capital market assumptions - d6g93j3kwyclp.cloudfront.net · consulting research group | position paper At CAPTRUST, we believe setting realistic capital market assumptions leads

consulting research group | position paper

At CAPTRUST, we believe setting realistic capital market

assumptions leads to more prudent asset allocation decisions

for institutional and private wealth investors alike and to a more

successful investment experience overall. In this year’s update to

our assumptions, we look at the four principal themes of slower

economic growth, low interest rates, monetary policy, and inflation

over the five to seven years of our forecast period. The concept

of normalization plays a central role in our thinking and could

meaningfully impact asset class returns in the coming years.

Financial literature has taught us

that risk and return are related,

and that optimized portfolios seek

to produce the highest expected

return per unit of risk. Formulating

risk and return assumptions for the

various asset classes that comprise

capital markets offers investors

a guide to the probable range of

investment performance over a

given period. These assumptions

can then guide the asset allocation

and risk levels that should be

chosen to meet investment goals.

Five years after the financial

crisis, central bank policies remain

accommodative, interest rates are

still near historical lows, inflation

remains contained, and economic

growth is below its long-term

trend. However, over the five- to

seven-year horizon of our forecast,

we expect a normalization of

these factors as central bankers

unwind their policies in response to

improving growth and inflation, and

interest rates gradually rise towards

longer-term equilibrium levels.

SUMMARY

capital market assumptions The Long Road Toward Normalization

May 2014

www.captrustadvisors.com

2 www.captrustadvisors.com

CAPTRUST FINANCIAL ADVISORS

capital market assumptions The Long Road Toward Normalization

overall, our new return forecasts are similar to our prior forecasts (published in april 2013) for most

asset classes, with several exceptions. historically low interest rates drive our subdued fixed income

returns, most notably in interest-rate-sensitive subsectors such as long-term treasurys, investment

grade corporate bonds, and mortgage-backed securities. a pick up in economic growth could aid equity

returns, although higher valuation levels provide a headwind, particularly for u.s. stocks. Despite lower

return forecasts across most asset classes compared to their long-term historical averages, we remain

generally constructive on capital markets.

GuidinG THemes Our forecast covers a full market cycle, typically a five- to seven-year period.

We look at four principal themes that guide our current thinking in formulating

capital market assumptions:

slower economic GrowTH

In recent years, growth has been held back by several factors, including corporate

and household deleveraging — or lessening reliance on debt — but that process

appears to be nearly complete. As shown in Figure One, the household and

financial sectors have made considerable strides in reducing their debt burdens;

debt-to-gross-domestic-product (GDP) ratios for both of these sectors are at

decade lows. Debt ratios for the corporate sector have steadily increased, but

high cash levels on corporate balance sheets are providing support. In contrast to

private sector deleveraging, government debt as a percentage of GDP continues to

increase at a rapid pace and is currently at historic highs. Fiscal tightening through


3capital market assumptions: The Long Road Toward Normalization

tax increases and spending cuts necessary to address the

government borrowing issue provided a headwind for U.S.

economic growth in recent years. However, we expect less

fiscal drag going forward, as these tax and spending measures

have significantly improved the U.S. federal budget deficit.

In our forecasts’ early years, we expect U.S. economic

growth to benefit from acceleration in the private sector

and reduced fiscal drag. In this environment, U.S. GDP

growth could finally break above the sluggish 2 percent level

witnessed since the 2008 financial crisis and possibly reach

3 percent growth for several years. Within the private sector,

homebuilding is beginning to recover and should boost

economic growth. In addition, consumer spending continues

at a solid pace as low inflation provides a quasi-tax cut for

U.S. consumers.

In our forecasts’ later years, GDP growth will likely return to a

more normalized level below 3 percent. Structural issues related

to the financial crisis, such as longer-term debt reduction and a

persistently high unemployment rate, may impact longer-term

growth. Demographic factors, such as an aging U.S. population,

could also play a role as the pace of labor force growth slows.

low inTeresT raTes U.S. interest rates have steadily fallen over the past thirty years

to historically low levels. In our forecast horizon’s early years,

we expect the Federal Reserve to keep short-term interest rates

at the present low levels, depending on the overall economy’s

trajectory. In the later years, the Fed will likely gradually raise

short-term interest rates towards their equilibrium level.

While the Fed is expected to keep short-term rates anchored in

the near term, it has less direct control over longer-term rates.

As U.S. economic momentum has improved over the past year,

longer-term interest rates have risen, although they remain

low by historical standards. In addition, the Fed has begun to

wind down its bond purchase program in light of an improving

labor market, a process that it will likely complete by year-end

2014. This action could also put some upward pressure on

longer-term interest rates. We expect interest rates to gradually

increase in the coming years to reach an equilibrium level more

consistent with history in the latter part of the forecast horizon.

As discussed later in this report, we expect subdued returns in

fixed income as this normalization process unfolds, since bond

prices move in the opposite direction of rates.

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100%

80%

40%

140%

0%

120%

20%

60%

Figure One: Debt Outstanding by Sector as a Percentage of U.S. GDP, 1966–2013

Financial

household

corporate

government

1970 1975 1985 1995 20051980 1990 2000 2010

4



moneTary Policy

With fiscal policy constrained in the developed world,

monetary policy is a critical asset class return determinant.

In some cases, such as with global equities, monetary policy

could distort asset prices as investors pay less attention to

corporate earnings and other fundamental factors. Developed

market monetary policy is expected to remain accommodative

in the near term, given subdued inflation and considerable

slack in most economies. As growth and inflation expectations

normalize in the coming years, central banks’ ability to

successfully unwind their accommodative policies could have

significant asset price implications.

inFlaTion

U.S. inflation, as measured by the Personal Consumption

Expenditures Index (the Fed’s preferred measure) shown in

Figure Two, has been contained in recent years due to sluggish

GDP growth and considerable slack in the economy, which

have kept wage growth at low levels. Inflation is currently

running well below the Fed’s 2 percent target, and we expect

it to remain subdued in the near term. In the later years of our

forecast horizon, inflation is expected to be roughly in line with

the Fed’s target due to the impact of accommodative monetary

policy and stronger economic growth.

Some observers are concerned that the aggressive steps taken by

central banks could eventually lead to higher inflation. The Fed

significantly expanded its balance sheet following the financial

crisis, driven by purchases of U.S. Treasurys and mortgage-

backed securities. While higher-than-expected inflation is still a

possibility in the latter part of the forecast horizon, we see little

evidence to support this concern at the moment.

These four themes could have a significant impact on asset

class results during our forecast horizon. If private sector

growth continues to accelerate and fiscal drag diminishes, U.S.

GDP growth may finally break above the 2 percent threshold.

The future path of interest rates is meaningful to our forecasts,

particularly for fixed income. If longer-term rates stay low for

an extended period, this could be supportive for fixed income

returns. In contrast, if rates normalize faster than expected

due to acceleration in economic growth, fixed income returns

could be adversely impacted. Accommodative monetary policy

continues to be supportive of traditionally riskier asset classes,

but central banks will eventually face challenges as they

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Figure Two: U.S. Personal Consumption Expenditure Inflation, 1964–2018

6%

8%

10%

12%

4%

Federal reserve Forecast

2%

19701965 1975 1985 1995 20051980 1990 2000 2010 2015



overview oF new assumPTions

We divide our full market cycle forecast horizon into three periods:

•Yearsoneandtwo(2014–15): acceleration of gDp growth, modest inflation, and

accommodative monetary policy but longer-term interest rates gradually move higher.

•Yearsthreethroughfive(2016–18): Federal reserve increases short-term interest rates due

to pick up in growth and inflation.

•Yearssixandseven(2019–20): interest rates reach equilibrium level following Fed tightening cycle.

Please note that our forecasts are at the asset class level only; we do not forecast the excess returns derived

from the use of active management.

unwind these policies. Ultimately, valuation will be a key consideration given strong

developed market equity returns since the 2008 financial crisis. A significant increase

in inflation, while not our current expectation, could have adverse effects on several

asset classes, including fixed income. In that scenario, assets such as commodities,

real estate, and inflation-protected securities could become relatively more attractive,

as they have historically acted as hedges against inflation risk.

asseT class reTurns

Figure Three illustrates that our new return forecasts are similar to our prior

forecasts for most asset classes, with several exceptions. When developing

capital market assumptions, the starting point for each asset class is an important

consideration, since it historically has a high correlation with future returns.

Historically low interest rates drive our subdued fixed income returns, most

notably in rate-sensitive subsectors such as long-term Treasurys and core fixed

income. Equity valuations have rebounded in recent years, which suggests a

lower probability of multiple expansion (investors paying a higher price per unit of

earnings) going forward.

Figure Four provides historical context for our return forecasts in certain asset

classes. For most asset classes, our assumptions are below their respective historical

returns, particularly for the prior five-year period, in which accommodative



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asset class Prior return new return Prior risk new risk

u.s. gDp growth 2.5% 2.6% — —

u.s. inflation 2.6% 2.2% — —

cash 1.2% 1.6% 0.5% 0.5%

long-term u.s. treasury 1.8% 2.1% 12.1% 12.6%

core Fixed income 2.5% 2.7% 5.5% 3.5%

u.s. investment grade corporate 3.6% 3.3% 6.1% 5.3%

u.s. high Yield corporate 7.0% 5.4% 15.0% 13.0%

long Duration corporate 5.0% 4.4% 11.3% 8.8%

emerging Market Debt 5.8% 6.2% 13.0% 11.9%

u.s. Municipal Debt 2.7% 3.1% 4.9% 5.2%

treasury inflation protected (tips) — 2.8% — 5.8%

u.s. large-cap equity 7.0% 6.6% 17.4% 15.4%

u.s. Mid-cap equity 7.5% 7.1% 20.6% 17.2%

u.s. small-cap equity 7.3% 6.8% 22.5% 20.0%

international equity — Developed 7.6% 7.0% 25.0% 17.5%

international equity — emerging 9.3% 8.6% 27.2% 23.5%

private equity 10.0% 9.6% 28.8% 24.0%

u.s. public real estate 7.2% 6.3% 22.8% 21.6%

u.s. private real estate 6.2% 5.9% 12.5% 12.0%

commodities 6.0% 5.0% 19.7% 15.8%

hedge Fund of Funds (Diversified) 4.0% 4.4% 5.0% 7.0%

Figure Three: Comparison of New and Prior Capital Market Assumptions

monetary policy has been a primary market driver. Our fixed

income return expectations are generally below historical

returns as we enter a period of rising interest rates. While

U.S. high yield corporate bonds are typically less sensitive

to interest rates than Treasurys and core fixed income, they

have enjoyed strong returns, in recent years as corporate

balance sheets were repaired and investors sought higher-

yielding asset classes. Our equity return expectations are

significantly below their five-year historical returns, as stocks

have rebounded sharply off 2009 lows. In addition, among

alternative asset classes, we expect public real estate to post

significantly lower returns compared to recent years as this

asset class benefited from lower interest rates. However, our

return forecast for emerging market equities is materially

higher than the twenty-year historical return due to attractive

valuations following recent underperformance.

asseT class risk

Figure Three also shows that our new risk forecasts are

modestly lower than our prior risk forecasts across most

asset classes. We use standard deviation — which measures

the possible divergence of the actual return for an asset

class from its expected return — as one risk metric. Note

that for our portfolio construction processes, we view

permanent capital impairment or loss of capital as the single

most important risk measurement. Our standard deviation

forecasts in Figure Five are based on historical trends, with

more weight placed on the twenty-year historical period.

Over the past five years, the deleveraging process and other

repercussions from the financial crisis drove increased

volatility in economic growth and asset prices. However, with

the deleveraging process largely complete, expected volatility

should be more in line with longer-term averages.



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20%

15%

10%

5%

core Fixed income

long-term u.s. treasury

u.s. high Yield corporate

u.s. large- cap equity

intl equity-Developed

private equity u.s. public real estate

hedge Fund of Funds

commoditiesintl equity-emerging

5-Year historical return

20-Year historical return

captrust Forecast return

Figure Four: CAPTRUST Forecast vs. Historical Asset Class Returns

over the past five years, the deleveraging

process and other repercussions from the

financial crisis drove increased volatility in economic growth and

asset prices.

asset classHistorical

standard deviation difference standard deviation

20 Years 5 Years 5 Yr – 20 Yr Forecast

cash 0.7% 0.0% -0.6% 0.5%

long-term u.s. treasury 11.8% 15.0% 3.2% 12.6%

core Fixed income 3.7% 2.9% -0.8% 3.5%

u.s. investment grade corporate 5.5% 4.9% -0.5% 5.3%

u.s. high Yield corporate 8.9% 9.1% 0.2% 13.0%

long Duration corporate 8.8% 8.8% -0.1% 8.8%

emerging Market Debt 13.3% 7.7% -5.6% 11.9%

u.s. Municipal Debt 5.3% 5.0% -0.2% 5.2%

treasury inflation protected (tips) 5.9% 5.6% -0.3% 5.8%

u.s. large-cap equity 15.2% 15.8% 0.6% 15.4%

u.s. Mid-cap equity 16.9% 18.0% 1.1% 17.2%

u.s. small-cap equity 19.7% 20.9% 1.3% 20.0%

international equity — Developed 16.7% 19.7% 3.0% 17.5%

international equity — emerging 23.8% 22.6% -1.2% 23.5%

private equity 11.0% 6.3% -4.7% 24.0%

u.s. public real estate 20.1% 25.9% 5.8% 21.6%

u.s. private real estate 4.7% 6.7% 2.0% 12.0%

commodities 15.7% 16.2% 0.5% 15.8%

hedge Fund of Funds (Diversified) 4.0% 3.0% -1.0% 7.0%

Figure Five: Standard Deviation Forecasts

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Figure Six: Risk-Adjusted Returns

hedge Fund of Funds (Diversified)

emerging Market Debt

u.s. private real estate

private equity

u.s. large-cap equity

u.s. investment grade corporate

core Fixed income

u.s. Mid-cap equity

long Duration corporate

international equity—Developed

international equity—emerging

u.s. high Yield corporate

u.s. Municipal Debt

u.s. small-cap equity

commodities

u.s. public real estate

treasury inflation protected (tips)

long-term u.s. treasury

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0.1 0.2 0.40.3Sharpe Ratio

Expected risk-adjusted returns for each asset class based on the

Sharpe ratio, which divides CAPTRUST’s expected return by our

expected standard deviation, are displayed in Figure Six. Sharpe

ratio is a helpful measure since it allows for easy comparisons

across asset classes. Risk-adjusted returns for most asset classes

are tightly clustered in the 0.25–0.35 range, although we note

several outliers. For example, although hedge funds of funds

have a low expected return of 4.4 percent, risk-adjusted returns

are more favorable. Emerging market debt is a standout among

fixed income, while Treasury inflation-protected securities

(TIPS) and long-term U.S. Treasurys rank at the bottom.

correlaTions

Our correlation forecasts (Figure Seven) are derived

from the same methodology as our risk assumptions.

Since the 2008 financial crisis, correlations among and

within asset classes generally increased as macroeconomic

issues and central bank actions drove markets. However,

correlations have declined recently as idiosyncratic

factors such as local economic and earnings trends are

playing a more prominent role. Thus, we now place more

weight on longer-term historical trends when developing

correlation forecasts.



cash 1.00

long-Term u.s. Treasury 0.09 1.00

core Fixed income 0.16 0.79 1.00

u.s. investment Grade corporate 0.03 0.50 0.84 1.00

u.s. High yield corporate -0.06 -0.19 0.21 0.58 1.00

long duration corporate 0.00 0.64 0.82 0.95 0.49 1.00

emerging market debt 0.06 0.10 0.39 0.54 0.57 0.49 1.00

u.s. municipal debt 0.02 0.45 0.66 0.64 0.31 0.58 0.34 1.00

TreasuryInflationProtected(TIPS) 0.05 0.51 0.74 0.66 0.27 0.61 0.40 0.50 1.00

u.s. large-cap equity 0.04 -0.24 0.02 0.26 0.63 0.20 0.52 0.04 0.03 1.00

u.s. mid-cap equity 0.01 -0.27 -0.01 0.26 0.69 0.20 0.52 0.08 0.05 0.94 1.00

u.s. small-cap equity -0.01 -0.29 -0.08 0.17 0.62 0.13 0.47 0.00 -0.02 0.84 0.94 1.00

international equity-developed 0.00 -0.25 0.03 0.32 0.66 0.26 0.54 0.06 0.09 0.84 0.84 0.77 1.00

international equity-emerging -0.01 -0.26 0.03 0.30 0.67 0.24 0.68 0.04 0.15 0.75 0.78 0.74 0.82 1.00

Private equity 0.12 -0.38 -0.27 0.05 0.46 0.00 0.41 -0.13 -0.15 0.78 0.77 0.74 0.72 0.59 1.00

u.s. Public real estate 0.03 -0.09 0.15 0.35 0.63 0.31 0.44 0.18 0.19 0.62 0.70 0.68 0.61 0.54 0.52 1.00

u.s. Private real estate 0.10 0.09 -0.07 -0.18 -0.20 -0.12 -0.03 -0.14 0.03 0.14 0.10 0.11 0.08 -0.09 0.37 0.16 1.00

commodities 0.09 -0.19 0.04 0.24 0.38 0.16 0.33 -0.03 0.26 0.40 0.45 0.39 0.51 0.52 0.42 0.32 0.12 1.00

HedgeFundofFunds(Diversified) 0.09 -0.31 0.00 0.32 0.61 0.21 0.44 0.16 0.13 0.58 0.62 0.56 0.63 0.63 0.74 0.35 0.14 0.50 1.00

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Figure Seven: Correlation Matrix

exPecTed PorTFolio PerFormance

A logical question for clients to ask is: What are the implications of CAPTRUST’s

capital market assumptions on my portfolio’s expected return and risk? Figure

Eight attempts to answer this question with three hypothetical portfolios containing

diversified mixes of asset classes. By increasing exposure to traditionally riskier asset

classes such as equities, clients will have a better chance of meeting their long-term

return objectives; however, they must be willing to accept higher portfolio return

variance. Our standard deviation assumptions for equities are considerably higher

than for fixed income; thus, investors should incorporate this factor into asset

allocation decisions. Note that the expected return and risk in Figure Eight are for

illustrative purposes over the long term. Actual results in a given year could differ

materially from these forecasts, and the expected returns do not account for any

excess returns that an active manager attempts to provide above a given benchmark.

source: ZephYr, captrust research



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Figure Eight: Forecast Portfolio Performance

weights

conservative Moderate aggressive

core Fixed income 39% 19% 0%

u.s. high Yield corporate 3% 3% 2%

u.s. large-cap equity 23% 26% 29%

u.s. Mid-cap equity 6% 10% 17%

u.s. small-cap equity 0% 4% 8%

international equity — Developed 9% 15% 18%

international equity — emerging 2% 5% 8%

u.s. public real estate 3% 3% 3%

commodities 3% 3% 3%

hedge Fund of Funds (Diversified) 12% 12% 12%

Total equity 40% 60% 80%

expected return 4.8% 5.7% 6.6%

expected risk 8.0% 11.3% 14.5%

risk-adjusted return 0.60 0.50 0.46

asseT class meTHodoloGy and imPlicaTions

GdP and inFlaTion

As discussed earlier, deleveraging’s impact has kept U.S. GDP growth below its long-

term average in recent years. With that process largely complete, we expect growth

closer to 3 percent in the early years of the forecast horizon as the private sector

gains momentum and fiscal drag diminishes. In the later years, growth may return to

a more sustainable pace, modestly below 3 percent. Overall, we expect 2.6 percent

U.S. GDP growth during the forecast horizon, similar to our prior assumption.

Given an acceleration of GDP growth in the early years of the forecast horizon,

inflation will gradually rise but remain below the Fed’s 2 percent target, partially

due to labor market slack. In the later years, inflation could modestly exceed the

Fed’s target due to the impact of accommodative monetary policy and an economy

operating closer to its potential level. We currently see little evidence to support a

sharp rise in inflation and thus project a 2.2 percent inflation rate, compared to our

prior assumption of 2.6 percent.

we see little evidence to support a sharp rise

in inflation and thus projecta2.2percent

inflation rate compared to our prior assumption

of2.6percent.



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Figure Nine: 10-Year U.S. Treasury Yield vs. U.S. Aggregate Index, 1977–2014 (Forward returns Beginning in 2010 are less than Five Years)

5%

10%

15%

20%

Barclays u.s. aggregate (5-Year Forward return)

10-Year treasury Yield (Beginning of Year)

An improved GDP growth outlook has positive implications

for our equity return forecasts, as it leads to higher earnings

growth. Inflation expectations normally have a negative

correlation with fixed income returns. If inflation remains

controlled, this could be supportive for fixed income. In

contrast, hard assets such as commodities and real estate

tend to perform well in inflationary environments.

Fixed income

Current yield is the starting point for our fixed income

forecast, as it has been a reasonable proxy for forward fixed

income returns with a correlation of 0.93 (see Figure Nine).

With the 10-year Treasury yield close to 3 percent, this

could signal subdued fixed income returns in future years.

Figure Nine also highlights that fixed income returns have

diminished over time as interest rates approach the nominal

“zero bound,” a term reflecting the idea that, in unadjusted

terms, bond yields cannot move below zero.

The biggest risk for fixed income returns is a sharp rise in

interest rates, such as the scenario in May-September 2013

in which the 10-year U.S. Treasury yield increased nearly 1.4

percent. In that instance, investors became concerned that

the Fed might reduce its bond buying program before the

U.S. economy was on firm footing. Although future interest

rate spikes cannot be ruled out, several factors could prevent

a repeat of the 2013 scenario. Risks to global growth remain a

concern due to a slowdown in emerging markets and a fragile

European recovery. In addition, demographic factors in the

U.S. and a lack of viable substitutes for U.S. Treasurys as a

safe haven asset could provide support even as rates rise.

Our cash and long-term U.S. Treasury forecasts incorporate

insights from the forward yield curve, which represents

market participants’ expectations for future interest rates. As

shown in Figure Ten, the forward curve suggests that short-

term interest rates will remain low for the next two years and

then rise for several years before reaching an equilibrium

level. While Treasurys and other rate-sensitive fixed income

subsectors could experience principal loss in a rising-rate

environment, they will eventually benefit from the higher

yields toward the end of our forecast horizon.

1985 1995 20051980 1990 2000 2010



For the remaining fixed income subsectors, we use current yield as a starting

point and then make adjustments for expected spread tightening, which could aid

returns. A credit spread is the difference between yields on Treasurys and corporate

bonds that have similar maturities. This differential typically narrows — or

tightens — as the economic outlook improves and investors have a more favorable

opinion about corporate debt. U.S. investment grade and high yield bond spreads

have tightened significantly in recent years, albeit from elevated levels during the

financial crisis. We see less room for further spread tightening, although strong

corporate balance sheets and investor appetite for yield in the current low-rate

environment provide support. For TIPS, we start with the current yield and add our

inflation forecast to derive the return.

equiTies

We use three building blocks to develop equity return forecasts: dividend yield,

expected earnings growth, and the impact from valuation changes. Our estimates

for each return component are illustrated in Figure Eleven.

Dividend yields should be supported by high cash levels on corporate balance

sheets and a focus on returning more capital to shareholders. Share buybacks have

been an increasingly important contributor to equity returns, so we factor them into

our dividend yield calculation.

During the forecast horizon, earnings growth for U.S. large-cap companies is

expected to be in line with our nominal GDP growth assumption of 4.8 percent.

Earnings growth for mid- and small-cap companies should continue to outpace

nominal GDP growth. For international developed equities, earnings growth is

held back by a fragile European recovery and an uncertain outlook for Japan as it

attempts to emerge from several decades of deflation. Emerging market growth may

be lower than in prior periods as China transitions to a more sustainable growth

rate; several other economies face the prospect of stagflation, a combination of

slowing growth and higher inflation.



For U.S. equities, the key takeaway is the negative valuation impact, which

more than offsets an improved growth outlook and solid dividend yields.

Following a strong run since the financial crisis, U.S. equity valuations are

elevated relative to their historical averages. Long-term expected returns

normally decline as the starting level of valuation increases. International

developed equities appear fairly valued following strong returns in recent

years. In contrast, we forecast a positive valuation impact for emerging market

equities following several years of underperformance. Although we forecast

lower returns from emerging market equities relative to our prior assumptions

(8.6 percent vs. 9.3 percent), we continue to expect outperformance compared

to developed markets due to favorable demographics and better valuation,

but we acknowledge some risks to the forecast, and our standard deviation

assumption reflects the potential variability with this asset class.

Figure Ten: Forward Yield Curve for 3-Month U.S. Treasury Bills

2.0%

2.5%

3.0%

1.0%

3.5%

1.5%

0.5%

3 Monthscurrent 6 Months 2 Years 4 Years1 Year 3 Years 5 Years 10 Years

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u.s. large-cap

u.s. mid-cap

u.s. small-cap

international equity—developed

international equity—emerging

Dividend Yield 2.7% 2.1% 1.5% 3.0% 2.4%

earnings growth 4.8% 5.8% 6.4% 4.0% 4.8%

Valuation impact -0.9% -0.8% -1.1% 0.0% 1.4%

total return 6.6% 7.1% 6.8% 7.0% 8.6%

source: captrust research, Bloomberg

Figure Eleven: Equity Building Blocks



commodiTies

Nominal global GDP growth is used as the starting point for commodity returns.

We expect divergent trends within global growth, with developed markets

gradually improving and emerging markets posting slower growth relative to

the prior decade. In particular, the transition of China’s economy to a more

sustainable growth level could impact commodity returns. China accounts for

a large percentage of global demand in many commodities, so changes in its

growth trajectory can be meaningful. Although commodity returns are forecast

to be lower than those of equities, commodities could be a useful hedge against

higher-than-expected inflation.

PrivaTe equiTy

To derive private equity returns, we add an illiquidity premium to our U.S. large-cap

equity forecast. Investors expect to be compensated for the illiquidity risk that is

inherent in private equity, so it has both the highest expected return and highest

expected risk of the asset classes in our forecast. The excess return of private equity

has diminished in recent years following strong returns in the pre-crisis period.

Individual manager return dispersion is wide within private equity, so manager

selection is important to fully capture this asset classes’ benefits. Our private

equity forecast is based on a broad index and does not incorporate the benefits of

individual manager skill.

although commodity returns are forecast

to be lower than those of equities,

commodities could be a useful hedge

against higher-than-expected inflation.



real esTaTe

For public real estate vis-à-vis real estate investment trusts (REITs), we use the

same three building blocks as equities. Solid dividend yields are offset by slower

earnings growth and a negative valuation impact. Although supply-demand

dynamics remain favorable for commercial real estate, higher interest rates will

likely be a headwind for this asset class. REITs underperformed the broader

equity market in 2013 as higher interest rates led to increased funding costs. REIT

valuations are more reasonable following their recent underperformance but remain

elevated relative to their historical average.

For private real estate, we forecast a modest discount to REIT returns based on

historical trends.

HedGe Funds oF Funds

Figure Twelve displays a multifactor model used to identify the components

of hedge fund returns. The model is driven by our cash forecast, which leads

to a subdued return expectation for the broad hedge fund-of-funds category.

Correlations both within and among asset classes have declined recently, which

could provide a more favorable environment for hedge funds compared to the

past few years. Despite low absolute returns, hedge funds provide the highest

risk-adjusted returns among the asset classes in our forecast. As with private equity,

hedge fund returns are characterized by a large amount of dispersion, so manager

selection is crucial for this asset class.

note: current Weight as of February 2014, source: Merrill lynch

Factor model current weight avg. weight 2003-present

s&p 500 total return index 21.6% -4.3%

russell 2000 total return index 2.9% 8.1%

Msci eaFe net total return index -2.3% 12.9%

Msci emerging Markets total return index 13.8% 13.2%

usD-eur spot rate -0.8% 3.1%

1-Month usD liBor 64.0% 70.1%

total (excludes usD-eur spot rate) 100.0% 100.0%

Figure Twelve: Hedge Fund Factor Model

despite low absolute returns, hedge funds provide the highest risk-adjusted returns among the asset classes in our forecast.


the opinions expressed in this paper are subject to change without notice. this material has been prepared or is distributed

solely for informational purposes and is not tax or legal advice. this is not a solicitation or an offer to buy any security or

instrument or to participate in any trading strategy. the information and statistics in this report are from sources believed

to be reliable, but are not warranted by captrust Financial advisors to be accurate or complete. the analyses are based

on hypothetical scenarios using various assumptions as detailed in each example and are not intended to illustrate the

experience of any particular investor or plan participant.

all publication rights reserved. no portion of the information contained in this publication may be reproduced in any form

without the permission of captrust: 800.216.0645

© 2014 captrust Financial advisors. Member Finra/sipc.

Hunter Brackett, cFasenior Manager

captrust consulting research group

aBouT THe auTHor

Hunter joined CAPTRUST in 2012 and works in

the Investment Research division, where he focuses

on strategic and tactical asset allocation for client

portfolios. Prior to joining CAPTRUST, Hunter

served with firms such as NCM Capital, where he

managed the firm’s financial sector exposure across

all equity portfolios for its institutional and high-net-

worth clients. He was also an associate, large/mid-

cap banks at Lehman Brothers, Equity Research

Division, and an international corporate banking

associate at First Union Corporation. Hunter is a

graduate of Washington and Lee University with

a Bachelor of Arts degree in economics, received

his Master of Business Administration degree from

UNC Kenan-Flagler Business School, and holds a

CFA® designation.

conclusion

Despite lower return forecasts across most asset classes compared to

their historical averages, we remain generally constructive on capital

markets. Following a multidecade bull market in fixed income and facing

the prospect of rising interest rates, it may be tempting for investors

to abandon this asset class. However, we continue to believe that fixed

income plays an important role in client portfolios. It has historically

been a less volatile asset class and provided a cushion during times of

economic stress. Nevertheless, we expect subdued returns for fixed

income going forward, so investors will need to be more selective

with their asset allocation decisions in this area. As economic growth

prospects improve and monetary policy remains accommodative,

traditionally risker assets such as equities could provide solid returns

over the forecast horizon; however, given their strong run over the past

five years, equity valuations are currently stretched, which could provide

a modest drag on returns. We are less constructive on commodity

returns due to slower global growth, although they could still play a

role in portfolios as an inflation hedge. Real estate continues to have

favorable supply-demand dynamics, although higher interest rates will

likely be a headwind and valuation metrics appear full. Alternative assets

such as private equity and hedge funds can benefit from individual

manager skill and are often less correlated with traditional asset classes.

With correlations, both within and between asset classes, returning to

more normalized levels recently, this could provide a more favorable

environment for hedge fund strategies to add value.

captrust Financial aDVisors

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