What Invesco’s expanded models are saying about equities and diversification

Five years ago, researchers at Invesco Investment Solutions debuted a robust methodology for developing capital market assumptions based on 10-year investment horizons. Today, its long-term return estimates for major asset classes are updated quarterly and help guide strategic asset allocation decisions by Invesco and its clients. Recently, Invesco expanded its methodology to include additional time horizons and alternative asset classes. Mark Humphreys, Invesco’s head of EMEA client solutions development, and Jacob Borbidge, head of research and portfolio manager, speak about the update and what their latest research has revealed.

Jacob Borbidge: We continually seek to identify and develop new and better ways to model asset classes and forecast returns and risk. The additional work we began last summer stemmed from our recognition that, as technology evolves, we are able to access new data sets for additional asset classes, allowing us to begin modelling them with the same precision we bring to more mainstream asset classes. And, for multi-asset-class investors, having more data about more asset classes is always welcome.

Borbidge: No. We have always used a fundamental ‘building-block’ approach to forecast returns based on the underlying drivers of asset class performance – that hasn’t changed and frankly it’s not uncommon. But what we do is distinctive. For example, we never assume a risk premium for an asset class simply because it is risky. Each asset class has to earn its risk premium based on the underlying fundamental drivers of its return components. And we cover an unusually wide range of asset classes and create assumptions for multiple investment horizons.

Mark Humphreys: Our capital market assumptions now include a range of what we call non-directional liquid alternatives, such as macro, equity-market-neutral and equity long-short. These sub-asset classes can act as proxies for hedge-fund-like strategies. And we now model a five-year horizon in addition to a 10-year horizon.

“As asset allocators ourselves, we live the same challenges and experiences as our clients. So we’re constantly trying to think of better ways to create multi-asset portfolios.”

—Jacob Borbidge

Borbidge: It was a little of both. As asset allocators ourselves, we live the same challenges and expe- riences as our clients. So we’re constantly trying to think of better ways to create multi-asset portfolios. One of the things we and our clients realised was that, after 10 years of economic expansion and a bull market in equities, concerns were emerging about the sustainability of that bull market. There was a need to think about other ways to invest capital that might include diversifying away from equities. One way to do that is to look at alternatives, which is where my team has been investing for over five years now. We help our clients to more clearly understand that space by providing risk-and-return forecasts for those asset classes directly. As for adding a five-year forecast, we always envisioned our 10-year forecast as one that would cover a full market cycle. But I think most of our clients would expect us to be in more of a contractory environment over the next five years. If so, and if you had to plan for the next quarter cycle or half cycle, you’d want to know what asset class returns and risks might look like over a shorter time period. That’s what prompted our decision to add the five-year forecast.

Borbidge: Part of this is about being resourceful and creative in finding data sources. There’s also a degree of practitioner experience that helps. For example, our experience has helped us identify linkages between supposedly non-directional, market-neutral strategies and traditional equities. We understand that, even though an equity market-neutral strategy is intended to have a moderate amount of beta relative to traditional asset classes, it’s still investing in equities. We also recognise that there are still inefficiencies in one’s ability to model the risk or the correlation of those asset classes. Because of that, there will be residual exposure to traditional assets in those alternative asset classes which we can model for our clients and the implications of which we can elaborate to them.

Humphreys: That’s actually a critical point. As we come up with our assumptions, we’re always thinking about how we’re modelling risk and the cross-correlations between traditional and alternative assets. Our findings contribute significantly to our convictions on asset allocation.

Borbidge: We went from a very low-return market forecast to one that’s a little higher – probably in the median range historically. As far as different asset classes are concerned, equities across the board looked more attractive at the end of the year than they did at the middle of the year – a natural consequence of a correction that brought valuations down. We haven’t seen much change there yet. In the fixed-income markets, things that had significant amounts of credit exposure probably experienced the largest upward revisions in terms of forward-looking return expectations. You’re picking up higher yields now, and paying less for roughly the same amount of growth you expected a few months ago. In the next couple of months, it will be interesting to see whether or not that growth story holds up.

Borbidge: It is. But the challenge is that we had an environment where forward-looking expectations had been continuously falling for a number of years. As a result, valuation spreads had widened further, and yield spreads on credit-sensitive assets had continued to contract, for several consecutive years. The market had grown used to demanding a small price for taking either equity or credit risk. The price has increased, but I think we have to be wary of jumping back into the markets based on the knowledge that, from a historical context, equities are not overly cheap and credit spreads are not wide. They’re just a little wider than they were a few months ago. To expand on that, it’s very rare for credit spreads or equity valuations that are at a significant high point to move from there to a median point and then not cross that median point and become significantly more discounted. It happens, but once the valuation spreads or the credit spreads start widening, they usually widen for a substantial amount of time and then cross that median point.

“We’re always thinking about how we’re modelling risk and the cross-correlations between traditional and alternatives assets.”

—Mark Humphreys

Borbidge: One solution is diversification – something that had not been hugely necessary when all asset classes – especially equities – were on the rise. We saw tremendous benefits to diversification in the fourth quarter last year, and I think diversification will matter more over the coming years than it has over previous years.

Borbidge: It is always helpful to contextualise a range of potential outcomes. One way to do that is by looking at different investment horizons for your risk and return forecasts. You always want to look at not just a single return forecast, but at a range of potential return expectations and outcomes. You hope things perform well, but you want to know how badly various asset classes could perform if we experience some elevated volatility or some significant discounting in the marketplace.

Humphreys: I would add that there is much to argue for using our capital market assumptions collectively rather than in isolation. What I mean is that, when we apply our capital market assumptions to our own investing, or think about how clients might use them, we also consider what solutions we or they are seeking. It is growth? Income? More diversification? Once we know that, looking at the forecasted risk and returns for the various asset classes, and the cross-correlations between those asset classes, can prove really valuable. If a client is looking for more diversification, for example, we can consider their current portfolio, analyse what we think their expected returns are and how they perform in stress tests. Then we can determine how we might layer new asset classes or new customised solutions into their portfolio to achieve their desired outcome. The point is that these assumptions can be used on an individual basis, but can also be used in tandem to create customised, outcome-oriented asset allocation strategies. And there’s never more reason to do that than when markets turn volatile.

Supporting literature

• Solutions CMA 2019 outlook
• Latest CMA
• Capital market assumptions methodology whitepaper

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(EMEA 2817/2019)