Capital Market Assumptions - aon.com Capital Market Assumptions Are emerging market equities as risky as they used to be? Asset prices do not move in a straight line and the future

Capital Market AssumptionsAs of 30 September 2017

Aon HewittConsulting | Investment Consulting Practice

2 Capital Market Assumptions

Aon Hewitt 3

Are emerging market equities as risky as they used to be? . . . . . . . . . . . 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


Are emerging market equities as risky as they used to be?

Asset prices do not move in a straight line and the future is always full of uncertainty. This publication sets out our annualised best estimate return assumptions for a range of asset classes over a 10 year projection period. One should note, however, that these are only ‘central’ estimates, as our analysis assumes that there is a 50/50 chance that what actually transpires will be higher or lower than these figures. Therefore, return assumptions are only one part of the story. An equally important part is the variability and uncertainty around these returns. One measure of this variability is volatility (the dispersion in returns over time). For reasons we outline below, we believe that our emerging market equity volatility assumption needs another look given our typical focus on looking ahead not looking back.

How volatile have emerging markets been?

There are different approaches to setting volatility

assumptions. Traditionally, the focus has been on long term

historical experience. However, we believe that taking this

approach unselectively can be very misleading. The world

changes over time. The emerging markets equity universe is

an example of this. As economies and markets have matured,

some of the structural risks have decreased over time so that

there will be a tendency for long period historical experience

to overstate expected volatility, if this is the approach being

used. For example:

• The development of the middle class consumer in emerging

economies has helped to support domestic growth and

emerging economies are now less dependent on the US

economy than in the past.

• Emerging economies’ vulnerability to Federal Reserve

interest rate tightening has been substantially reduced

by a reduction in currency pegs against the US Dollar.

Furthermore, floating exchange rates also increase the

flexibility of domestic monetary policy; domestic interest

rates do not have to track the Fed’s interest rate path as

closely and can instead respond to domestic needs.

• Emerging market companies’ have less uncertainty on their

financial performance thanks to better corporate governance

and stronger balance sheets over the past decade.

These changes do come through in historical data, especially

if we take it in ‘rolling form’. The 10-year rolling annualised

standard deviation of emerging market equity returns has

been trending lower and is now around 17% when looking

in local currency terms and 23% if we looked in US dollar

terms. Emerging market equities are still significantly exposed

to currency volatility. One message that does come through

in the chart below is that currency volatility remains an

important part of emerging market equity volatility given

that exposures are rarely hedged. Equally, however, this

should not hide the reduced intrinsic risk of emerging

market investing compared with years gone by, thanks to

the structural improvements previously outlined. This clearly

emerges from the data in local currency terms.

10-year rolling annualised standard deviation

Q 15 years ago Q 10 years ago Q 5 years ago Q 30 Sep 17

Source: Datastream, Aon Hewitt

15%

20%

25%

MSCI EM(in US dollar terms)

MSCI EM(in local currency)

10%

5%

0%

Aon Hewitt 5

This observation of lower 10-year rolling volatility is not only

true at the aggregate level. If we look at some of the larger

emerging markets on a standard basis, we also see that these

equity markets demonstrate lower volatility.

When looking at the volatility for the eight largest country

constituents of the MSCI EM index, China, Korea, Taiwan,

India, Brazil, South Africa, Mexico and Russia, volatility has

generally moved lower compared with a decade earlier.

The difficulty here is that volatility in equity markets has

generally been moving lower. To the extent that systemic

factors in markets have suppressed volatility (due to ultra-low

interest rates and quantitative easing), how should we allow

for this when it comes to emerging markets? Our developed

market equity volatility best estimates allow for some reversion

in volatility towards historic norms. This means that we must

be careful that internal consistency is achieved between the

broader trends in market volatility and the volatility which

is specific to emerging markets, which we see as a kind of

volatility premium.

We would expect emerging markets to be more volatile than

developed markets. The key question then is how much more

volatile would we expect emerging markets to be relative to

developed markets?

We do believe that some of the more extreme ‘tail’ events

in emerging markets are lower than they used to be for the

reasons stated above. This should imply lower volatility for

emerging markets for any given level of developed market

volatility.

Our approach to setting volatility assumptions

In our capital market assumptions’ methodology on volatility

we make some forward-looking assessments but an important

element is also to look at broader market views and expectations

on volatility. For stocks, one clue to 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. Given the lack of available implied option volatility

pricing for emerging market equities, we need to think about

how we apply a multiplier to the implied volatility for US

equities. We note that given market cycles, big and small, there

will be some variability to such a multiplier. Outside of stressed

environments however, we see emerging market equities as

converging towards a volatility that appears to be around 1.5x

as volatile as US equities (in US dollar terms).

There is another important observation here. Our view is that

volatility suppression from the monetary policy environment

has been stronger in the US (and developed markets) at large

than in emerging markets. This means that as volatility starts

to normalise in the US market over time, we would expect the

volatility premium to be less prone to ratcheting up than in

the past. While it is true that the 1.5x premium appears at the

lower end of history, our view is that this looks reasonable in the

context of both the lower structural risks that we see in emerging

markets as well as the likely behaviour of volatility in both

emerging and developed markets over time.

10-year rolling annualised standard deviation (using MSCI indices in local currency)

Q 10 years ago Q 5 years ago Q 30 Sep 17

0%

10%

20%

30%

40%

50%

60%

China Korea Taiwan Brazil SouthAfrica

India Mexico Russia



10-year rolling annualised standard deviation

MSCI EM over MSCI US

Estimate for EM equities 10-year implied volatility derived from US 10-year implied option volatility

EM Equities 10-year Implied Volatility


Source: Bloomberg, Aon Hewitt

1 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9

2

02/1994

08/1995

02/1997

08/1998

02/2000

08/2001

02/2003

08/2004

02/2006

08/2007

02/2009

08/2010

02/2012

08/2013

02/2015

08/2016

Mul

tip

le

10%

20%

30%

40%

50%

60%

70%

03/2006

12/2006

09/2007

06/2008

03/2009

12/2009

09/2010

06/2011

03/2012

12/2012

09/2013

06/2014

03/2015

12/2015

09/2016

06/2017

This allows us to have a forward looking indicator of future volatility for emerging market equities.

At this point, it is worth pausing and asking why we would not

use implied option volatility as a marker for expected volatility

in emerging markets. Our view is that the volatility premium

approach is a sounder one than using implied volatility.

For what it is worth, as the chart above shows, implied

volatility 10 years ahead has been broadly stable while slightly

higher than back in 2014/2015.

Bringing it all together

Based on our analysis and with very much a focus on a forward

looking approach, this amounts to an emerging markets volatility

assumption at 27%. This is a volatility premium of 6% versus

the US equity market. Our earlier assumption of a 10% volatility

premium, while within the ranges of historical experience,

in effect, now appear a little too pessimistic a forward looking

view on the intrinsic risks to emerging market equity investing.

Clearly some key risks remain, particularly on the currency front,

but this premium captures the added risk.

By reducing the volatility assumption for emerging equities

from 31% to 27%, there is now a 7.5% difference with the global

developed equity volatility assumption, versus 11.5% before.

Needless to say, despite this change in the volatility assumption,

emerging market equities are still the highest risk element of the

public equity space.

Aon Hewitt 7

Inflation

Although the U.S. economy continues to advance and the

labour market remains tight, U.S. inflation continues to

undershoot analyst expectations. The U.S. Federal Reserve

believes one-off factors are suppressing inflation, but these

transitory effects may well be longer lasting. Our near term

inflation assumption for the U.S. has decreased. Near term

inflation expectations for Japan have also fallen. Meanwhile,

inflation expectations in the UK and Switzerland have edged

higher. However, longer term inflation assumptions are

unchanged for all regions.

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. 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 (10-year assumption) 2.3% 2.1% 1.7% 1.1% 2.0% 1.2%

RPI Inflation (10-year assumption) — 3.2% — — — —

Source: Aon Hewitt Capital Market Assumptions. Please see appendix for more information.


Fixed income government bonds

Bucking the downward slide in yields since the start of the

year, U.S. nominal government bond yields were largely

unchanged over the third quarter of 2017. As a result, there

has been no change in our U.S. government bond return

assumptions since last quarter. The same was true for European

government bond returns as yields were largely unchanged

as Mario Draghi, President of the European Central Bank,

was quick to downplay expectations of imminent monetary

tightening. In contrast, the UK government bond yields moved

higher across all maturities with much of the increase seen in

September following a more hawkish tone being struck by

Monetary Policy Committee members. Increased expectations

of monetary tightening later in 2017 led to higher nominal

government bond return assumptions for both short and

long-dated UK government bonds.

The Bank of Canada (BoC) joined the U.S. Federal Reserve

in being one of few central banks to embark on a monetary

tightening cycle. The BoC hiked interest rates on two occasions

over the quarter to 1.0% and also raised expectations of further

increases to interest rates in the future. The significant increase

in nominal yields over the quarter led to the largest change in

our government bond return assumptions; up 0.3% since last

quarter. The Japanese yield curve steepened slightly over the

quarter, but the return assumptions on both short and long-

dated government bonds were broadly unchanged.

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.


U.S. 5yr 2.3% 2.1% 1.7% 1.1% 2.0% 1.2%

15yr 3.0% 2.8% 2.4% 1.8% 2.7% 1.9%

UK 5yr 1.5% 1.3% 0.9% 0.3% 1.2% 0.4%

15yr 1.8% 1.6% 1.3% 0.7% 1.5% 0.8%

Eurozone 5yr 1.2% 1.0% 0.7% 0.1% 0.9% 0.2%

15yr 2.1% 1.9% 1.5% 0.9% 1.8% 1.0%

Switzerland 5yr 1.1% 0.9% 0.5% -0.1% 0.8% 0.0%

15yr 1.8% 1.6% 1.2% 0.6% 1.5% 0.7%

Canada 5yr 2.2% 2.0% 1.7% 1.1% 1.9% 1.1%

15yr 3.2% 3.0% 2.6% 2.0% 2.9% 2.1%

Japan 5yr 1.0% 0.8% 0.5% -0.1% 0.7% 0.0%

15yr 1.5% 1.3% 1.0% 0.4% 1.2% 0.5%

10-year 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

The UK real yield curve moved higher but slightly flattened

with the short end of the curve rising more than the long

end. This resulted in higher UK index-linked government

bond return assumptions for both short and long durations.

Higher inflation expectations in the Eurozone and the U.S.

led to lower real yields, and therefore lower index-linked

government bond return assumptions for both regions

compared to last quarter. Similar to their nominal equivalents,

the Canadian real yield curve moved higher over the quarter

and as such resulted in a 0.5% increase in our assumption for

Canadian index-linked government bond returns.

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.


U.S. 5yr 2.9% 2.7% 2.3% 1.7% 2.6% 1.8%

10yr 2.9% 2.7% 2.4% 1.7% 2.6% 1.8%

UK 5yr 1.6% 1.4% 1.0% 0.4% 1.3% 0.5%

15yr 1.2% 1.0% 0.6% 0.0% 0.9% 0.1%

Eurozone 5yr 1.7% 1.6% 1.2% 0.6% 1.5% 0.7%

10 yr 1.7% 1.5% 1.2% 0.6% 1.4% 0.6%

Canada 5yr – – – – – –

15yr 2.8% 2.7% 2.3% 1.7% 2.6% 1.8%


Source: Aon Hewitt Capital Market Assumptions. Please see appendix for more information. In our assumptions we take French bonds to represent Eurozone bonds.


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.

Investment grade credit spreads narrowed across all regions

over the quarter, but the higher underlying government

bond assumptions for both the UK and Canada were able to

offset this, leading to slightly higher returns. Our expectations

moved the most for Canadian corporate bonds, which

increased by 0.3% for both short and long term corporate

bonds. Conversely, the lower government bond return

assumptions for the U.S. and the Eurozone were unable to

offset the downward pressure from tighter credit spreads

and therefore lower expectations for corporate bond returns

Meanwhile, our Japanese and Swiss corporate bond return

assumptions are marginally lower this quarter due to slightly

lower credit spreads.


U.S. 5yr 3.0% 2.8% 2.5% 1.8% 2.7% 1.9%

10yr 3.6% 3.4% 3.1% 2.4% 3.3% 2.5%

UK 5yr 2.2% 2.1% 1.7% 1.1% 2.0% 1.2%

10yr 2.5% 2.3% 1.9% 1.3% 2.2% 1.4%

Eurozone 5yr 1.5% 1.3% 0.9% 0.3% 1.2% 0.4%

10yr 1.9% 1.7% 1.3% 0.7% 1.6% 0.8%

Switzerland 5yr 1.4% 1.2% 0.9% 0.2% 1.1% 0.3%

10yr 1.6% 1.4% 1.1% 0.5% 1.3% 0.6%

Canada 5yr 3.3% 3.1% 2.7% 2.1% 3.0% 2.2%

10yr 4.0% 3.8% 3.5% 2.8% 3.7% 2.9%

Japan 5yr 1.2% 1.1% 0.7% 0.1% 1.0% 0.2%

10yr 1.4% 1.3% 0.9% 0.3% 1.2% 0.4%



U.S. high yield debt and emerging market debt

Over the next 10 years, we expect U.S. high yield debt to

return 3.6% per annum; 0.1% lower than in the previous

quarter. The general positive sentiment for risky assets over

the third quarter led to a downward movement in non-

investment grade credit spreads which alongside a fall in the

underlying government bond return led to the slightly lower

return for U.S. high yield debt. 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”) now matches the return of U.S. high

yield debt at 3.6% per annum for the next 10 years. Similar

to U.S. high yield debt, the assumption has moved lower

due to the fall in yields on the underlying government bond

component and falling credit spreads.

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. Continued

equity market appreciation continues to be a drag on long

term return expectations for all regional equities. However,

an expectation of stronger earnings growth, supported by an

upturn in commodity prices, offset higher Canadian equity

prices. As such, our Canadian equity assumption is unchanged

at 6.6%. Meanwhile, the continued improvement in net profit

margins and further weakness of the Japanese yen supports

the rebound in earnings growth expectations in Japan

which more than offset higher equity prices. Our estimates

for Japanese equity returns moved 0.1% higher to 5.5%.

Elsewhere, downward revisions to earnings growth expectations

compounds pressure from market appreciation in the U.S. and

Europe. Assumptions for both regions are down 0.2% to 6.3%

and 6.4% respectively. However, expectations of greater inflation

have been supportive in most regions. Our U.S. equity return

assumption is unchanged at 6.5% as higher market valuations

and downward revisions to earnings growth expectations offset

the improvement from higher inflation expectations. Similarly,

our UK equity return assumption is roughly flat over the quarter.

A fall in market valuations which is beneficial for the return

outlook for equities, alongside a slight improvement in earnings

growth expectations were not sufficient enough to significantly

impact our forecast for UK equities. Increases to our earnings

growth expectations for Europe, Japan and Canada led to

improvements in our return assumptions for all the regions.

Return assumptions remain fairly close between the U.S., UK and

Europe. UK equities were trading on a multiple of around 17.6

times our 2016 earnings assumption, while U.S. equities were

valued at around 19.0 times our 2016 earnings assumption.

Our emerging market equities return assumption has fallen from

last quarter. The upward revision in earnings growth was not

sufficient to offset downward pressure 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.


U.S. 6.3% 6.1% 5.8% 5.1% 6.0% 5.2%

UK 6.6% 6.4% 6.0% 5.4% 6.3% 5.5%

Europe ex UK 7.0% 6.8% 6.4% 5.8% 6.7% 5.9%

Switzerland 6.2% 6.1% 5.7% 5.1% 6.0% 5.1%

Canada 6.8% 6.7% 6.3% 5.6% 6.6% 5.7%

Japan 6.6% 6.4% 6.1% 5.4% 6.3% 5.5%

Emerging markets 7.6% 7.4% 7.1% 6.4% 7.3% 6.5%



Continued on next page...


Private equity

We assume that global private equity will return 8.7% per

annum over the next 10 years in U.S. dollar terms; a decrease

of 0.3% from the previous quarter. 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. The decrease in our expectations was driven by

lower equity return assumptions across all different private

equity strategies, particularly buyout strategies which

represent over half of the weighting in our global private

equity assumption. The cost of debt financing, meanwhile,

did not decrease that much.

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.

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.

Aon Hewitt 13

Real estate


U.S. 5.6% 5.4% 5.1% 4.4% 5.3% 4.5%

UK 5.6% 5.5% 5.1% 4.5% 5.4% 4.5%

Europe ex UK 5.9% 5.7% 5.4% 4.7% 5.6% 4.8%

Canada 5.1% 4.9% 4.5% 3.9% 4.8% 4.0%

10yr annualised nominal return assumptions

Expensive valuations continue to act as a headwind on most of

our real estate assumptions. The UK assumption is unchanged

at 5.5%. Higher capital values have driven initial yields slightly

lower and continue to be a drag on returns. However, this

was fully offset by a slight increase in expected rental value

growth as well as upward revisions to our near term inflation

assumptions. 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. Over the quarter, we have updated the source

of the underlying yield estimates for U.S. real estate as well

as refining our fee assumptions. Due to these changes, the

U.S. real estate assumption is up 0.1% higher at 5.6%. The

real estate return assumptions for the European and Canadian

markets are both 0.1% lower at 5.4% and 4.8% respectively.

The change to the European return assumption has brought

our expectations for the region lower compared to the U.S.

and UK property markets.

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.



Hedge funds

Our fund of hedge funds return assumption is unchanged at

3.7% 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 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

Over the quarter, we decided to adjust our emerging market

equity volatility assumption lower to 27.0% from 31.0%.

Consequently, this has brought our emerging market equity

assumptions more in line with the risk-return line based on our

developed market assumptions and it is our view that a smaller

volatility premium is now sustainable. This now represents

a 7.0% difference to our global developed equity volatility

assumption. There have been no changes to our other key

volatility assumptions this quarter.

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 10 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 27.0%

Global Private Equity 25.0%

Global Fund of Hedge Funds 9.0%



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 Q3 2017 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 0.5 0.4 0.1 -0.1 -0.1 -0.1 0 -0.1 -0.1 0 0 -0.1

FI 1 0.8 0.1 -0.2 -0.2 -0.2 -0.1 -0.2 -0.2 -0.1 0 -0.2

CB 1 0.1 0.1 0.1 0.1 0 0.1 0.1 0 0.1 0.1

RE 1 0.4 0.4 0.4 0.3 0.4 0.4 0.3 0.3 0.3

UK Eq 1 0.9 0.9 0.7 0.9 0.9 0.8 0.6 0.7

U.S. Eq 1 0.9 0.7 0.9 0.9 0.8 0.7 0.8

Eur Eq 1 0.7 0.9 0.9 0.8 0.6 0.7

Jap Eq 1 0.7 0.7 0.6 0.4 0.5

Can Eq 1 0.8 0.8 0.6 0.7

CHF Eq 1 0.8 0.6 0.7

EM Eq 1 0.6 0.7

Gbl PE 1 0.5

Gbl FoHF 1

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 30 June 2014 Capital Market Assumptions

publication included further detail on the drivers of the equity/

government bond correlation.



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 bondss.

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]

Jas Thandi

T: +1 312 381 [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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