave a comment to automatically be entered into our contest to win a free Echo Show.