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The asset mix decision involves an analysis of all capital markets and is complex. Virtually all information that may affect each asset class has to be incorporated into the decision-making process. The scope of this material includes expected activities in the private and public sectors, both nationally and internationally. It includes government policies, corporate earnings, economic analysis, existing market conditions and the forecaster’s interpretation of the data. Because of the complexity of the data and the subjectivity in interpretation, it is very difficult to make an accurate prediction about the magnitude of change in a particular asset class. For this reason, forecasts are sometimes expressed in ranges, with a minimum and maximum level. The use of a range not only reflects the unpredictability of capital markets, but it can also indicate the degree of risk anticipated.

The width of the ranges used in an asset mix return forecast will vary with the level of confidence the portfolio manager has in the forecast. When capital markets are volatile, market risk increases. The forecasting process is more difficult and so the ranges will tend to widen.

The expected total returns for each asset group are calculated by adding the expected annual income to the expected capital gain or loss for each group. For example, if stock prices are expected to increase 10% and dividend yields are forecast to be 4%, then the expected total pre- tax return for equities would be 14%.

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Rates of return are forecasted after analyzing the outlook for those factors that may affect them. While there are many factors to include in the analysis, not all will be of equal importance at all times. Frequently one or two factors, such as inflation or interest rates, will dominate the direction of capital markets. When this occurs, it is necessary to give greater weight to these factors in the analysis.

Quantifying the factors in each group is complex. For this reason, the words “positive,” “neutral,” or “negative” are frequently used to measure the impact of each factor in subjective terms.

Qualifiers, such as “moderately,” “very” or “extremely” can be added to positive and negative to give added emphasis to a particular factor. Once each individual factor has been rated, a consensus is taken and the outlook for the group is formed. The outlook is expressed as a

minimum and maximum expected total return (capital gain or loss plus expected income) for the group. The following examples (Tables 16.8 to 16.12) are provided to demonstrate the process of return forecasting. The numbers and range of expectations will change depending on the economic situation at the time the result is being forecast.

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Since asset mix decisions are based on the comparison of entire asset classes, the direction and magnitude of change in a stock market index must be forecast when assessing the outlook for equities. On this basis, an analysis of Canadian markets would conclude by forecasting a future level for the S&P/TSX Composite Index and in the United States by forecasting future levels for the Dow Jones Industrial Average (DJIA) or the Standard & Poor’s 500 Stock Index.

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The indicators that help assess future stock prices fall into four general categories: fundamental, technical, economic and value indicators. While the factors under each heading can vary

according to the preferences of the analyst, the factors shown in Table 16.8 provide a basic model upon which to analyze and forecast equity prices.

TABLE 16.8 3!-0,% Factors Rating Fundamental Indicators: s #ORPORATE 0OSITIVE Technical Indicators: s 30438 .EUTRAL s $*)! .EGATIVE Economic Indicators: s ,EADING 0OSITIVE s #OINCIDENT .EUTRAL s ,AGGING .EUTRAL Value Indicators: s #OMPOSITE .EGATIVE s #OMPOSITE .EUTRAL

Consensus or Outlook .EUTRAL

When the analysis is complete, each factor shown in the table would be rated positive, neutral or negative, reflecting expectations that levels will rise, fall or remain constant. Then, using the same terminology, a consensus for the group would be formed.

For example, suppose the S&P/TSX Composite Index was expected to fall significantly. This would be reflected in a negative rating under technical indicators. There would be a flow-through effect in the value indicators. The rating for price-earnings ratios would be negative if prices were expected to fall more than expected earnings. Dividend yields would be rated positively if dividend payouts stayed constant despite falling prices.

The next step is to express the word(s) used in the consensus as a percentage to reflect the expected gain or loss for the group. As explained earlier, a range is used because the predictability of capital markets is limited. For example, if the consensus for equities was neutral, then the expected change in the S&P/TSX Composite Index would be plus or minus an equal percentage. If, on the other hand, the consensus was positive, the expected change in the S&P/TSX

Composite Index might reflect only a small percentage decline and a greater percentage rise. Finally, as shown in Table 16.9, the expected income or dividend yield is added to the expected capital gain (or loss) to determine the expected total return for equities. Note that the dividend yield on the S&P/TSX Composite Index is often used as an approximation for the Expected Income Yield.

TABLE 16.9 3!-0,% Minimum Maximum %XPECTED   %XPECTED   %XPECTED   .OTE RESULT &)8%$ ).#/-%

The method used to determine the expected total return for fixed-income securities is similar to that used for equities. However, the focus of the analysis is more specific. Here, in order to calculate an expected total return, an investment manager must forecast future levels for interest rates.

Unlike equity prices, interest rates are influenced by governments to achieve specific economic goals. Therefore, when forecasting interest rates, an investment manager assesses the potential effect of certain factors on the supply/demand equilibrium for money and how changes in that relationship may affect government policy. Factors assessed include monetary policy, fiscal policy, economic indicators, inflation and the value of the Canadian dollar. Since interest rates are international, these factors should be examined from both the Canadian and foreign perspective when feasible.

Table 16.10 provides a model with which to analyze and forecast interest rates. Since declining interest rates increase bond and preferred share prices, those factors that may currently cause rates to drop are said to be bullish, those having no effect, neutral, and those that may contribute to higher interest rates, bearish. As in the equity market analysis, the qualifiers “moderately,” “very” or “extremely” may be used to modify a manager’s feelings about a particular factor.

At different points in the economic cycle, ratings might lead to different conclusions in terms of anticipated interest rate changes as the market makes valuations on central bank policies.

TABLE 16.10 3!-0,% Factors Status/Trend Anticipated Impact on Interest Rates Monetary Policy: s .EUTRAL .EUTRAL s .EUTRAL .EUTRAL Fiscal Policy: s .EUTRAL .EUTRAL s .EUTRAL .EUTRAL

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TABLE 16.10 3!-0,% Factors Status/Trend Anticipated Impact on Interest Rates Economic Indicators:* s 2ISING "EARISH s 2ISING "EARISH s 2ISING "EARISH s 2ISING "EARISH

#ANADIAN &ALLING "EARISH

#ONSENSUS Bearish

When the analysis of the factors is complete, a consensus is taken and the outlook for interest rates is formed. The portfolio manager needs to relate the interest rate analysis to the terms to maturity relevant for the securities being considered for the portfolio. For example, when considering midterm bonds, the portfolio manager needs to make decisions about expectations for mid-term interest rates.

The consensus from the analysis is expressed as an expected increase or decrease in absolute interest rates. To reflect the reality that interest rates are also difficult to predict, a range of rates is sometimes used to describe the potential change. For example, if the consensus for interest rates is neutral, then they may be expected to increase or decrease by an equal amount and remain within this range for the period being forecast. Should the consensus forecast for interest rates be bearish, the percentage decline expected will be less than the percentage rise expected.

The expected gain or loss of capital is calculated by determining the present value of a

representative bond, in the example in Table 16.11, an 8%, semi-annual bond that matures in five years with a yield to maturity of 5.2%. The present value of this bond is then recalculated taking into account the expected rise or decline in interest rates consistent with the consensus outlook forecast earlier. The percentage change in present value from that derived in the original interest rate scenario equals the capital gain or loss to be expected under the forecast interest rate change.

To calculate the expected total return for the fixed-income group, it is necessary to add in the income component of the return. Thus, the coupon or interest rate is added to the expected gain or loss that would result from the projected interest rate change.

TABLE 16.11 &)8%$ ).#/-%

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Interest Rate Change

+1% -0.5% %XPECTED  2.11 #OUPON   %XPECTED   .OTE #!3(

This asset group is generally viewed as one through which managers can obtain a guaranteed rate of return with little risk to capital. Because cash investments are short term, the returns on cash and cash equivalents are the easiest to forecast.

The basis for estimating cash returns is a short-term interest rate (i.e., one year or less) forecast. For example, if interest rates are expected to increase, the portfolio manager takes current cash rates, adjusts them upwards to reflect the forecasted increase, and averages the returns over a 12-month period. The resulting figures are the expected rates of return for cash for the year (see Table 16.12). This return, since it is considered risk free, provides a standard upon which to measure the relative attractiveness of the riskier groups: fixed-income securities and equities. To shift capital from cash to other asset groups, the portfolio manager must feel that the added return potential offsets the added risk.

Continuing from the analysis above, the portfolio manager applies the interest rate changes of 1% and -0.5% to the current yield on cash. It is quite possible for short-term interest forecasts to range between a positive and negative value.

TABLE 16.12 %80%#4%$ Percentage Return Minimum Maximum !   " n  #   $   .OTE

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The expected minimum and maximum returns for the three asset classes based on the above analysis are summarized in Table 16.13.

TABLE 16.13 2%452.

Minimum Maximum

#ASH  

&IXED )NCOME  

%QUITIES