As a portfolio manager, our mission is to help clients allocate their money to investment portfolios that provide efficient risk-adjusted returns over the long-term. Given the ever-expanding list of potential investment products, how do we determine the composition of client portfolios and select the securities to include? Our portfolio construction process – something we review each year – consists of four main steps:
- Creating long-term capital market assumptions for various asset classes.
- Developing model portfolios with varying asset allocations and a range of risk/return characteristics.
- Reviewing the universe of available investment products and determining which ones to approve for use in our model portfolios.
- Mapping approved investment products to model portfolios across various account types to minimize costs and taxes.
In this article we will focus on the first step of the portfolio construction process and discuss our updated long-term capital market assumptions for 2022.
What are Long-Term Capital Market Assumptions?
You can think of long-term capital market assumptions as the building blocks of an investment portfolio. To begin, we identify a list of asset classes that we might want to include in our client portfolios. Our current list of approved asset classes includes:
|Fixed Income||Equity (Stocks)||Alternatives|
|Canada – Cash||Canada||Gold|
|Canada – Short-term Bonds||United States|
|Canada – Universe Bonds||International – Developed Markets|
|International – Emerging Markets|
|Global – Low Volatility|
For each asset class we then come up with a set of assumptions (i.e. forward-looking projections) for:
- Expected return: the average annual percentage return we expect to generate over the long term (i.e. 10+ years).
- Expected risk: a measure of the expected year-to-year volatility of the expected return.
- Expected correlation: the degree to which the values of any two asset classes are expected to move up or down in relation to each other.
Developing long-term capital market assumptions is a complex task typically undertaken by large institutional investors with teams of experts that develop financial models aimed at predicting the future path of interest rates, inflation, employment, and economic growth. These models are used to develop forward-looking assumptions for the return, risk, and correlation of various asset classes. Some firms develop capital market assumptions for their own internal purposes, but many firms publish reports detailing their findings. Each year we survey the publicly-available long-term capital market assumptions from a range of trusted sources and consolidate them into our own set of assumptions. In rare circumstances we apply professional judgement to the consolidated data and make adjustments where we believe it is warranted, but for the most part we just let the data speak for itself.
Our 2022 Long-Term Capital Market Assumptions
After completing the data collection process outlined above, we’ve updated our long-term capital market assumptions for 2022. While it is difficult to predict the future with a high degree of certainty, these assumptions represent our best guess of the returns (before fees or taxes) that a Canadian investor can reasonably expect to achieve over the long-term by investing in various asset classes: