Role and Framework of Capital Market Expectations (CMEs)

Capital market expectations involve setting likely risk and return parameters for a portfolio. These expectations inform the asset allocation that is ultimately selected, which is the investment results’ primary driver.

Macro expectations involve forecasting risk and returns for an entire asset class. In contrast, micro expectations involve setting expectations for individual securities. Expectations should show cross-sectional consistency, meaning internal consistency within a specific asset class. In addition, expectations need to adhere to intertemporal consistency, which refers to the maintenance of similar traits across various investment horizons.

In summary, Capital Market Expectations (CMEs) play the following roles:

• They are critical inputs in deciding strategic asset allocation.
• They allow portfolio managers to build efficient portfolios.
• They help formulate risk and return expectations for broad asset classes.
• They align the risk-return objectives with investor expectations.
• They can be used to identify short-term mispricing.

The 7-step Process

The CFA curriculum recommends investment professionals’ adherence to a disciplined approach to setting capital market expectations. The approach involves the following 7-step framework:

1. Specify expectations needed: This initial step requires creating an explicit, written list of the asset classes and investment time horizons involved.
2. Examine historical records: While not the final projection, analysts must study and understand previous asset class characteristics and attempt to understand what drives them.
3. Specify methods and models: The most appropriate methods must be predetermined and used throughout the framework to ensure consistency.
4. Determine best sources of information: Established sources are the best. However, analysts are expected to stay abreast of emerging sources and fully understand the data used.
5. Interpret current environment: Analysts must deliver a common set of assumptions with consistent methodologies and judgments based on experience.
6. Deliver documented expectations: The expectations should be supported by reasoning and assumptions in a documented form.
7. Monitor actual outcomes: As the expectations turn into outcomes, they should be recorded, monitored, and studied. This can improve and hone future forecasts.

Question

Which of the following most likely serves as the primary driver of portfolio returns?

1. Portfolio asset allocation.
2. Tax efficiency and tax location.
3. Returns in the form of dividends versus capital gains.

Solution

The correct answer is A:

Capital market expectations inform the process of choosing a portfolio asset allocation, which positively correlates to portfolio returns.

B is incorrect. Taxes are considered a secondary consideration in portfolio management.

C is incorrect. Returns in dividends versus capital gains refer to investor preferences and do not change the portfolio’s return  since dividends can be ‘homemade’.

Reading 1: Capital Market Expectations – Part 1 (Framework and Macro Considerations)

Los 1 (a) Discuss the role of, and a framework for, capital market expectations in the portfolio management process