NEWS AND INSIGHTS | INSIGHTS

Understanding Capital Market Assumptions

December 09, 2022
PRIVATE WEALTH INVESTMENT GROUP

Long-term capital market assumptions are a key consideration in the creation of strategic asset allocations for investors.

The development of a potentially effective long-term investment strategy incorporates multiple elements. At the macro level is the concept that diversification across asset classes can enhance return outlooks and mitigate risk. Generally, this is expressed in a strategic asset allocation catering to individual investment goals. At the micro level is implementation: seeking investment strategies within each asset class with the potential to meet or exceed expectations on a risk-adjusted basis. In between and related to these two elements is a key consideration for investment planning: capital markets assumptions, which are essentially estimates for long-term asset class returns. These inform a strategic asset allocation and thus the weightings that individual investments may ultimately represent.

Akin to a manufacturing process, capital market assumptions are building blocks that go into the creation of the strategic asset allocation. Estimated returns, risk and asset class correlation can work together in what’s called a mean variance optimization to create portfolios that seek to provide an optimal level of return for each unit of risk. These portfolios can be shown graphically in what’s known as the “efficient frontier.”

The Search for an ‘Optimal’ Portfolio

Chart: The Search for an ‘Optimal’ Portfolio

Source: Neuberger Berman. For discussion purposes only.

How one goes about creating such estimated returns is, naturally, crucial to the potential reliability of an asset allocation. Moreover, it’s no exaggeration that having credible capital market assumptions is essential to the entire investment process: If you are using poor materials, the caliber of your equipment won’t do you much good because you’ll still end up with a faulty product.

At Neuberger Berman, we employ a multifaceted approach to estimating returns of various asset classes with the aim of being both systematic and objective. Our fundamentally based bottom-up methodology considers the drivers of returns for each asset class at the time of the forecast and over its long-term history. (See “Exploring Our Approach,” below.)

Exploring Our Approach

To understand our approach to generating capital market assumptions, it may help to highlight some of the factors we employ within certain key asset classes.

In large-cap equities, for example, we consider three underlying drivers of return: (1) earnings growth, (2) yield generated by dividends and buybacks, and (3) change in valuation. Earnings growth is based on projections of Gross Domestic Product, inflation and corporate profit margins from economists’ forecasts and market valuations. Dividend/buyback yields are culled from historical trends and rates implied in futures prices. Valuation changes are estimated based on current price-to-earnings ratios compared to historical trends.

Our return assumptions within fixed income consider fundamental drivers within each sub-asset class, including current market yields, defaults and coupon levels, and we look at the potential impact of changes in interest rates and differences in yield compared to U.S. Treasuries based on price changes and reinvested yield, among other factors.

While asset class returns have historically varied widely, their volatility and correlation have tended to be more stable. For this reason, our volatility estimates are generally based on historical levels experienced by each asset class.

An important element is the baseline valuations from which the investor is starting. Following a period of significant outperformance, a given asset class may have a forward-looking return estimate that is lower than in the past. By the same token, estimated returns may go up after a period of weakness. Similarly, a phase of declining interest rates may reduce the total return potential for fixed income assets, but a sharp upward turn in rates could actually make bonds more valuable going forward—something that may help salve the recent pain experienced by many investors amid higher inflation and market declines.

Where Our Capital Markets Assumptions Stand Today

The following graphics provide our 2023 capital markets assumptions, both in terms of return and volatility, for select asset categories over a 20-year period. Note that these figures reflect the extraordinary market action that took place in 2022. Amid severe market declines, long-term return profiles have improved—reflecting the additional opportunity that lower valuations can create on a strategic basis. Equity assumptions have generally increased by about a percentage point per year, while fixed income assumptions, in the wake of an interest rate reset, have increased by about 1.5% annually.

The breadth of assets is important, in our view. Just as global companies now seek flexibility and diversification of supply chains, investors can capitalize on multiple asset classes, sectors and strategies to mitigate risk exposure, and capitalize on the potential compounding advantages of a smoother return path for portfolios.

2023 NB Capital Market Assumptions

20-Year Return and Risk Estimates for Sample Assets

Estimated Annual Return (%)1 Annual Standard Deviation (%, Risk)2 Year-Over-Year Change in Annual Return (%) Year-Over-Year Change in Standard Deviation (%, Risk)
FIXED INCOME
Cash (risk-free rate) 3.7% 0.3% 2.1% 0.0%
Investment Grade 5.7% 5.8% 1.7% 0.3%
Municipals 4.5% 4.5% 1.4% 0.2%
High Yield 6.5% 8.7% 0.8% 0.2%
Non-U.S. Developed Market Fixed Income 4.8% 5.4% 2.3% 2.7%
Emerging Market Debt 7.1% 9.1% 2.1% 0.2%
EQUITY
U.S. Large Cap 7.8% 15.7% 0.8% 0.3%
U.S. Small Cap 8.6% 20.5% 1.2% 0.1%
Developed International Equities 8.1% 17.5% 0.6% 0.0%
Emerging Market Equities 8.8% 21.1% 0.9% -0.4%
Other Equities3 8.0% 16.5% 0.8% 0.1%
ALTERNATIVES
Commodities 6.2% 16.8% -0.1% 0.3%
Hedged Strategies 6.1% 6.3% 1.7% -0.1%
Private Markets 11.7% 17.5% 0.9% -1.0%
INFLATION
Inflation 2.7%

Source: Neuberger Berman, Bloomberg Barclays, Cambridge Associates, FactSet. Analytics are as of 1Q 2022.

1. Arithmetic return = average (mean) return across years. Arithmetic returns ignore the impact of compounding in the context of analyzing investment returns.

2. Standard deviation is a statistical measure of the volatility based on the distribution of a set of data from its mean (average value). For example, a portfolio with an average return of 10% and a standard deviation of 15% would return a result between -5% and +25% the majority of the time (68% probability or 1 standard deviation); almost all of the time, the return would be between -20% and +40% (95% probability or 2 standard deviations). If there were 0 standard deviation, then the result would always be 10%. Generally, more aggressive portfolios have a higher standard deviation and more conservative portfolios have a lower standard deviation.

3. Other Equities may include thematic, global, MLPs and opportunistic equity strategies.

IMPORTANT: Estimates reflect both current and historical market conditions and are reviewed and revised at least annually. These returns and risk estimates are hypothetical in nature and used for discussion purposes only and are not intended to represent, and should not be construed to represent, predictions of future rates of return. Asset classes are represented by benchmarks. Actual returns and volatility may vary significantly. Assumptions are subject to change without notice.

Long-Term Return Profiles

NB Return Assumptions for Sample Asset Classes, 2022 vs. 2023 (%)

Chart: Long-Term Return Profiles

Source: Neuberger Berman, Bloomberg Barclays, Cambridge Associates, FactSet. Analytics are as of 1Q 2022.

IMPORTANT: Estimates reflect both current and historical market conditions and are reviewed and revised at least annually. These return estimates are hypothetical in nature and used for discussion purposes only and are not intended to represent, and should not be construed to represent, predictions of future rates of return. Asset classes are represented by benchmarks. Actual returns may vary significantly. Assumptions are subject to change without notice.

Developing Investment Solutions for Clients

As part of our process, the Private Wealth Investment Group leverages broad expertise to help develop investment solutions for U.S.-based private wealth clients. Private Wealth Investment Group works closely with wealth advisors, portfolio managers and clients with the goal of designing and implementing customized and diversified investment plans. By tapping into the extensive investment capabilities across the firm, including the capital markets assumptions, asset allocation and environmental, social and governance disciplines, Private Wealth Investment Group incorporates our best thinking across both public and private markets to construct tax-efficient, multi-asset class portfolios.

Ideally, investment planning should not be a one-off process. Rather, it is important to revisit your overall investment framework on a regular basis in light of your goals. As reflected in our capital markets assumptions and more tactical market views, the investment backdrop may change, and so may your priorities, lifestyle and/or family circumstances. Maintaining regular contact with your NB Private Wealth team can help facilitate the process of keeping your asset allocation on track. For more information on the development of a strategic asset allocation and our process, see our article, “Asset Allocation: Reaching for the Summit.”

Related Insights

This material is provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This material is general in nature and is not directed to any category of investors and should not be regarded as individualized, a recommendation, investment advice or a suggestion to engage in or refrain from any investment-related course of action. Neuberger Berman is not providing this material in a fiduciary capacity and has a financial interest in the sale of its products and services. Neuberger Berman, as well as its employees, does not provide tax or legal advice. You should consult your accountant, tax adviser and/or attorney for advice concerning your particular circumstances. Information is obtained from sources deemed reliable, but there is no representation or warranty as to its accuracy, completeness or reliability. All information is current as of the date of this material and is subject to change without notice. Any views or opinions expressed may not reflect those of the firm as a whole. Neuberger Berman products and services may not be available in all jurisdictions or to all client types. Investing entails risks, including possible loss of principal. Investments in hedge funds and private equity are speculative and involve a higher degree of risk than more traditional investments. Investments in hedge funds and private equity are intended for sophisticated investors only. Indexes are unmanaged and are not available for direct investment. Past performance is no guarantee of future results.

The views expressed herein may include those of the Neuberger Berman Multi-Asset Class (MAC) team, Neuberger Berman’s Asset Allocation Committee and Neuberger Berman’s Private Wealth Investment Group. The Asset Allocation Committee is comprised of professionals across multiple disciplines, including equity and fixed income strategists and portfolio managers. The Asset Allocation Committee reviews and sets long-term asset allocation models, establishes preferred near-term tactical asset class allocations and, upon request, reviews asset allocations for large diversified mandates. Tactical asset allocation views are based on a hypothetical reference portfolio. The Private Wealth Investment Group analyzes market and economic indicators to develop asset allocation strategies. The Private Wealth Investment Group also consults regularly with portfolio managers and investment officers across the firm. The views of the MAC team, the Asset Allocation Committee and the Private Wealth Investment Group may not reflect the views of the firm as a whole, and Neuberger Berman advisers and portfolio managers may take contrary positions to the views of the MAC team, the Asset Allocation Committee and the Private Wealth Investment Group. The MAC team, the Asset Allocation Committee and the Private Wealth Investment Group views do not constitute a prediction or projection of future events or future market behavior. This material may include estimates, outlooks, projections and other “forward-looking statements.” Due to a variety of factors, actual events or market behavior may differ significantly from any views expressed. Nothing herein constitutes a prediction or projection of future events or future market or economic behavior. The duration and characteristics of past market/economic cycles and market behavior, including length and recovery time of past recessions and market downturns, is no indication of the duration and characteristics of any current or future market/economic cycles or behavior. Due to a variety of factors, actual events or market behavior may differ significantly from any views expressed or any historical results.

The duration and characteristics of past market/economic cycles and market behavior, including any bull/bear markets, is no indication of the duration and characteristics of any current or future be market/economic cycles or behavior. Nothing herein constitutes a prediction or projection of future events or future market behavior. Due to a variety of factors, actual events or market behavior may differ significantly from any views expressed or any historical results.

A bond’s value may fluctuate based on interest rates, market conditions, credit quality and other factors. You may have a gain or a loss if you sell your bonds prior to maturity. Of course, bonds are subject to the credit risk of the issuer. If sold prior to maturity, municipal securities are subject to gain/losses based on the level of interest rates, market conditions and the credit quality of the issuer. Income may be subject to the alternative minimum tax (AMT) and/or state and local taxes, based on the investor’s state of residence. High-yield bonds, also known as “junk bonds,” are considered speculative and carry a greater risk of default than investment-grade bonds. Their market value tends to be more volatile than investment-grade bonds and may fluctuate based on interest rates, market conditions, credit quality, political events, currency devaluation and other factors. High yield bonds are not suitable for all investors and the risks of these bonds should be weighed against the potential rewards. Neither Neuberger Berman nor its employees provide tax or legal advice. You should contact a tax advisor regarding the suitability of tax-exempt investments in your portfolio. Government bonds and Treasury bills are backed by the full faith and credit of the United States Government as to the timely payment of principal and interest. Investing in the stocks of even the largest companies involves all the risks of stock market investing, including the risk that they may lose value due to overall market or economic conditions. Small- and mid-capitalization stocks are more vulnerable to financial risks and other risks than stocks of larger companies. They also trade less frequently and in lower volume than larger company stocks, so their market prices tend to be more volatile. Investing in foreign securities involves greater risks than investing in securities of U.S. issuers, including currency fluctuations, interest rates, potential political instability, restrictions on foreign investors, less regulation and less market liquidity. The sale or purchase of commodities is usually carried out through futures contracts or options on futures, which involve significant risks, such as volatility in price, high leverage and illiquidity.

ASSET CLASS ASSUMPTIONS AND ESTIMATES

Capital market assumptions used herein reflect Neuberger Berman’s forward-looking estimates of the benchmark return or volatility associated with an asset class. Estimated returns and volatilities are hypothetical return and risk estimates generated by Neuberger Berman’s Institutional Solutions Group. Estimated returns and volatilities do not reflect the alpha of any investment manager or investment strategy/vehicle within an asset class. Information is not intended to be representative of any investment product or strategy and does not reflect the fees and expenses associated with managing a portfolio or any other related charges, such as commissions and surrender charges. Estimated returns and volatilities are hypothetical and generated by Neuberger Berman based on various assumptions and inputs, including current market conditions, historical market conditions and subjective views and estimates. Capital market assumptions shown reflect Neuberger Berman’s long-term (20+ years into the future) estimates or intermediate-term (5-7 years into the future) estimates which are reviewed at least annually. Results will differ depending on whether they are based on Neuberger Berman’s long-term (20+ years into the future) or intermediate-term (5-7 years into the future) capital market assumptions. Neuberger Berman’s capital market assumptions are derived using a building block approach that reflects historical, current and projected market environments, forward-looking trends of return drivers, and the historical relationships asset classes have to one another. These hypothetical returns are used for discussion purposes only and are not intended to represent, and should not be construed to represent, predictions of future rates of return. Actual returns may vary significantly. Neuberger Berman makes no representations regarding the reasonableness or completeness of any such assumptions and inputs. Assumptions, inputs and estimates are periodically revised and subject to change without notice. Estimated returns and volatilities should not be used, or relied upon, to make investment decisions.

Neuberger Berman Investment Advisers LLC is a registered investment adviser. The “Neuberger Berman” name and logo are registered service marks of Neuberger Berman Group LLC.