strategic asset allocation - lombard odier · pdf fileand the robustness of our portfolio...

Strategic Asset Allocation

unexplored.

Table of Contents

· Foreword 03

· Section 1 - Understand 04

· Section 2 - Forecast 09

· Section 3 - Allocate 17

· Conclusion 20

Please see important information at the end of this document.Lombard Odier · Strategic Asset Allocation · September 2017 /24

History’s most successful regimes – from economies to ecosystems – are united in their ability to replicate and evolve, without ever repeating themselves. While obvious patterns may occur, true success calls for perpetual adaptation. We believe that the same applies to successful wealth management.

The paradigm by which economies grow shifted in 2008. As fundamental investors, we acknowledge the fact that today’s low-growth environment dampens expected returns for traditional asset classes – this is a landscape in which investors must not only live, but thrive within.

We must therefore look beyond the obvious to provide our clients with access to less traditional sources of return. To achieve this, we have adapted our strategic asset allocations1.

While expanding the set of opportunities, we have narrowed our focus – thinking in terms of primary risk premia rather than asset classes. Our aim is to enhance portfolio performance by improving the quality of our estimates and the robustness of our portfolio construction and asset allocation tools.

In this paper, we outline Lombard Odier’s strategy for navigating this new investment environment, and discuss our assumptions for how this new strategic asset allocation will perform.

We begin by highlighting the importance of factors: the underlying drivers of risk and return within an individual asset class. We then discuss the likely macroeconomic scenario of the coming decade and use it to derive factors’ expectations. Finally, we outline how we are harnessing the power of factor-based investing to build, what we believe to be, one of the most robust asset allocation frameworks available to private investors.

Foreword

From idea to implementation: a three-stage journey

1 Definition: The Strategic Asset Allocation (SAA) is the positioning skeleton of a multi-asset portfolio, designed to support it through the full business cycle. The corresponding time-horizon we chose here is a decade. As such, SAA combines both cyclical and structural perspectives. Empirical studies show that most of a portfolio performance comes from its SAA, hence its key positioning within portfolio construction. 2 Forecasts are not a reliable indicator of future performance.

Our aim is to enhance portfolio performance

by improving the quality of our estimates and the robustness of our asset

allocation tools

· Long-term macroeconomic forces and their impact on financial markets

· Identify factors as drivers of asset class returns

· Long-term expected returns

· Asset-class risk metrics

· Asset-class mix to generate returns across a variety of market environments

· Target optimal risk/return ratio

UNDERSTAND FORECAST2 ALLOCATE

1 2 3

/24Please see important information at the end of this document.

Lombard Odier · Strategic Asset Allocation · September 2017

Section 1Understand

Acknowledging that all asset returns can be

expressed as a combination of well-known primary risk

premia, we reviewed our process based on

the most advanced academic work on the topic:

factor-based investing

Power of factors: the key to portfolio performanceTraditional investment strategies have tended to focus on asset classes. If you imagine each asset class to be an atom, factors are the components – i.e. the electrons, protons and the nuclei – that enable that atom to perform whatever function it is designed to do.

In an investment sense, factors can be therefore understood as the characteristics that drive the risk and return of the asset class in question (i.e. the risk premia3). But, in line with the metaphor, factors themselves exhibit a very different set of behaviours to the atom or the asset class it supports, and are therefore a powerhouse of performance in their own right. As illustrated below, factors can arise either organically from the macro environment (primary risk premia) or from the market (secondary risk premia).

Section 1 – Understand

Primary Risk Premia

Equity

Liquidity

Credit

Interest Rate

Emerging Market

Secondary Risk Premia

ValueSmall Cap

Quality

Momentum

Carry

3 Risk premia differ from risk factors by virtue of the fact that the former refers to a risk that must be compensated by the market. A risk factor does not necessarily need to be compensated for.

/24Please see important information at the end of this document.Lombard Odier · Strategic Asset Allocation · September 2017

Isolating the factors that matterThere may be a small number of factors affecting the price of financial assets. The first step in moving from the theory of factor-based investing to the practice is to decide which factors to build one’s investment strategy around: which factors capture the best of the investable universe, while limiting correlation or overlap. To begin the process of isolating the most relevant factors, we asked three key questions:

• Is it fundamentally driven and predictable?

• Does it have a proven ability to deliver persistent performance?

• Does it complement the other factors (performing at different stages of the business cycle)?

The five factors: expanding the opportunity set, narrowing the focusIn a world of low potential growth – and, therefore, low expected returns for traditional assets – it is essential to expand one’s opportunity set to include less traditional asset classes, such as emerging debt or private equity. To this end, we have narrowed our focus to a primary risk premia set that will allow any asset class to be expressed as a combination of the following premia or factors:

Figure 1: Definition of the primary risk premia underlying the performances of a multi-asset portfolio We focus on a few, broad and persistent drivers of return

INTEREST RATE PREMIUM

CREDIT PREMIUM

EQUITY PREMIUM

EMERGING PREMIUM

LIQUIDITY PREMIUM

Compensating for duration, inflation and monetary policy risk

Earning income by lending to corporations

Capturing global economic growth

Taking advantage of stronger emerging markets (EM) growth

Getting rewarded for longer-term commitments

Government bonds versus cash

Credit bonds versus government bonds

Equity versus cash

Emerging markets debt (local currencies) versus cash

Illiquid stocks versus liquid stocks4

4 Pastor, L., Stambaugh, R.F., 2003. Liquidity risk and expected stock returns. Journal of Political Economy



In this segment, we discuss the structural trends that we believe will be pivotal to the long-term performance of portfolios.

Our approach to long-term investing calls for a time horizon of at least 10 years and a strategy that can accommodate the mix of cyclical and structural scenarios likely to playout over that period.

Investors must think beyond the cycle and anticipate structural shifts in nominal growth dynamics. Indeed, the positioning of the cycle cannot be ignored.

We focused our outlook on two key macroeconomic pillars: growth and inflation.

GrowthSince the global financial crisis began in 2008, economies have faced a new paradigm of sustained, but lower, potential growth (Fig. 2). Driven by an ageing global population and low productivity growth, this trend for low potential growth globally is, in our view, here to stay.

Welcome to the real world: Assessing the macroeconomic backdrop


Lower potential growth, driven by an ageing population

and low productivity growth, is here to stay

Figure 2: Potential growth estimates and forecasts

Source: Lombard Odier Investment Strategy

2.7%

1.8%

1.4%

0.8%

2.0%

0.3%

1.8%

0.9%

US EU Japan Switzerland

Average since 1980 (exc. EU: 91) LO Long-term assumptions (2017-2026)

Demography is fundamental to economic growth – as the latter ultimately results from people’s work. To anticipate demographic trends, we have referred to long-term forecasts made by the United Nations. The trend that stands out markedly for the outlook for global growth is that of the ageing global population. Over the next 10 years, emerging and developed economies alike will see their growth potential hampered by a decline in the workforce.

Productivity is the second variable that must be taken into account. While this is, by far, the most-challenging element to predict, the very low level of investment spending over recent years warrants a conservative outlook on global productivity.

Insight


Inflation The second pillar driving our long-term outlook is inflation. Over the past 20 years, the US Federal Reserve (Fed) has enjoyed great success in anchoring inflation close to its target of 2.00%.

Since the late nineties, expectations have stabilised between 2.00% and 2.50%, in line with the Fed’s mandate. Even with very accommodative monetary policy stances, inflation expectations have remained well anchored since the Global Financial Crisis.

Going forward, our projections assume that inflation will remain close to these goals, albeit slightly lower (1.8% in the US). In our view, central banks’ credibility is here to stay. Yet, we see specific demographic factors (such as baby boomers retiring and being replaced by a workforce with less bargaining power) weakening the traditional Phillips curve for an extended period of time, as consequences of the financial crisis – such as excess capacities and indebtedness – will continue to weigh on expectations.

Source: Livingston Survey (Federal Reserve of Philadelphia), Datastream

Figure 3: US inflation expectations are well-anchored%

The Phillips curve is named after economist William Phillips who devised an equation showing the existence of an inverse relationship between rates of unemployment and the corresponding rates of inflation that result within an economy.

Insight

5.00

4.50

4.00

3.50

3.00

2.50

2.00

1.50

1.00

0.501991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017

Core consumer price in�ationConsensus expectations for US in�ation

FED Target:in�ationaround 2%

Our baseline scenario for the long-run: 1.80%



Based on the pillars of growth and inflation, we have derived the path of the risk-free rate, which can be considered the common ground for all asset returns. Indeed, even though the Fed takes a holistic approach to rate-setting, the well-known Taylor’s rule can give us some guidance.

Figure 4: US potential growth points to Fed Funds rates around 1.75-2%

A common starting point: The path of the risk-free rate

Source: Datastream, Lombard Odier estimates

In the short term, we have used our assessment of the current positioning of the cycle to generate an interest-rate scenario consistent with our macroeconomic outlook. As such, we found that the current tightening cycle is approaching its end, while the long-term equilibrium level should be close to 1.75-2% (Fig. 4). Meanwhile, we cannot exclude the possibility that the Fed may have to, again, lower interest rates to support a cyclical economic slowdown.

Based on this outlook for the Fed Fund rates, we are able to compute the total return of an investment in monetary markets, i.e. the cash return. This estimate forms the starting point for how we predict the performance of the factors that will ultimately power portfolios.


Introduced by economist John Taylor, the well-known Taylor’s rule is an empirical guideline for how central banks should alter interest rates in response to changes in economic conditions.

Many versions of this rule have been tested. We use a rule based on three components:

1) Actual inflation versus targeted levels;

2) Actual employment versus full employment levels;

3) Potential growth.

What is Taylor’s rule?

25

20

15

10

5

0

-5

1981 1985 1989 1993 1997 2001 2005 2009 2013 2017 2021 2025

US Fed Funds Rate Model (covers 1981-2016.

Empirical Taylor ruleFed Fund Rate as a function of- Potential Growth- Unemployment Gap- In�ation Gap

Structural factorCyclical factors(ie = over the long run)

LO long-runscenario

US PotentialGrowth

1.8%US Fed Fund

rates1.75 - 2%

Forecasts start in 2017)


Section 2Forecast

We have designed a robust framework for primary risk premia forecasting

and will estimate long-term expected returns

Expected returnsBased on the market drivers that we identified earlier, we can now begin to predict the long-term expected return for each of the five factors.

We have designed a robust framework for primary risk premia forecasting and will estimate long-term expected returns for:

• Rate premium

• Credit premium

• Equity premium

• Emerging premium

• Liquidity premium.

Our forecasts for a 10-year horizon for each primary risk premium is shown in Figure 5.

Figure 5: Expected returns of primary risk factors %, 10Y horizon (returns for indices expressed in USD terms – i.e. for USD profiles and investors)

Source: Datastream, Lombard Odier estimates

The most striking point is that most primary risk premia are likely to deliver lower returns. Only the credit and, more significantly, emerging markets risk premia should experience improved returns in the coming 10 years.

In the following pages, we will discuss in detail the rationale for the estimates outlined above.

Section 2 – Forecast

Expected Returns Past Returns

4.70%

6.80%

6.90%5.20%

1.10%1.20%

4.50%

3.00%

0% 2% 4% 6% 8%

InterestRates

CreditSpread

EmergingMarkets

Liquidity

Equity

1.70%1.20%



To forecast the rate premium, our first step was to anticipate the evolution of long-term interest rates. Following recent research by the Federal Reserve Bank of New York, we decomposed the 10-year interest rate into two components:

• expectations of the path of short-term interest rates

• and a term premium.

The former can be derived from our forecasts of the risk-free rate, while the latter relates to the extra return an investor receives for holding a longer-term bond, as opposed to rolling short-term securities.

Figure 6 shows the 10-year US interest rate and the evolution of the associated term premium since 1961. While potential growth is positively correlated with the expected risk-free rate, the term premium is driven by time-varying external factors. Strikingly, this term premium has revolved around zero since the start of 2015. Numerous factors have been highlighted to explain this situation. We retain the lower level of uncertainties on inflation and monetary policy, along with the purchases made by the Fed during its quantitative easing programs as the key drivers.

Going forward, while we see little reason for the Fed to change its stance and become less transparent, we expect more rebuilding of the term premium on the back of lesser pressure from its purchases. At our 10-year horizon, we assume that the term premium will normalise from its current abnormally low level and reach 70 basis points (bps) – well below its long-term average of 160bps, and the 105bps level experienced during the past decade. Combined with our expectations on short-term rates, this should lift 10-year yields around 2.75% in the long run.

The Rate Premium: Dampened on the path to normalisation

Source: Federal Reserve Bank of New York (Adrian, Crump and Moench), Bloomberg, Datastream

Figure 6: US interest rates breakdown and potential growth (%)


Expected return

1.2%

Term Premium (ACM Model)Expectations on short-term rates

US 10y interest ratesUS nominal potential growth

0

2

4

6

8

10

12

14

16

1966 1976 1986 1996 2006


Moving from governments to corporates, the next premium we focus on is the credit premium. This is defined as the extra money required by a lender to compensate for the corporate default risk (i.e. the excess return of credit bonds over government bonds).

There is a clear connection between investors’ confidence in future economic activity and the rate they require for lending funds. Typically, a company borrowing money is expected to pay, at the very least, the same interest rate offered by the government, plus a premium to compensate for bearing the extra risk linked to the quality of its balance sheet and the markets’ sentiment regarding its ability to repay this debt in the future.

As shown in Figure 7, the spread between interest rates paid by corporates and governments is time varying and relates to business conditions. We expect this spread to widen from its current historically low levels when/if the economy falls into recession and then normalises in line with the potential growth (hence at higher levels than in the past).

This premium relates on corporate and high yield bonds’ expected returns most notably, but also – as we will see later – convertible bonds.

The Credit Premium: A relative bright spot

Source: Moody's, Datastream, LO estimates

Figure 7: US credit spread (investment grade) and real activity

-10

-8

-6

-4

-2

0

2

4

60

200

300

400

1979 1983 1987 1991 1995 1999 2003 2007 2011 2015 2019 2023

700

600

500

100

US Spread IG (bps)US GDP (%, RhS)

Average annual credit excess return on US investment grade bonds for 1979-2017 is 125 bp.

Lower Growth Wider spreads

Higher Growth Tighter spreads

LO long-run scenario

Ongoing demand for yield and limited

credit losses during a long but shallow economic cycle.

Expected return

1.2%



Another major premium underlying the performance of numerous risky assets is the equity premium. It represents the expected return advantage of holding equity over cash. To draw an expectation over the long run, we decompose total returns into easy-to-forecast ratios as drivers of return.

Starting with the strong relationship between sales and nominal growth (Fig.8), our macroeconomic assumptions point to average revenue growth of around 5% for the next decade, compared with 6.5% since 1980. Furthermore, profit margins appear already toppish – we therefore expect it to come under pressure.

We think that the valuation component of our calculation should experience some de-rating. We expect a gradual convergence of the price-to-earnings ratio close to its post-Global Financial Crisis average, hence higher than long-run average. Indeed, we consider that our assumptions on growth, inflation and yields depicted earlier should support valuations. In a stable growth and positive but contained inflation environment, hence low yield environment, valuations can remain high by historical standards.

Finally, regarding the cash yield hypothesis, we assume that the current buybacks trend in the US is not sustainable and we thus adopt a conservative stance, assuming a cash yield (dividends + buybacks) of 3% in the US in the long-run.

To sum up, our expected returns on US equities for the next decade are based on lower sales and cash yield. We also have to embed some negative influences from valuation and margins, which leads us to a 6.6% estimate of expected return for the next decade on US equities, and 5.2% of expected return for the equity premium (over cash).

The Equity Premium: Less rewarding on lower revenue expectations

Figure 8: Revenues as a function of nominal growth

Source: Datastream, LO estimates


Expected return

5.2%

Sales Normal Growth

1990 1996 2001 2007 2013 2019 2025

25%

20%

15%

10%

5%

0%

-5%

-10%

-15%

12

10

8

6

4

2

0

-2

-4

LO long-run scenarioIn the long-run lower potential growth means lower Sales and, in turn, earnings growth.


Now we turn to less traditional premia, starting with emerging premium, which we express through emerging market (EM) local bonds.

We decompose the premium into two elements:

• the carry

• and the currency effect.

Regarding the carry, yields have been stable over recent decades, mainly as a result of the heterogeneity that characterises the EM universe. In our view, this heterogeneity, and in turn the yield stability, should remain such that carry will continue to evolve around 6.5%.

When it comes to the currency part of the EM premium, our fundamental valuation, the purchasing power parity (Fig. 9) states that, if inflation trends remain the same, EM currencies will have to appreciate by 1.8% each year against USD to converge at the equilibrium in 10 years. So if we combine these two elements – carry and currencies – EM local debt should return at 8.3% on average in USD terms (6.8% of expected returns for the emerging premium) over the coming decade. This is notably due to the fact that we are exiting a bear market on EM assets, so today’s valuations are very attractive for long-term investors.

The Emerging Premium: A nice entry point

Source: Bloomberg, Datastream, LO estimates

120

110

100

90

80

70

602000 2003 2006 2009 2012 2015 2018 2021 2024

Composite EM/USDPPP Fair Value20% Under/Overvaluation

LO long-run scenarioCurrencies should recover against the US dollar and converge toward the long-term equilibrium value

Figure 9: EM currencies are undervalued vs the USD Composite index vs purchasing power parity (PPP) EM/US

Expected return

6.8%

Inde

x va

lue



Finally, we introduce our last primary risk premium, the liquidity premium. This premium is most suited to investors that are able to commit to an investment for a longer period – and thus be rewarded accordingly. Indeed, this premium is usually embedded in assets:

• in which investment is locked contractually (private equity, hedge funds), or

• that experience liquidity squeezes during periods of market stress (typically, high yield bonds).

We expect this premium to shrink in the coming years as more investors are seeking exposure to it, reducing the average profits in a limited pool of opportunity. Against this backdrop, the search for the top managers will be key, warranting access to the best deals. That said, when it comes to the median investment, this premium should gradually converge toward 3%, i.e. slightly lower than its long-term average (4.7%, Fig. 10).

The Liquidity Premium: A victim of investors’ appeal

Figure 10: Liquidity on US stock markets Performance of a strategy long illiquid stocks / short liquid stocks, with liquidity measured by daily turnover

Source: Pastor and Stambauch, University of Chicago Booth School of Business


1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016

40%

30%

20%

10%

0%

-10%

-20%

-30%

Liquidity Premium

Expected return

3.0%


From primary risk premia to a wide range of assets

Lower growth and monetary policy normalisation –

warrant lower expected returns for the main

asset classes. The assets that will be able to

perform the best are those exposed to

the emerging premium

The final step in designing expected returns is to link the primary risk premia (depicted in Section 3) to traditional investable asset classes. As mentioned, we have chosen our primary risk premia set so that any asset class can be expressed as a combination of these five factors.

To achieve this, we have used statistics; and the outcome of our analysis is shown in Figure 11.

The primary risk premia should be seen as building blocks which, when combined with the others, enable us to replicate the historical patterns of assets. The column on the farthest right of the chart measures the share of the asset returns explained by our multi-variate model: the higher this metric5, the better the quality of the estimation. Between the brackets, the beta reflects how much the asset moves along with the primary risk premium.

Convertible bonds, high yield bonds and emerging equities are relatively well explained by our set of risk premia. Hedge funds and private equity returns are partly explained by these primary risk premia. Other factors affecting these asset classes must be taken into consideration, and this will be discussed in the following section.

Figure 11: Assets through a factor lens Mapping asset classes to factors: some examples

82%

57%

% Explained

78%EM Equity Equity(0.8)

EM Premium(0.87)

High Yield Credit(1.5)

Equity(0.15) 77%Liquidity (0.07)Interest Rate

(0.25)

Equity(1.2)

Private Equity Liquidity(0.3)

Credit(0.02)

59%Credit(0.5)Hedge Fund Equity

(0.35) Liquidity (0.05)Interest Rate(0.25)

Convertible Interest Rate(0.25)

Credit(0.5) Liquidity (0.05)Equity

(0.43)

Source: Lombard Odier calculations

5 Beta is a measure of the tendency of a security's returns to respond to swings in the market.



As we explain most of the variability of the asset returns with our building blocks, but not all the variability, we allow some discretionary input to our model. Beyond the output produced by the linear combination of primary risk premia, we adjust our calculations based on what we call secondary risk premia.

In our framework, this concept of secondary risk premia embeds, among others, value or size investing styles or idiosyncratic characteristics such as managers’ skills in the case of hedge funds.

We thus incorporate some discretionary views to strengthen or dampen expectations built initially on the sole structural economic outlook.

Room to manoeuvre: Creating the space for discretionary input

Figure 12: Expected returns versus past returns (% 10y horizon, in USD)


Our final output in terms of expected returns of asset classes (by opposition to the expected returns of the risk premia expressed earlier) confirms lower returns for the majority of the asset classes.

Indeed, the two major trends we have identified for the coming decade – lower potential growth and monetary policy normalisation – warrant lower expected returns across the fixed income and equity asset classes.

The assets that will be able to perform the best are those exposed to the emerging premia.

Insight

Source: Datastream, Bloomberg, Lombard Odier calculations

Private Equity

Hedge Funds (HFRI FoF)

EM Equity

Equity (US Large Cap)

EM Local Debt

High Yield

Corp. Bonds

Gov. Bonds (1-10Y)

Cash

0% 5% 10% 15%

12.0%9.3%10.8%

6.7%

5.6%3.8%

2.6%3.9%

1.4%

6.6%7.2%

8.4%8.1%4.7%

Historical Returns (1989-2015)

LO Expected returns (2017-2026)

12.7%9.0%

6.8%3.5%


Section 3Allocate

Our factor asset allocation framework is designed to construct portfolios

that capture broad, persistent drivers of returns

while ensuring effective diversification and flexibility

A factor-based asset allocationWe use our long-term expected returns as a key input for strategic asset allocation. Based on these estimates we optimally allocate between factors in the first stage, and assets in the second stage. Initially, narrowing our analysis to the key factors leads to more robust allocations.

Focusing on factors and only then on asset classes provides us with a flexible framework in which we can accommodate a variety of desirable assets and portfolios in the second step. Accordingly, our factor asset allocation framework is designed to construct portfolios that capture broad, persistent drivers of returns while ensuring effective diversification and flexibility.

Our analysis shows that, compared to the global capital market portfolio, we should:

• increase our emerging exposure;

• slightly increase credit premium;

• maintain equity exposure and

• dampen exposure to interest rates.

More generally, we believe that the higher the return objective the more exposure to emerging, equity and liquidity premiums is warranted in the current environment.

Finally, our process can integrate seemingly less quantifiable investments ideas (e.g. private equity or hedge funds) around a rigorous foundation while keeping in check the factor exposure with our overall strategy.

Section 3 – Allocate



Figure 13: Factor allocation - defining the optimal allocation

Section 3 – Allocate

STAGE 1: Allocating factors

We select appropriate factor exposures using insights from portfolio optimisation.

Notes Compared to traditional asset class allocation, there is no requirement that the factor exposure amounts to 100 % as some assets embed a leverage exposure to some factors. However, the optimisation framework ensures that any optimised factor allocation can be mapped into assets. Ultimately, a set of additional constraints imposed will depend on specific investor preferences. * The target expected shortfall is used to define the SAA while the upper-bound limit defines the maximum risk permissible tactically. 6 Expected shortfall is the average loss the portfolio is expected to experience in the worst year in every twenty (or equivalently, the average loss in the worst 5%of all years).

In the first step, as described previously, we forecast the expected returns of the factors as well as their risks and correlation metrics.

We then define the investor’s goals, desired universe and constraints. For instance, as outlined in the Figure 13, we consider our three distinct risk profiles: Conservative, Balanced and Growth.

Finally, for specific investment objectives and outcomes we compute the factor blend that is the most desirable. Technically speaking, we rely on the mean-expected shortfall6 optimisation procedure to indicate which factor exposures are optimal.

Conservative

Balanced

Growth

Expected shortfall

Expe

cted r

etur

ns

Interest Rates

Credit Spread

Equity Premium

Emerging Markets

Liquidity

Target 8%limit 12%*

Target 16%limit 24%*

Target 24%limit 36%*


STAGE 2: Allocating assets

We tilt the portfolio towards the preferred asset classes.

As there are more assets than factors, there is an infinite number of investable asset portfolios that result in an equivalent factor exposure. For instance, the equity factor can be equally accessed through investment in convertible bonds, listed equity or private equity. There are two elements that encourage us to prefer one asset to another one for a given factor exposure: asset preferences and a new dimension, illiquidity.

Preferences:

• Firstly, some assets have an exposure to secondary risk factors which have generated excess performance and deserve meaningful allocation due to higher expected returns. For example, smaller firms (size premium) should outperform their larger counterparts.

• Non-systematic views on what cannot be explained by our factor model, for instance the capability to generate alpha7 or the relative valuation, further guide our choices in terms of asset preferences.

A new dimension: illiquidity

Finally, when a client can withstand low liquidity in part of their portfolio, a new dimension can be considered: liquidity premium can usually provide return enhancement.

Rates CreditEquity Emerging MarketsLiquidity

Government Bonds

CorporateBonds

ConvertiblesHigh Yield

Local EM Debt

EM Debt Hard Currency

DevelopedEquities

Expected ReturnsExpected Shortfall

5.20%16.60%

EmergingEquities

SmallCap

Private Equity

HedgeFunds

Cash

Asset Allocation Factor Exposure

Bonds

Equities

OtherPreferences

Constraints

Secondary Premia

From factors to asset allocation: an example

7 Alpha is a measure of an investment's performance compared to a benchmark.



Conclusion

We seek to build portfolios that are fully adapted to the new economic paradigm of low potential growth – precipitating low investment returns. This paradigm is here to stay. Although deflation is no longer a concern, inflation should remain contained going forward as structural issues also weigh on prices.

In our analysis, we found that a set of five primary risk premia can be combined to replicate the historical patterns of a wider range of asset classes.

Most primary risk premia are likely to deliver lower returns. Only the credit and, more significantly, emerging markets risk premia should experience improved returns in the coming 10 years.

From an allocation standpoint, we have found that the higher the return objective, the more exposure to the emerging, equity and liquidity premiums is warranted in the current environment.

Our process is fundamentally driven and technically robust, however, we are aware that this outcome is not fixed for the next decade and will be subject to periodical reviews. For instance, we cannot rule out the emergence of a disruptive –and by nature unpredictable – factor that could boost productivity and challenge our present analysis.

Ultimately, our process aims integrate seemingly less quantifiable investments ideas around a rigorous foundation while maintaining the factor exposure with our overall strategy.


Contacts

Grégory Lenoir Head of Asset Allocation Discretionary Portfolio Management [email protected]

Sophie Chardon Cross-Asset Strategist Discretionary Portfolio Management [email protected]

Paul Bésanger, CFA Mutli-Asset Portfolio Manager Discretionary Portfolio Management [email protected]

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Lombard Odier make its best efforts to ensure the timeliness, accuracy, and completeness of the information contained in this marketing communication. Nevertheless, all information and opinions as well as the prices, market valuations and calculations indicated herein may change without notice. Past performance is no guarantee of current or future returns, and the investor may receive back less than he/she invested. The value of any investment in a currency other than the base currency of a portfolio is subject to foreign exchange rate risk. These rates may fluctuate and adversely affect the value of the investment when it is realised and converted back into the investor’s base currency. The liquidity of an investment is subject to supply and demand. Some products may not have a well-established secondary market or in extreme market conditions may be difficult to value, resulting in price volatility and making it difficult to obtain a price to dispose of the asset.European Union Members: This marketing communication has been approved for use by Lombard Odier (Europe) S.A and by each of its branches operating in the following territories: Belgium: Lombard Odier (Europe) S.A. Luxembourg · Belgium branch, a credit institution supervised in Belgium by the Banque nationale de Belgique (BNB) and the Financial Services and Markets Authority (FSMA); France: Lombard Odier (Europe) S.A. · Succursale en France, a credit institution supervised in France by the Autorité de contrôle prudentiel et de résolution (ACPR) and by the Autorité des marchés financiers (AMF) in respect of its investment services activities; Italy: Lombard Odier (Europe) S.A. · Succursale in Italia, a credit institution governed in Italy by the Italian stock market regulator (Commissione Nazionale per la Società e la Borsa, or CONSOB) and the Bank of Italy; Netherlands: Lombard Odier (Europe) S.A. · Netherlands Branch, a credit institution supervised in the Netherlands by De Nederlandsche Bank (DNB) and by Autoriteit Financiële Markten (AFM); Spain: Lombard Odier (Europe) S.A. · Sucursal en España, a credit institution supervised in Spain by the Banco de España and the Comisión Nacional del Mercado de Valores (CNMV); and United Kingdom: Lombard Odier (Europe) S.A. · UK Branch, a credit institution in the UK subject to limited regulation by the Financial Conduct Authority (‘FCA’) and the Prudential Regulation Authority (‘PRA’).Notice to investors in the United Kingdom: Lombard Odier (Europe) S.A. • UK Branch is authorised in the UK by the Prudential Regulation Authorities (PRA) and is subject to limited regulation by the Financial Conduct Authority (‘FCA’) and the Prudential Regulation Authority (‘PRA’). Details of the extent of our authorisation and regulation by the PRA and regulation by the FCA are available from us on request. UK regulation for the protection of retail clients in the UK and the compensation available under the UK Financial Services Compensation Scheme does not apply in respect of any investment or services provided by an overseas person. In addition, this marketing communication has also been approved for use by the following entities domiciled within the European Union: Gibraltar: Lombard Odier & Cie (Gibraltar) Limited, a firm which is authorised and regulated by the Financial Services Commission, Gibraltar (FSC) to conduct banking and investment services business; Spain: Lombard Odier Gestión (España) S.G.I.I.C., S.A.U., an investment management Company authorised and regulated by the Comisión Nacional del Mercado de Valores (CNMV).Switzerland: This marketing communication has been approved for issue by Bank Lombard Odier & Co Ltd.United States: Neither this document nor any copy thereof may be sent, taken into, or distributed in the United States of America, any of its territories or possessions or areas subject to its jurisdiction, or to or for the benefit of a United States Person. For this purpose, the term “United States Person” shall mean any citizen, national or resident of the United States of America, partnership organized or existing in any state, territory or possession of the United States of America, a corporation organized under the laws of the United States or of any state, territory or possession thereof, or any estate or trust that is subject to United States Federal income tax regardless of the source of its income.This marketing communication may not be reproduced (in whole or in part), transmitted, modified, or used for any public or commercial purpose without the prior written permission of Lombard Odier. © 2017 Bank Lombard Odier & Co Ltd – all rights reserved. Ref. LOCH/LOESA-GM-en-072017.

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