Taking on the return challenge

As professional investors, it is critical to have a base-case view on what markets are likely to deliver over the long-term. For two decades we have published annual Long-Term Capital Markets Return Assumptions, sharing our in-house views with our clients. The good news is, these 10- to 15-year projections have been on target and have helped us meet client objectives over the last market cycle. Using our 2004 assumptions, we estimated a 60/40 portfolio of stocks and bonds would return approximately 7.5% over a 10- to 15-year period. Our estimates came within 60 basis points of the actual performance of 8.1% — a staggering result considering the volatility of the last 10 years. (See accompanying chart.)

The bad news is, our return expectations do not look as attractive for the next 10 to 15 years. We expect traditional asset class returns to remain generally below historical long-term averages. This pushes our expected return of a 60/40 portfolio down to 6% — a significant difference to the 8% return investors were able to capture during the past 10 years.

If 6% is the new 8%, how will investors bridge the gap to meet liabilities and return objectives? It's possible, but it's going to require some challenging work.

We're all facing the same backdrop of increased volatility, and subdued global growth. Diverging monetary policy, with the Fed expected to raise rates and the eurozone and Asia-Pacific in easing mode, will make regional diversification a critical component of investment decisions. In addition to the uncertainty caused by impending rate hikes, the August correlation breakdown between stocks and bonds further contributed to investor fears of continued volatility.

To ease the impact of these global economic realities, we need to step outside of traditional return levers, and leverage alternative sources of return to generate alpha.

Asset allocation alpha: Time has proven that asset allocation decisions and asset allocation alpha are important drivers of overall portfolio performance, and they can be quantified. Studying the specific contribution of asset allocation decisions to a portfolio's performance, both quantitative and qualitative, can help identify ways to adjust these sources of return.

Illiquidity premium: Not all assets are created equal when it comes to liquidity. Assets that are less liquid could provide more return over the long term, which is known as the “illiquidity premium.” If we are long-term investors, then we should be conducting a thorough analysis of our liquidity needs rather than settling for current spreads. Areas of less liquid investment could include private equity, hedge funds and real assets.

Prudent use of leverage: On its face, leverage gets a bad rap. When used irresponsibly, it can result in unintended consequences. For example, leverage should not be used as a source of funds during periods of market stress. When used prudently leverage, including options strategies or strategies that introduce asymmetric return patterns, is a sensible and effective way to produce additional returns.

Manager selection: Much like we are accustomed to identifying and selecting attractive securities, the same rigorous due diligence process should be applied to managers. Extensive screening of performance drivers can result in manager selection acting as an alpha driver in a portfolio. This lever is even more critical when evaluating managers of private, less liquid investments, where return dispersion spreads widen the most.

Exposure to opportunistic investing: Opportunistic strategies provide experienced managers with the flexibility to react quickly to complex market opportunities. These managers strive to take advantage of market dislocations by bringing together a source of capital, operating expertise and an entrepreneurial approach to the management of risk.

The upcoming market cycle and investing environment is going to be challenging. Like most things in life, to be successful we will have to meet that challenge by working harder and smarter. The traditional return levers we have relied on in prior market cycles will not be enough to fulfill the return needs of investors. It's time to start lifting the hood on portfolios to see where additional return levers can be employed.

Jed Laskowitz is co-head of global investment management solutions at J.P. Morgan Asset Management.