Capital Market Assumptions - September 2019 (Global)

Aon’s Capital Market Assumptions are our asset class return, volatility, and correlation assumptions. Developed by Aon's Global Asset Allocation Team, they represent the long-term capital market outlook (i.e. 10 years) based on data at the end of the third quarter of 2019.

Read the article below to learn more about Capital Market Assumptions.


Expanding the universe of our U.S. real estate assumptions

We are expanding the coverage of our U.S. real estate assumptions to better reflect the opportunity set available to investors and better reflect the experience of investors in U.S real estate strategies. This quarter we are releasing three new assumptions to cover the U.S. real estate opportunity set – levered core U.S. real estate (this better reflects opportunities within the NFI-ODCE index), value-add, and opportunistic real estate.

Before we delve into the details of assumptions, it is useful to talk through what differentiates the various opportunities in U.S. real estate. The key characteristics of these real estate strategies relate to target properties, leverage, risk and potential return. In the core market, strategies target "stabilized" properties that have a rental occupancy of 70% or above, and use a limited amount of leverage.As we move through to value-add and opportunistic the mix shifts from stabilized properties to speculative development, while the leverage employed and risk increases. Development focuses on building acquiring land and developing the property but is less concerned with completing it all the way through to a stabilized investment.

As one would expect, the additional risk investors may experience moving from core to opportunistic real estate has been compensated with higher returns.

How do we build asset class assumptions for these opportunity sets? This is an important question as our clients build more sophisticated real estate portfolios. As always, we use a variety of approaches, depending on what data is available and the quality of that data. First, we will focus on return assumptions, then volatility and correlation estimates.

Returns

To develop our return assumptions, we start with our existing methodology and return assumption for unlevered real estate. This methodology builds up a real estate return from the cash flows that would be generated by a mature core real estate portfolio. More information on this methodology can be found in the lead article from our June 2018 Capital Market Assumption publication. Briefly, this methodology is based on current valuations and forward Net Operating Income (NOI) projections.

To develop our levered assumption, we can apply leverage to our unlevered assumption and include elements of the NCREIF Fund Index - Open End Diversified Core Equity (NFI-ODCE) that are not included in our unlevered assumption.

To do this we must create assumptions for components of the following equation:

Three new assumptions must be made to solve this problem. First, how much leverage is embedded in core real estate portfolios and, secondly, what is the price of leverage? Thirdly, what other things do we need to incorporate into
the assumption?

The amount of leverage that core open ended real estate funds (such as those represented by the ODCE) have is tracked by NCREIF and is shown in the chart on the right. It shows that over the long-term leverage has been approximately 20% and we believe this is a reasonable assumption to make for the future.

From the following chart, we can see that other than a hump around the 2008 financial crisis, which was driven by falling capital values rather than a deliberate increase in the use of leverage, the amount of leverage has remained stable at around 20%. In our assumption we assume that the cost of this leverage is in line with the median yield of intermediate BBB bonds over the 10-year period.

Above we alluded to “other sources of return” in the core open end fund universe. This is an acknowledgement that real estate managers do not simply hold a set of existing properties forever. Investment managers in this space undertake capital improvements on existing buildings and deploy capital in the funds in development to ensure a pipeline of prime assets. This is known as build-to-core. Approximately 10% of a core real estate fund is invested in such strategies. The return profile of these assets in the portfolio are like opportunistic real estate – essentially ground-up development.

To capture this added return, we incorporate the risk premium offered by opportunistic real estate investments which we estimate to be 400bps gross of fees above core (see below for more details). We estimate that this boosts core real estate returns by 40bps in total.

Pulling all the above together brings us to our return assumption for core levered real estate. We currently estimate the return to be 6.0%, and the breakdown is shown below.

So far, we have built a robust assumption for core levered real estate based on observable drivers of the asset class. But what happens when we begin to move into less well documented parts of the real estate market, such as value-add or opportunistic real estate, where we do not have the clear data to build returns from first principles, and the investments become more heterogenous? Here we must rely on the information we have, which is return data for the universe. The consequence is that we must change our methodology to one which uses fixed risk premiums over levered core.

What are acceptable risk premiums for value-add and opportunistic real estate?

We have data that gives us reliable insight into the returns that have been historically achieved by the value-add (beginning 1983) and opportunistic (beginning 1987) real estate markets. From this dataset we can assess the outperformance of these segments against core levered real estate over a market cycle, which we define as a 5-year rolling period, for the average manager in this space.

The history is shown in the following chart. 

Based on this analysis, we believe that reasonable estimates for the gross of fee excess return of value-add and opportunistic real estate are 1.5% and 4% respectively. We believe that a reasonable fee assumption to use on average is 2% (1% higher than core real estate), which brings the net of fee excess returns for value-add and opportunistic real estate to 0.5% (a 1% fee is subtracted to account for the 1% fee embedded in the core assumption) and 3% respectively, to add on to the core levered assumption.

Using these risk premiums, we estimate value-add real estate is expected to return 6.5%, and opportunistic real estate is expected to return 9.0%, over the next 10 years.

Volatility

As with all assumptions returns are only half the picture. Volatility is equally important. For private assets, such as real estate, Aon de-smooths return series to account for lagged valuations of assets. We do not use the reported history because these volatility and correlations calculated on smoothed returns do not give a true reflection of the risks involved when investing in private asset classes.

Our methodology to estimate the volatility of levered, value-add, and opportunistic real estate is anchored in our volatility for unlevered real estate. To get a baseline on how volatile real estate is we take a base line from the NCREIF National Property Index (NPI), an index that tracks the value of unlevered properties in real estate portfolios. On a smoothed basis volatility for the underlying properties has historically been 4.6% per annum. However, when we de-smooth the series to allow for stale pricing of assets, the volatility is 11.6% per annum – a 2.8x difference. For reference, our assumption for unlevered real estate is 12.5%. To convert this unlevered assumption to volatilities for levered, value-add, and opportunistic volatility we scale it by the ratio of the strategies smoothed historical volatility to the smoothed volatility of the NPI. The table below shows these ratios, and the volatility assumptions they imply.

Pulling it all together

In this article we have outlined our approach to creating long-term return and volatility assumptions for an expanded universe of real estate strategies. We have outlined risk and return separately, and in isolation, not against other asset classes. The chart below shows our expanded set of assumptions against a select set of asset classes. As expected, the riskier segments of real estate have higher returns, but with a commensurately higher volatility. We believe that these expanded assumptions play an important part in investment portfolios, but we stress that when moving into value-add and opportunistic strategies manager selection is extremely important as the strategies employed become more heterogeneous and manager skill becomes more important in executing a successful strategy.

Inflation

Forces that have in the past led to higher inflation have failed to take hold in most economies. The efficacy of these inflationary forces (for example, the relationship between tight labor markets and core inflation) have been questioned while attempts have also been made to provide some rationale of why they have not led to higher inflation. Many, including us, also believe that there have been considerable headwinds that have kept inflation low and are unlikely to dissipate in the near term. This global reduction in inflation pressures is reflected in our downward revisions in near-term inflation expectations for most of the regions we cover.

The sole exception to this is the UK where we have increased near-term expectations by 10bps for both consumer and retail price inflation. Although there were major developments late in the quarter in the deliberation of RPI methodology reform, the likely impact on RPI is still being digested and as such, there were no significant changes to either our near or long-term RPI inflation assumptions. We do anticipate, however, that potential reform will likely impact our assumptions but is unlikely to be enacted for several years. For now, there were no changes in our RPI-CPI differential. All our global longer-term inflation assumptions stay unchanged this quarter.

Of the countries considered, we believe persistent systemic deflationary pressures in Japan and Switzerland are likely to result in inflation undershooting the respective central bank targets over the 10-year horizon. For the U.S., UK, Canada and Europe, long-term inflation is expected to be at or near the respective central bank inflation targets. Note the European Central Bank adopts an asymmetric inflation target of below (but close to) 2%.

Fixed Income Government Bonds

The downward trend in global government bond yields that has been a firm feature over the last several months was once again prominent among developed market government bonds. Persistent themes of escalating trade tensions and rising recession risks among other factors dragged yields lower. Amid this uncertain economic backdrop, central banks moved to a firmly monetary easing mindset. The U.S. Federal Open Market Committee cut the Federal Funds rate by 25bps twice to leave the target Fed Funds range at 1.75-2.00%. Following a similar stance, the European Central Bank (ECB) eased monetary policy with the deposit rate now 10bps lower at -0.5%, while the ECB also announced that their Asset Purchase Programme would be restarted. Although cutting interest rates has a greater direct impact on shorter-term yields, longer-term yields fell by more as expectations of lower yields for longer grew. Consequently, our U.S. long-term government bond assumption is now 0.4% lower at 2.3% while the short-term assumption decreased by 0.3% to 1.7%. A similar 0.4% reduction in our long-term Euro-Area government bond assumption now results in a negligible return over our 10-year horizon. This flattening trend in yield curves was not confined to the U.S. or the Euro-Area with the UK flattening significant while Japanese and Canadian yield curves flattened by a lesser extent.

Out of all our assumptions, our Canadian and Japanese return assumptions moved only marginally lower (down 0.1%) at longer maturities while unchanged at shorter maturities.

The Canadian yield curve was relatively stable over the quarter with only the long end of the curve falling marginally leading to a small reduction in our assumptions. The Japanese Central Bank continues to employ its yield curve control policy which limits the extent to which yields at the 10-year tenor point can move. This has helped to anchor Japanese government bond yields when other developed government bond yields fell to 2019-lows. Despite rebounding late in the quarter, UK government bond yields ended the third quarter lower across all maturities. Much of the move down in yields appears to be driven by global factors while domestic issues, such as ongoing Brexit uncertainty, have also depressed yields. As a result, both short and long-duration government bond assumptions are significantly lower with the 0.6% reduction in expectations for our long-duration UK government bond returns the largest move in our assumptions across all asset classes this quarter.

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 that 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.

Inflation-Linked Government Bonds

In general, inflation-linked yields fell in a similar fashion to nominal yields over the quarter with most developed market inflation-linked government bond yield curves flattening over the quarter. The exception to this were Canadian inflation-linked bond yields of durations longer than five years, which were stable over the quarter. As a result, our Canadian assumption is unchanged from last quarter at 2.0%. Lower real yields have driven our UK index-linked government bond return assumptions lower for both short and long durations. The significant move down in longer duration yields have led to a substantial fall in our return assumptions to a point that we now estimate negative annualized returns (-0.3% p.a.) over the next ten years. There was more of a flattening in the short and intermediate parts of the real yield curve relative to the nominal yield curve, and as such the assumption decreased more than the nominal counterparts.

Although U.S. inflation-linked yields fell over the quarter, they did not fall to the same extent as their nominal counterparts with breakeven inflation (the difference between nominal and inflation-linked government bond yields) narrowing over the quarter as near-term inflation expectations decreased slightly. Based on these factors, our U.S. inflation-linked government bond return assumptions have not fallen by as much as nominal government bonds.

Similarly, despite larger declines seen in longer-duration yields, our Euro-Area inflation-linked government bond return assumptions have both been lowered by 30bps to 0.6%; the effect of a flatter real yield curve as the benefit ("roll effect") of rebalancing to maintain the same duration exposure is less than the prior quarter (see the lead article from our December 31 2018 Capital Market Assumptions glossy on how we formulate our government bond return assumptions for
more detail).

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 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 five-year-duration Canadian inflation-linked government bond assumption due to the lack of short-duration bonds in this market.

Investment Grade Corporate Bonds

Corporate bond returns depend on both a government yield component and a credit spread component but also account for losses arising from defaults and bonds being downgraded. The lead article in Aon’s 31 December 2017 Capital Market Assumptions publication discusses our investment grade corporate bond methodology in more detail, while the 30 June 2015 publication sheds more light on defaults and downgrades as two potential drivers of credit losses.

With the exception of Japanese corporate bonds, all of our investment grade corporate bond return assumptions are lower since last quarter. The primary driver behind this has been the significant decrease in our underlying government bond returns with corporate bond spreads mostly unchanged over the quarter. Similar to our fixed-interest government bonds, the largest change in our assumptions were for UK corporate bonds which are now estimated to respectively return 0.4% and 0.5% less than the prior quarter.

Both Swiss corporate bond assumptions are now expected to return less than 0.0% over the next ten years. Standing apart from other developed market corporate bonds, Japanese corporate bond return estimates were revised higher with no material changes to our underlying government bond assumptions while corporate bond spreads bucked the wider trend and ended the quarter higher. The combination of these two effects have led us to increase our short-duration Japanese corporate bond return estimate from 0.0% to 0.1%, while our longer-duration estimate is unchanged at 0.2%.

U.S. High Yield Debt and Emerging Market Debt

With spreads on U.S. high yield corporate bonds broadly unchanged since the prior quarter, spread movement did not have a meaningful impact on our return assumption. Instead, lower estimates for underlying government bond returns were primarily behind the 0.4% reduction in our high yield debt assumptions to 3.6%. No changes were made to our default and downgrade expectations. It is worth noting that our high yield debt assumption already incorporates an expectation that defaults will be consistently higher in the future than the very low levels seen in recent years. The lead article in Aon’s 31 December 2015 Capital Market Assumptions publication discusses the high yield assumption in more detail.

A similar 0.4% downward revision was made for USD-denominated emerging market debt which are now expected to return 3.7% p.a. over the next ten years. The assumption was led lower by our lower underlying government bond return assumption as well as tighter credit spreads.

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 at recent experience, strong equity market performance has been driven more by increasing valuations than by increasing profits.

Developed market equities moved higher for a third successive quarter but it was clear that equity market momentum has slowed since the start of the year with low single-digit returns common among most markets. Limited price movement has meant our equity return assumptions are broadly either unchanged or only slightly lower. This contrasts with the significant moves in our fixed income assumptions. The exceptions to this were European and Japanese equities where a combination of market appreciation over the third quarter alongside downward revisions made to our earnings forecasts have led to 0.3% and 0.2% changes to the return assumptions, respectively. Both of our U.S. and UK equity return assumptions are unchanged since last quarter with minimal to no impact from market appreciation nor were there any changes made to our earnings forecasts. Our Swiss equity return assumption is similarly unchanged – the downward pressure from market appreciation was offset by upward revisions to our earnings estimates. While not significant to detract from our return assumptions individually, the combination of weaker expected earnings growth, inflation and economic growth alongside muted market appreciation dampened our return estimate for Canadian equities by 0.1%. We now expect Canadian equities to return 6.1% on an annualized basis over the next ten years.

Unlike the first half of the year where we saw equity markets in general re-rate with market valuation expansion driving returns, equity market valuations were slightly lower with the exception of European (ex-UK) equities. Slowing equity market momentum led to muted price movement along with broadly stable near-term earnings growth saw U.S. equities de-rate to 17.4 from 17.5 times our 2019 earnings assumption. Similarly, UK equity valuations slightly decreased from 12.6 to 12.5 times our 2019 earnings assumption. Conversely, stronger market appreciation and slightly lower expected earnings have led to European equity valuations to increase from 12.3 to 13.1 times our earnings assumption.

With trade tensions still weighing on a number of emerging economies, emerging market equities continued to underperform their developed market peers with a negative price return (in U.S. dollar terms) over the third quarter. The market depreciation, which would provide a boost to our return estimates were fully offset by a reduction in our earnings growth forecasts. Consequently, our emerging market equity return assumption is unchanged at 7.9% in USD terms.

The lead article in Aon’s 30 June 2019 Capital Market Assumptions publication introduced our return assumption for China A-shares, from now on we will cover how this assumption is changing quarter over quarter. Since the third quarter news flow was dominated by how are evolving the discussion between Chinese authorities and the U.S. administration, it is not surprising we have seen China A-shares being penalised by the unresolved trade tensions. As other factors were unchanged, the fall in market valuation has put upward on our return assumption which is 0.1% higher at 8.4% in USD terms.

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 has 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.

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 apply this strategy 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.

Private Equity

The global private equity return assumption is down 0.1% to 8.6%. While all of our underlying private equity strategies have decreased since last quarter, the main driver has been the reduction in our Buyouts return assumption. Compared to the previous quarter's publication, the lower high yield return assumption as well as higher cost of debt have driven our Buyout strategy return assumption lower. While underlying government bond yields have fallen, spreads of loans used to finance the levered buyouts have increased significantly and more than offset the impact of lower yields. Given the greater weighting of LBOs strategy in our overall private equity assumption (representing over half of the global private equity assumption), we consequently assume that global private equity will return 8.6% per annum over the next 10 years in U.S. dollar terms—a decrease of 0.1% from the previous quarter. The global private equity assumption represents a diversified private equity portfolio with allocations to leveraged buyouts (LBOs) and venture capital, as well as 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 and 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 the future, managers’ ability to add value through operational improvements will become more important.

Real Estate

The economic capitalization rate, which we use as a primary input for our U.S. unlevered real estate methodology (see the lead article from the June 30 2018 edition of our Capital Market Assumptions for further details), was broadly unchanged over the third quarter. However, we have upgraded our rental growth forecasts for the U.S. market and have accordingly increased our return assumptions by 0.1% to 5.2%. Both Canadian and UK real estate return assumptions are unchanged at 4.4% and 5.3%, respectively. The key drivers to our assumptions: initial yields, inflation and rental growth expectations, were all relatively stable over the third quarter for both regions. Canadian real estate remains our lowest returning real estate market in local currency terms. Rental yields in European real estate markets fell over the quarter, driven lower by higher property values. In the absence of higher rental growth or inflation expectations, our return assumption for the region is now 0.1% lower at 4.9%.

Our assumptions here are based on a large fund that 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

For a second successive quarter, our fund of hedge funds return assumption return has decreased by 0.2% p.a. in U.S. dollar terms. The decrease to 3.3% was driven by lower return assumptions for credit, government bonds and LIBOR. We formulate this by combining the return assumptions for a number of representative hedge fund strategies. This assumption includes allowances for manager skill and related fees (including the extra layer of fees at the fund of funds level), and 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 explained in the lead article in Aon’s 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” they did in the more distant past and that alpha generation is likely to remain challenging moving forward.

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 modeling of these strategies includes an analysis of their underlying building blocks. For example, we consider 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 far 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 that are related to these markets, such as equity long-short and distressed debt strategies.

Volatility

Historically, forward-looking indicators and our view on the economic cycle all play a role in our volatility assumption-setting process, and the volatilities in the table above are representative of 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 toward 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.

Risk and Return

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.

Correlations

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 modeled). A different set of correlations apply for Japanese investors.

Correlations are highly unstable and vary greatly over time. This feature is captured in our modeling, 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 in Aon’s 30 June 2014 Capital Market Assumptions publication included further detail on the drivers of the equity/ government bond correlation.


Appendix: Capital Market Assumptions Methodology

Overview
Aon’s Capital Market Assumptions are our asset class return, volatility, and correlation assumptions. The return assumptions are “best estimates” of annualized returns. By this, we mean median annualized returns—that is, there is a 50/50 chance that actual returns will be above or below the assumptions. The assumptions were developed by Aon's Global Asset Allocation Team and represent the long-term capital market outlook (i.e., 10 years) based on data at the end of the third quarter of 2019. CMAs contain projections about future returns on asset classes. These do not assume additional alpha for active management strategies within these asset classes, and are modeled to represent a low nominal fee passive index, with the exception of hedge funds, real estate and private equity, where traditional passive investments are not available. Therefore, the model assumptions for theses asset classes include a higher model fee impact.

You cannot invest in an asset class directly, or within the model asset classes assumed within the CMAs. Expected returns are geometric (long-term compounded; rounded to the nearest decimal). Expected returns presented are models and do not represent the returns of an actual client account. Not a guarantee of future results. Should you have any queries regarding the methodology behind our assumptions, please direct them to one of our specialists. Please consult the Contacts page towards the end of this document for their contact information.

Material uncertainty
Given that the future is uncertain, there is material uncertainty in all aspects of the Capital Market Assumptions, and the use of judgment 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; 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 that are annually rebalanced (to maintain constant duration). This is formulated by stochastic modeling of future yield curves.

Inflation-linked government bonds
We follow a process similar 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 bonds.

Corporate bonds
Corporate bonds are modeled in a manner similar to government bonds but with additional modeling of credit spreads and projected losses from defaults and downgrades.

Other fixed income
Emerging market debt and high yield debt are modeled in a manner similar 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 and venture capital, as well as 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 that is quoted in the Capital Market Assumptions.

Currency movements
Assumptions regarding currency movements are related to inflation differentials.

Volatility
Assumed 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 that 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.


Appendix: Index Definitions

NCREIF Fund Index - Open End Diversified Core Equity (NFI-ODCE)
A capitalization-weighted,gross of fees,time-weighted return index with an inception date of 1/1/1978. Published reports may also contain equal-weighted and net of fees information. Open-end funds are generally defined as infinite life vehicles consisting of multiple investors who have the ability to enter or exit the fund on a periodic basis, subject to contribution and/or redemption requests, thereby providing a degree of potential investment liquidity. The term Diversified Core Equity style typically reflects lower risk investment strategies utilizing low leverage and generally represented by equity ownership positions in stable U.S. operating properties (as defined herein).The NFI-ODCE is a quasi-managed index based on the periodic review by the Index Policy Committee("IPC") of the index's criteria thresholds.
NCREIF National Property Index (NPI)

A quarterly, unlevered composite total return for private commercial real estate properties held for investment purposes only with an inception date of 1/1/1978. All properties in the NPI have been acquired, at least in part, on behalf of tax-exempt institutional investors and held in a fiduciary environment.


Disclaimer

This document has been produced by Aon’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 to be reliable and are not necessarily all inclusive. Aon 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 June 2019, 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.


About Aon

Aon Limited is authorized and regulated by the Financial Conduct Authority. Registered in England & Wales No. 4396810. When distributed in the US, Aon Investment Consulting, Inc. (“AHIC”) is a registered investment adviser with the Securities and Exchange Commission (“SEC”). AHIC is a wholly owned, indirect subsidiary of Aon plc. In Canada, Aon Inc. and Aon Investment Management Inc. (“AHIM”) are indirect subsidiaries of Aon plc, a public company trading on the NYSE. Investment advice to Canadian investors is provided through AHIM, a portfolio manager, investment fund manager and exempt market dealer registered under applicable Canadian securities laws. Regional distribution and contact information is provided below. Contact your local Aon representative for contact information relevant to your local country if not included below.

Investment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc. (“AHIC”). 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.

This document is not intended to provide, and shall not be relied upon for, accounting, legal or tax advice or investment recommendations. Any accounting, legal, or taxation position described in this presentation is a general statement and shall only be used as a guide. It does not constitute accounting, legal, and tax advice and is based on AHIC’s understanding of current laws and interpretation.

This document is intended for general information purposes only and should not be construed as advice or opinions on any specific facts or circumstances. The comments in this summary are based upon AHIC’s preliminary analysis of publicly available information. The content of this document is made available on an “as is” basis, without warranty of any kind. AHIC disclaims any legal liability to any person or organization for loss or damage caused by or resulting from any reliance placed on that content. AHIC. reserves all rights to the content of this document. No part of this document may be reproduced, stored, or transmitted by any means without the express written consent of AHIC.

Aon Hewitt Investment Consulting, Inc. is a federally registered investment advisor with the U.S. Securities and Exchange Commission. AHIC is also registered with the Commodity Futures Trading Commission as a commodity pool operator and a commodity trading advisor, and is a member of the National Futures Association. The AHIC ADV Form Part 2A disclosure statement is available upon written request to:

Aon Hewitt Investment Consulting, Inc.
200 E. Randolph Street
Suite 700
Chicago, IL 60601
ATTN: AHIC Compliance Officer


About Aon
Aon plc (NYSE:AON) is a leading global professional services firm providing a broad range of risk, retirement and health solutions. Our 50,000 colleagues in 120 countries empower results for clients by using proprietary data and analytics to deliver insights that reduce volatility and improve performance.

For further information on our capabilities and to learn how we empower results for clients, please visit http://aon.mediaroom.com.

© Aon plc 2019. All rights reserved.

The information contained herein and the statements expressed are of a general nature and are not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information and use sources we consider reliable, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation.

Aon Hewitt Limited is authorised and regulated by the Financial Conduct Authority. Registered in England & Wales. Registered No: 4396810.
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