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Capital Market AssumptionsAs of 31 March 2017
Aon HewittConsulting | Investment Consulting Practice
Risk. Reinsurance. Human Resources.
2 Capital Market Assumptions
Aon Hewitt 3
Low volatility: is it here to stay? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Fixed income government bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Inflation-linked government bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Investment grade corporate bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
U.S. high yield debt and emerging market debt . . . . . . . . . . . . . . . . . 10
Equities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Private equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Real estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
Hedge funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Risk–return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Correlations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Capital Market Assumptions methodology . . . . . . . . . . . . . . . . . . . . . . 17
Contacts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Table of contents
Aon Hewitt 3
4 Capital Market Assumptions
Low volatility: is it here to stay?
Volatility running at low levels for some time
Volatility in global markets has been strikingly low in recent
years. Over the last three years, volatility in U.S. equities has
been running at only a little over 10% on an annualised basis,
substantially lower than the long-term average in the
mid-teens. The downturn in volatility is less marked in
fixed income markets, but the three year rolling numbers for
long duration U.S. treasuries (15 year duration) also show
a similarly low path. As both charts show, this measure of
‘running’ volatility measured across rolling three year periods,
is approximately at the levels seen about a decade ago near
the time of the outbreak of the great financial crisis.
A key question we need to ask when framing our forward
looking volatility assumptions now is whether the low
volatility over the past few years is indicative of a sustained
period of much lower volatility having arrived? This is a
reasonable challenge to our assumptions process. As we can
see from the chart below, even on a ten year rolling view,
realised volatility is appearing below our current long term
forward looking assumption for U.S. equities. If the recent
pattern of low volatility were to persist, our assumption would
look far too conservative. In fixed income, the picture is more
nuanced, though here too, a continuation of recent trends
would also indicate excessive volatility pessimism on our part.
Volatility path dependent on markets
There is an important contextual point to make here on our
volatility assumption. First, our assumption is associated with
a range of possible outcomes, and as a median in this range,
it has a 50/50 probability of outcomes being either above or
below. This matters because the level of volatility depends on
market states; market falls tend to be associated with higher
volatility and buoyant market conditions tend to be associated
with low volatility. In our models, we allow volatility to have
‘extreme tails’, allowing for sensitivity to broad market risk
factors or shocks. Our median U.S. volatility assumption is 17%,
but the tails show figures as low as 10% and as high as 25%.
With market conditions having been on the strong side for
both fixed income and equities for a number of years, we
already have a ready explanation for the downward trend in
volatility over this period. The question as we look ahead is
whether volatility remains this low and for how long. Our
volatility assumption needs to take into account the prospect
of a full market cycle being completed, and given that this is
already the second longest bull market in history, it would not
be unreasonable to assume that a period of market falls now
fall within our horizon, with a consequent impact on volatility.
We also have an additional and potentially more important
0%
5%
10%
15%
20%
25%
2003
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
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2014
2015
2016
0%
2%
4%
6%
8%
10%
18%
16%
14%
12%
2003
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2011
2012
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2014
2015
2016
Equity market volatility
(MSCI U.S., monthly returns) 3Y rolling standard deviation 5Y rolling standard deviation
10Y rolling standard deviation CMA — 10Y Volatility
Fixed income volatility
(Barclays Long Treasury — 10 Year Duration, monthly returns) 3Y rolling standard deviation 5Y rolling standard deviation
10Y rolling standard deviation CMA — 10Y Volatility
Source: Datastream, MSCI, Aon Research
Source: Datastream, MSCI, Aon Research
Aon Hewitt 5
factor here which adds another dimension to the volatility
assumption. Though too complex to statistically test to any
degree of satisfaction, it is our firmly-held view, and a widely
held view too, we believe, that low volatility and strong asset
prices over an extended period of time (fixed income and
equities) have been encouraged by the activities of central
banks around the world. The regime of ultra-low interest rates,
quantitative easing and massive central bank balance sheet
expansion seen since 2009 was intended by central banks as
a stimulus to combat weak economic growth and inflation.
A key mechanism for this type of monetary policy to work its intended effect was the so-called ‘portfolio balance channel’1, which seeks to encourage investors to move to riskier assets and away from low or near zero yielding ‘risk-free’ assets. This
has worked well. Risky asset prices have been stronger than
they would have been otherwise in such a mixed economic
environment. Investors have driven up risky asset prices given
low returns on cash and bonds, the latter also bid up strongly.
Equally important, volatility has been suppressed by these
measures. Of course, there have been times when market
conditions have become unsettled, but active central banks
have restored calm quickly and volatility spikes have been
very short-lived.
We expect volatility to rise
What happens looking ahead? We are now moving to the
final stages of global monetary policy support to markets.
We should expect volatility to rise. Even without central
banks’ balance sheet expansion of quantitative easing in the
picture, rising interest rates are normally associated with some
move up in volatility. This time, we have the additional factor
of a reversal of quantitative easing as the U.S. Federal Reserve
attempts to unwind its balance sheet expansion. The effects
are very uncertain, as this has not been attempted before.
The U.S. Federal Reserve may well manage it well with no
impact on volatility, or it could introduce some level of
disruption to markets. The grounds for believing that
volatility will rise are therefore at least as strong as in
previous monetary policy cycles.
Finally, and this is difficult to evaluate quantitatively, higher
political uncertainty than in the past, given the loss of
support of the political centre in many countries, is another
factor that markets are likely to have to contend with. So far,
U.S. political risk has only sporadically brought volatility to
markets, but there could be a tipping point.
Bringing all this together, we expect market volatility to
more closely match the perceived risks of the economic and
market environment than seen in the recent past. How will
this happen in practice? It may be that the period of very low
volatility seen ends suddenly in a large market drawdown as
in 2008 if economic or other market conditions deteriorate
quickly. Alternatively, volatility could edge up gradually
as markets become less confident in the ability of both
governments and central banks to alleviate weak or uncertain
economic conditions. We do not have a high-conviction
view on how this plays out. What is clear, though, is that
in either case, much like the end of previous periods
of low volatility, the seeming calm seen in markets will
retrospectively be seen to have been quite transitory.
The bottom line is that high as our volatility projections
might seem against recent experience, and this is
particularly so in equities, they are consistent with our
expectation of a reversion to somewhat higher levels over
time. It should be said that though the low volatility anomaly
is more marked in equities, our view is that some edging
up of fixed income volatility is also likely.
1 www.federalreserve.gov/newsevents/speech/bernanke
6 Capital Market Assumptions
What markets are saying about the volatility outlook
Our capital market assumptions’ methodology on volatility
makes some forward-looking judgements but an important
element is also to look at broader market views and
expectations on volatility. For stocks, one clue on how
markets are thinking about volatility looking ahead is to look
at implied option volatility, an indication of the market’s view
of expected volatility in the future. The most widely observed
measure by commentators is the so called VIX index. This is
a forward looking measure, but this is only useful as a short
term gauge. We are more interested in how volatility is likely
to fare over the next few years rather than the next month.
There are some longer option volatility measures available
which provide some clues. The level of volatility in these
options is not a predictor of levels of realised volatility given
the long established tendency of realised volatility to be lower
than signalled by option volatility. However, moves in option
volatility over different points in time do carry important
information on how markets see likely trends developing.
We show a compilation of a volatility term structure curves at
different points in time over the past few years below to look
at shifting expectations.
As the chart shows, an upward slope to volatility pricing
remains an abiding feature of volatility markets. However,
there are movements in the steepness or shape of the upward
sloping term structure over time. In the middle of 2016
when market conditions were unsettled, the starting point of
expected volatility was on the higher side of recent history,
and this was also accompanied by a fairly steep upward slope
of the volatility curve for the next few years. That slope has
since flattened. The market is back to signalling low expected
volatility over the next few years in the way seen in the 2014/15
period, albeit moving higher over time. Further out, however,
i.e. between 5 and 10 years, there is an indication of a steeper
climb in volatility than that seen in the 2014/15 period.
S&P Index impled volatility term structure
19/05/17 30/06/16 30/06/15 30/06/14
Source: Bloomberg, Aon ResearchS&P 500 index — The market-cap weighted index includes 500 leading companies and captures approximately 80% of available market capitalization
10%
15%
20%
25%
30%
5 10 15Year ahead
20 25 30
Aon Hewitt 7
Inflation
Longer term inflation assumptions are unchanged for the UK,
U.S., Europe, Canada, Switzerland and Japan relative to last
quarter. Energy prices have been one of the main drivers of
late pushing inflation higher but we see this impact being
completely absorbed over the last few months and we expect
its impact to moderate over the short term. As a result we
reduced our near term inflation expectations for U.S., UK,
Canada and Europe.
Of the countries considered, inflation in only the UK, U.S. and
Canada are expected to be at or above their respective central
bank 2% targets. Meanwhile, systemic deflationary pressures
in Japan and Switzerland persist meaning the respective
central bank inflation targets will continue to undershoot over
the 10 year horizon, based on our expectations.
USD GBP EUR CHF CAD JPY
CPI Inflation (10yr assumption) 2.2% 2.1% 1.6% 1.1% 2.0% 1.1%
RPI Inflation (10yr assumption) — 3.2% — — — —
Source: Aon Hewitt Capital Market Assumptions. Please see appendix for more information.
8 Capital Market Assumptions
Fixed income government bonds
In the first quarter of 2017, nominal government bond yields
partially retraced the upward movement seen toward the
end of 2016. This has led to lower nominal government bond
returns that are considered in the Capital Market Assumptions,
with the exception of Eurozone government bond returns
which have moved materially higher.
UK fixed income return assumptions have fallen the most
which reflects the larger fall in yields relative to other regions.
Alongside slowing reflationary momentum, a more pessimistic
outlook of the UK economy over Brexit pushed nominal yields
lower. UK interest rates reached their lowest point since the
immediate aftermath of the EU referendum vote. The U.S.
administration faces hurdles in passing bills on tax reform
and confidence in a positive boost to economic growth and
inflation has somewhat reduced. This had the result to push
U.S. nominal yields, and therefore government bond returns,
lower. In contrast, Eurozone nominal government bond yields
moved higher on the back of greater political uncertainty
before the French presidential elections. The upward
movement in yields had also been supported by improving
economic conditions, firming commodity prices and a mild
uptick in expected interest rates over the next half-decade. As
such, Eurozone nominal government bond returns are 0.4%
higher since last quarter. Japanese yields firmed slightly since
31 December 2016, especially for long-dated bonds which has
driven the government bond assumptions slightly higher.
In our assumptions we take French bonds to represent Eurozone
bonds, as we want to ensure consistency between the nominal
and inflation-linked government bond returns and there is a
reasonably liquid market in French inflation-linked bonds. Our
calculation of a weighted average Eurozone government bond
yield leads to a figure which is slightly higher than the yield on
French government bonds. Our analysis therefore supports the
use of French bonds as a proxy for Eurozone bond portfolios,
where these portfolios do not have a large exposure to the
higher yielding periphery.
USD GBP EUR CHF CAD JPY
U.S. 5yr 2.4% 2.3% 1.8% 1.3% 2.2% 1.3%
15yr 3.1% 2.9% 2.5% 1.9% 2.9% 2.0%
UK 5yr 1.1% 1.0% 0.6% 0.0% 0.9% 0.1%
15yr 1.5% 1.4% 0.9% 0.4% 1.3% 0.4%
Eurozone 5yr 1.5% 1.4% 0.9% 0.4% 1.3% 0.4%
15yr 2.3% 2.1% 1.7% 1.1% 2.1% 1.2%
Switzerland 5yr 0.9% 0.8% 0.3% -0.2% 0.7% -0.2%
15yr 1.6% 1.5% 1.1% 0.5% 1.4% 0.6%
Canada 5yr 1.8% 1.7% 1.2% 0.7% 1.6% 0.7%
15yr 2.7% 2.6% 2.2% 1.6% 2.5% 1.7%
Japan 5yr 1.0% 0.9% 0.5% -0.1% 0.8% 0.0%
15yr 1.5% 1.4% 0.9% 0.4% 1.3% 0.4%
10yr Annualised Nominal Return Assumptions
Source: Aon Hewitt Capital Market Assumptions. Please see appendix for more information. In our assumptions we take French bonds to represent Eurozone bonds.
Aon Hewitt 9
Inflation-linked government bonds
Similar to their nominal counterparts, the return assumptions
for index-linked government bonds decreased across the
board with the exception of Eurozone and long-dated
Japanese bonds. Relative to other regions, U.S. index-linked
government bond returns decreased the most due to a
combination of lower near-term inflation expectations and
falling real yields. Whilst changes in the UK real yield curve
were limited over the quarter, the return assumption for UK
index-linked government bonds was lowered on the back of
a decrease in long-duration real yields and a slight downward
adjustment to inflation expectations. Elevated political risk in
the Eurozone drove real yields upwards and as a result moved
index-linked government bond returns significantly higher.
We have taken French bonds to represent Eurozone
bonds, partly because there is a reasonably liquid market
in French inflation-linked bonds. Our analysis of nominal
government bonds also suggests that French bonds are
a reasonable proxy for Eurozone government bonds so
we make the same assumption here for consistency. The
bonds represented are linked to Eurozone inflation.
We formulate return assumptions for 10 year U.S. and
Eurozone inflation-linked government bonds rather than
15 year bonds. This is because we think that the absence
of inflation-linked bonds at the longest durations in these
markets can lead to misleading 15 year bond return
assumptions. We no longer publish a 5 year duration
Canadian inflation-linked government bond assumption
due to the lack of short duration bonds in this market.
USD GBP EUR CHF CAD JPY
U.S. 5yr 2.8% 2.7% 2.2% 1.6% 2.6% 1.7%
10yr 2.8% 2.7% 2.2% 1.7% 2.6% 1.7%
UK 5yr 1.3% 1.2% 0.7% 0.2% 1.1% 0.2%
15yr 0.8% 0.7% 0.2% -0.3% 0.6% -0.2%
Eurozone 5yr 1.9% 1.8% 1.4% 0.8% 1.7% 0.9%
10 yr 1.9% 1.8% 1.3% 0.8% 1.7% 0.9%
Canada 5yr — — — — — —
15yr 2.4% 2.2% 1.8% 1.2% 2.2% 1.3%
10yr Annualised Nominal Return Assumptions
Source: Aon Hewitt Capital Market Assumptions. Please see appendix for more information. In our assumptions we take French bonds to represent Eurozone bonds.
10 Capital Market Assumptions
Investment grade corporate bonds
Corporate bond returns depend on both a government
yield component and a credit spread component but also
take account of losses arising from defaults and bonds being
downgraded. The lead article to the Aon 30 June 2015
Capital Market Assumptions publication discusses these
two potential drivers of credit losses in more detail.
The corporate bond return assumptions have generally
moved slightly lower over the quarter, primarily due to the
fall in underlying government bond returns. Lower initial
credit spreads compound lower return expectations.
The only exception to this is our corporate bond returns in
Europe where significant increases in French government
bond yields (used as proxy for Eurozone bonds in our
modelling) has given the appearance of very low credit
spreads. An additional risk adjustment to the longer-dated
Eurozone corporate bond assumption has led to a 0.2%
lower return over the quarter. UK corporate bond return
expectations fell the most, which reflected the stronger
fall in UK government bond yields over the quarter. A similar,
albeit weaker, trend relative to the UK, was followed by
U.S. investment grade corporate bonds.
USD GBP EUR CHF CAD JPY
U.S. 5yr 3.2% 3.1% 2.6% 2.1% 3.0% 2.1%
10yr 3.9% 3.8% 3.3% 2.8% 3.7% 2.8%
UK 5yr 2.0% 1.9% 1.4% 0.9% 1.8% 0.9%
10yr 2.2% 2.1% 1.6% 1.1% 2.0% 1.1%
Eurozone 5yr 1.7% 1.5% 1.1% 0.5% 1.5% 0.6%
10yr 1.6% 1.5% 1.0% 0.5% 1.4% 0.5%
Switzerland 5yr 1.3% 1.2% 0.7% 0.2% 1.1% 0.2%
10yr 1.6% 1.4% 1.0% 0.4% 1.4% 0.5%
Canada 5yr 2.9% 2.7% 2.3% 1.7% 2.7% 1.8%
10yr 3.7% 3.5% 3.1% 2.5% 3.5% 2.6%
Japan 5yr 1.3% 1.2% 0.7% 0.2% 1.1% 0.2%
10yr 1.4% 1.3% 0.8% 0.3% 1.2% 0.4%
10yr Annualised Nominal Return Assumptions
Source: Aon Hewitt Capital Market Assumptions. Please see appendix for more information.
U.S. high yield debt and emerging market debt
U.S. high yield debt spreads continued on a narrowing trend
over the first quarter of 2017, buoyed by improving risk
appetite. Similar to investment grade corporate bonds, lower
spread levels detract from our return expectations. This is
compounded by the reduction in the lower assumptions for
government bond returns. Overall, the assumption has been
adjusted lower by 0.4% to 3.9% per annum over the next 10
years. It is worth noting that our high yield debt assumption
already incorporates an expectation that defaults will be
consistently higher in future than the very low levels seen
over recent years. The lead article to the Aon 31 December
2015 Capital Market Assumptions publication discusses the
High Yield assumption in more detail.
Our return assumption for USD-denominated emerging
market debt (“EMD”) is 4.1% a year for the next 10 years.
Similar to high yield, the assumption moved lower due to the
fall in yields on the underlying government bond component
and a narrowing of credit spreads over the quarter, reversing
the effect that followed the U.S. election.
Aon Hewitt 1111 Capital Market Assumptions
Equities
Our equity return assumptions are driven by current market
valuations, earnings growth expectations and assumed
payouts to investors. The price you pay is one of the biggest
drivers of returns, even over the long term. Looking back over
recent experience, strong equity market performance has
been driven more by increasing valuations than increasing
profits. With the exception of Japanese equities, higher
valuations continue to act as headwinds to all regional
equities. However, corporate earnings growth in the UK, U.S.
and Europe have more than offset these expensive valuations.
A volatile energy outlook has led to downward revisions for
our earnings growth estimates for Canadian equities. Swiss
and Japanese equities have similarly had their respective
earnings growth expectations lowered over the quarter. UK
assumptions increased the most by 0.3% this quarter ending
31 March 2017, as sterling weakness and a relative rebound
in commodity prices have boosted expected profit margins.
Our European equity assumptions have increased on the back
of an upward adjustment in earnings forecasts with greater
expectations of a revival in cyclically depressed earnings.
Return assumptions remain fairly close between the U.S., UK
and Europe. UK equities were trading on a multiple of around
17.5 times our 2016 earnings assumption, while U.S. equities
were valued at around 17.8 times our 2016 earnings assumption.
Our emerging market equities return assumption has fallen
from last quarter, primarily due to higher valuations on the
back of greater investor inflows; a reversal of the trend that
followed the U.S. election late in 2016. A modest increase in
our earnings growth assumptions for the region offset some
of the decrease in our assumptions from higher valuations.
The earnings growth component of our equity return
assumptions comprises both near term and longer term
elements. While our Capital Market Assumptions process
typically involves using consensus inputs, for some time we
have believed that the consensus of analysts’ forecasts has
been unrealistically optimistic regarding near term earnings
growth prospects. Unlike analysts, against a backdrop of
weak global growth, we do not expect company profit
margins to increase from their already elevated levels. For
this reason, we have developed our own in-house corporate
earnings paths which have led to lower growth assumptions
than forecast by the consensus. Not being influenced by
short-term market sentiment, our near term earnings growth
assumptions have been relatively stable overall, in contrast
to consensus expectations, which have varied far more.
In the long term, we assume that companies’ earnings
growth is related to GDP growth. Crucially, we do not
assume a one-to-one relationship between a country’s
growth rate and the long term earnings growth potential of
companies listed on the stock market within that country.
We do this because many companies are international in
nature and derive earnings from regions outside of where
they have a stock market listing. An implication is that
European company earnings have only about a 50% direct
exposure to developments in the Eurozone and similarly,
investors in non-European equity markets should not
consider themselves insulated from events there either.
It is also notable that emerging markets are an important
driver of profits earned in the developed world.
USD GBP EUR CHF CAD JPY
U.S. 6.5% 6.4% 5.9% 5.3% 6.3% 5.4%
UK 6.8% 6.6% 6.2% 5.6% 6.6% 5.7%
Europe ex UK 7.0% 6.9% 6.4% 5.8% 6.8% 5.9%
Switzerland 6.2% 6.1% 5.6% 5.1% 6.0% 5.1%
Canada 6.5% 6.3% 5.9% 5.3% 6.3% 5.4%
Japan 6.2% 6.0% 5.6% 5.0% 5.9% 5.1%
Emerging Markets 7.5% 7.4% 6.9% 6.3% 7.3% 6.4%
10yr Annualised Nominal Return Assumptions
Source: Aon Hewitt Capital Market Assumptions. Please see appendix for more information.
12 Capital Market Assumptions
Private equity
We assume that global private equity will return 8.6% per
annum over the next 10 years in U.S. dollar terms; an increase
of 0.1% from the previous quarter, following similar increases
in our listed equity assumptions. The slightly lower high
yield assumption has had a minimal impact on expected
returns. The assumption represents a diversified private
equity portfolio with allocations to leveraged buyouts (LBOs),
venture capital, mezzanine and distressed investments.
Return expectations for these different strategies depend on
different market factors. For example, distressed investments
are influenced by the outlook for high yield debt so receive a
boost from higher return expectations in this area. Similarly,
LBO returns are influenced by the outlook for equity markets
as well as the cost of the debt used to finance these LBOs.
Notwithstanding this, whereas in the past leverage has
been a big driver of private equity returns, particularly for
LBOs, in future the ability of managers to add value through
operational improvements will become more important.
On our analysis, the median private equity fund manager has
historically performed in line with the median public equity
manager, but high performing private equity managers have
performed significantly better. Our assumption incorporates
the level of manager skill (‘alpha’) associated with such a high
performing manager. This contrasts with our other equity
return assumptions where no manager alpha is assumed.
Aon Hewitt 13
Real estate
USD GBP EUR CHF CAD JPY
U.S. 5.5% 5.4% 4.9% 4.3% 5.3% 4.4%
UK 5.6% 5.5% 5.0% 4.5% 5.4% 4.5%
Europe ex UK 6.0% 5.9% 5.4% 4.8% 5.8% 4.9%
Canada 5.1% 4.9% 4.5% 3.9% 4.9% 4.0%
10yr Annualised Nominal Return Assumptions
Expensive valuations continue to exert downward pressure on
most of our real estate assumptions. However, lower capital
values in the U.S. and UK support higher rental yields.
The UK assumption has increased by 0.1% thanks to a
combination of higher rental yields (driven by lower capital
values) as well as higher expected rental growth. Our
assumptions, however, still remain below pre-Brexit levels,
where concerns over the impact of Brexit on capital values
and rental growth weighed on return expectations. The
U.S. assumption is also 0.1% higher from the previous
quarter, supported by higher rental yields. Lower rental
yields, meanwhile, has led our European assumptions 0.1%
lower. Our Canadian assumptions are, meanwhile, unchanged
from last quarter, despite downward pressure applied from
higher capital values. The fall in the European assumptions
has driven our expectations for the region lower than both
the UK and U.S. markets, for the first time in over a year.
Our assumptions here are in respect of a large fund which is
capable of investing directly in real estate. The assumptions
relate to the broad real estate market in each region rather
than any particular market segment. Our analysis allows
for the fact that real estate is an illiquid asset class and
revaluations can be infrequent, leading to lags in valuations
compared with trends in underlying market value. These
assumptions do not include any allowance for active
management alpha but do include an allowance for the
unavoidable costs associated with investing in a real estate
portfolio. These include real estate management costs,
trading costs and investment management expenses.
Source: Aon Hewitt Capital Market Assumptions. Please see appendix for more information.
14 Capital Market Assumptions
Hedge funds
Our fund of hedge funds return assumption is unchanged at
3.8% a year in U.S. dollar terms. We formulate this by combining
the return assumptions for a number of representative hedge
fund strategies. As with private equity, this assumption includes
allowances for manager skill and related fees (including the
extra layer of fees at the fund of funds level), but unlike private
equity, this is for the average fund of funds in the hedge
fund universe rather than for a high performing manager.
Dispersion in returns is high and we expect top quartile
managers to deliver considerably better performance.
As set out in the lead article to the Aon 30 September
2015 Capital Market Assumptions publication, our analysis
allows for the fact that hedge fund managers have been
unable to deliver the high levels of ‘alpha’ that they
did in the more distant past and that alpha generation
is likely to remain challenging moving forwards.
The individual hedge fund strategies we model as components
of our fund of hedge funds’ assumption are equity long/
short, equity market neutral, fixed income arbitrage, event
driven, distressed debt, global macro and managed futures.
Our modelling of these strategies includes an analysis of
the underlying building blocks of these strategies. For
example, we take into account the fact that equity long/
short funds are sensitive to equity market movements. In
practice the sensitivity of equity long/short funds to equity
markets can vary substantially by fund with some behaving
almost like substitutes for long only equity managers, while
others retain a much lower exposure. Our assumptions are
based on our assessment of the average sensitivity across
the entire universe of equity long/short managers.
Given the nature of the asset class, our hedge fund return
assumptions are more stable than, for example, our U.S. equity
return assumption. Nonetheless, the strategies are impacted
by changes to the other asset class assumptions. For example,
most hedge funds are ‘cash+’ type investments to a greater
or lesser extent, so changes in return expectations for cash
will contribute to hedge fund assumptions. Similarly, changes
to our equity and high yield return assumptions influence
expected returns for those strategies which are related to
these markets, such as equity long-short and distressed debt.
Aon Hewitt 15
Volatility
Risk–return
History, forward looking indicators and our view on
the economic cycle all enter our volatility assumption
setting process and the volatilities in the table above
are representative for each asset class over the next ten
years overall. For illiquid asset classes, such as real estate,
de-smoothing techniques are employed. All volatilities
shown above are in local currency terms. For emerging
market equities, global private equity and global fund
of hedge funds the local currency is taken to be USD.
Please note that due to the level of yields and shapes
of the yield curves in Japan and Switzerland, lower
volatility assumptions apply to bond investments in these
markets. This is because as yields fall towards 0% (or
even below), the potential for further significant declines
becomes more limited and this limits volatility — although
clearly the risk of upward moves remains high.
15yr Inflation-Linked Government Bonds 9.0%
15yr Fixed Income Government Bonds 11.0%
10yr Investment Grade Corporate Bonds 9.0%
Property / Real Estate 12.5%
U.S. High Yield 12.0%
Emerging Market Debt (USD denominated) 13.0%
UK Equities 19.0%
U.S. Equities 17.0%
Europe ex UK Equities 19.0%
Japan Equities 20.0%
Canada Equities 19.0%
Switzerland Equities 19.0%
Emerging Market Equities 30.0%
Global Private Equity 25.0%
Global Fund of Hedge Funds 9.0%
Source: Aon Hewitt Capital Market Assumptions. Please see appendix for more information.
Source: Aon Hewitt Capital Market Assumptions. Please see appendix for more information.
The chart below plots our risk and return assumptions for a selection of asset classes that
are covered as part of our Capital Market Assumptions. These asset classes are shown
from a U.S. perspective and as such, all returns are quoted in U.S. dollar terms.
Japan Equities Canada Equities
SwitzerlandEquities
EmergingMarketEquities
Global Private Equity
Global Fund of Hedge Funds U.S. High Yield
Emerging Market Debt (USD denominated)
UK Equities
U.S. Equities
Europe exUK Equities
10yr Investment GradeCorporate Bonds
Property / Real Estate
15yr Fixed IncomeGovernment Bonds
15yr Inflation-LinkedGovernment Bonds
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
0% 5% 10% 15% 20% 25% 30% 35% 10-Year Volatility
10-Y
ear
Nom
inal
Ret
urn
Risk–return based on Q1 2017 Capital Market Assumptions
16 Capital Market Assumptions
Correlations
IL FI CB RE UK Eq U.S. Eq Eur Eq Jap Eq Can Eq CHF Eq EM Eq Gbl PE Gbl FoHF
IL 1.0 0.5 0.4 0.1 -0.1 -0.1 -0.1 0.0 -0.1 -0.1 0.0 0.0 -0.1
FI 1.0 0.8 0.1 -0.2 -0.2 -0.2 -0.1 -0.2 -0.2 -0.1 0.0 -0.2
CB 1.0 0.1 0.1 0.1 0.1 0.0 0.1 0.1 0.0 0.1 0.1
RE 1.0 0.4 0.4 0.4 0.3 0.4 0.4 0.3 0.3 0.3
UK Eq 1.0 0.9 0.9 0.7 0.9 0.9 0.8 0.6 0.7
U.S. Eq 1.0 0.9 0.7 0.9 0.9 0.8 0.7 0.8
Eur Eq 1.0 0.7 0.9 0.9 0.8 0.6 0.7
Jap Eq 1.0 0.7 0.7 0.6 0.4 0.5
Can Eq 1.0 0.8 0.8 0.6 0.7
CHF Eq 1.0 0.8 0.6 0.7
EM Eq 1.0 0.6 0.7
Gbl PE 1.0 0.5
Gbl FoHF 1.0
Domestic Inflation-Linked Government Bonds
Europe ex UK Equities
Domestic Fixed Income Government Bonds
Japan Equities
Domestic Investment Grade Corporate Bonds
Canada Equities Global Fund of Hedge Funds
U.S. Equities
Global Private EquityDomestic Real Estate / Property
Switzerland Equities
UK Equities
Emerging Market Equities
The matrix above sets out representative correlations
assumed in our modelling work, shown on a rounded basis.
All correlations shown above are in local currency terms
and can be used by UK, U.S., European, Canadian and Swiss
investors for the asset classes where return and volatility
assumptions exist (e.g. Swiss real estate is not modelled).
A different set of correlations apply for Japanese investors.
Correlations are highly unstable, varying greatly over time, and
this feature is captured in our modelling, where we employ a
more complex set of correlations involving different scenarios.
Our correlations are forward looking and not just historical
averages. In particular, we think that in many ways the
experience of this millennium has been quite different from
the previous 20 years, being more cyclical in nature with
less strong secular trends. This has many implications. For
example, the equity/government bond correlation in the
table above is negative, which also incorporates the feature
that this correlation is negative in stressed environments.
The lead article to the Aon 30 June 2014 Capital Market
Assumptions publication included further detail on the
drivers of the equity/government bond correlation.
Source: Aon Hewitt Capital Market Assumptions. Please see appendix for more information.
17 Capital Market Assumptions
Capital Market Assumptions methodology
Overview
Aon Hewitt’s Capital Market Assumptions are our asset class return, volatility and correlation assumptions. The return assumptions are ‘best estimates’ of annualised returns. By this we mean median annualised returns – that is, there is a 50/50 chance that actual returns will be above or below the assumptions. The assumptions are long term assumptions, based on a 10 year projection period and are updated on a quarterly basis.
Material uncertainty
Given that the future is uncertain, there is material uncertainty in all aspects of the Capital Market Assumptions and the use of judgement is required at all stages in both their formulation and application.
Allowance for active management
The asset class assumptions are assumptions for market returns, that is we make no allowance for managers outperforming the market. The exceptions to this are the private equity and hedge fund assumptions where, due to the nature of the asset classes, manager performance needs to be incorporated in our Capital Market Assumptions. In the case of hedge funds we assume average manager performance and for private equity we assume a high performing manager.
Inflation
When formulating assumptions for inflation, we consider consensus forecasts as well as the inflation risk premium implied by market break-even inflation rates.
Fixed income government bonds
The government bond assumptions are for portfolios of bonds which are annually rebalanced (to maintain constant duration). This is formulated by stochastic modelling of future yield curves.
Inflation-linked government bonds
We follow a similar process to that for nominal government bonds, but with projected real (after inflation) yields. We incorporate our inflation profiles to construct nominal returns for inflation-linked government bonds.
Corporate bonds
Corporate bonds are modelled in a similar manner to government bonds but with additional modelling of credit spreads and projected losses from defaults and downgrades.
Other fixed income
Emerging market debt and high yield debt are modelled in a similar fashion to corporate bonds by considering expected returns after allowing for losses from defaults and downgrades.
Equities
Equity return assumptions are built using a discounted cashflow analysis. Forecast real (after inflation) cashflows payable to investors are discounted and their aggregated value is equated to the current level of each equity market to give forecast real (after inflation) returns. These returns are then converted to nominal returns using our 10 year inflation assumptions.
Private equity
We model a diversified private equity portfolio with allocations to leveraged buyouts, venture capital, and mezzanine and distressed investments. Return assumptions are formulated for each strategy based on an analysis of the exposure of each strategy to various market factors with associated risk premia.
Real estate / property
Real estate returns are constructed using a discounted cashflow analysis similar to that used for equities, but allowing for the specific features of these investments such as rental growth.
Hedge funds
We construct assumptions for a range of hedge fund strategies (e.g. equity long/short, equity market neutral, fixed income arbitrage, event driven, distressed debt, global macro, managed futures) based on an analysis of the underlying building blocks of these strategies.
We use these individual strategies to formulate a fund of hedge funds’ assumption which is quoted in the Capital Market Assumptions.
Currency movements
Assumptions regarding currency movements are related to inflation differentials.
VolatilityAssumed volatilities are formulated with reference to implied volatilities priced into option contracts of various terms, historical volatility levels and expected volatility trends in future.
Correlations
Our correlation assumptions are forward looking and result from in-house research which looks at historical correlations over different time periods and during differing economic/investment conditions, including periods of market stress. Correlations are highly unstable, varying greatly over time. This feature is captured in our modelling.
18 Capital Market Assumptions Aon Hewitt 18
ContactsTapan Datta T: +44 (0)20 7086 [email protected]
Matthieu Tournaire T: +44 (0)20 7086 [email protected]
Disclaimer
This document has been produced by Aon Hewitt’s Global Asset Allocation Team, a division of Aon plc and is appropriate solely for institutional investors. Nothing in this document should be treated as an authoritative statement of the law on any particular aspect or in any specific case. It should not be taken as financial advice and action should not be taken as a result of this document alone. Consultants will be pleased to answer questions on its contents but cannot give individual financial advice. Individuals are recommended to seek independent financial advice in respect of their own personal circumstances. The information contained herein is given as of the date hereof and does not purport to give information as of any other date. The delivery at any time shall not, under any circumstances, create any implication that there has been a change in the information set forth herein since the date hereof or any obligation to update or provide amendments hereto. The information contained herein is derived from proprietary and non-proprietary sources deemed by Aon Hewitt to be reliable and are not necessarily all inclusive. Aon Hewitt does not guarantee the accuracy or completeness of this information and cannot be held accountable for inaccurate data provided by third parties. Reliance upon information in this material is at the sole discretion of the reader.
Past results are not indicative of future results. The tables and graphs included herein present expected returns, which are forward-looking expectations by AHIC based on informed historical results and internal analysis. These do not represent actual historical results. There can be no guarantee that any of these expected results will be achieved. The Capital Market Assumptions (CMAs) represents AHIC’s outlooks on capital markets and economies over the next 10 years. These views are constructed based on our framework of analyzing fundamental, valuation and long-term drivers of capital markets.
Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. The views and strategies described may not be suitable for all investors. Opinions referenced are as of December 2016, and are subject to change due to changes in the market, economic conditions or changes in the legal and/or regulatory environment and may not necessarily come to pass. This information is provided for informational purposes only and should not be considered tax, legal, or investment advice.
References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations. This material is distributed for informational purposes only. The information contained herein is based on internal research derived from various sources and does not purport to be statements of all material facts relating to the information mentioned, and while not guaranteed as to the accuracy or completeness, has been obtained from sources we believe to be reliable.
This document does not constitute an offer of securities or solicitation of any kind and may not be treated as such, i) in any jurisdiction where such an offer or solicitation is against the law; ii) to anyone to whom it is unlawful to make such an offer or solicitation; or iii) if the person making the offer or solicitation is not qualified to do so. If you are unsure as to whether the investment products and services described within this document are suitable for you, we strongly recommend that you seek professional advice from a financial adviser registered in the jurisdiction in which you reside. We have not considered the suitability and/or appropriateness of any investment you may wish to make with us. It is your responsibility to be aware of and to observe all applicable laws and regulations of any relevant jurisdiction, including the one in which you reside.
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