Case study
Return forecasts at Aldine Advisors
Marta Kowal, CFA, sets capital market expectations at Aldine Advisors for a five-year horizon. For developed market equities she uses the Grinold-Kroner model with these inputs: a dividend yield of 2.0%, net share repurchases equal to 0.5% of shares outstanding a year, nominal earnings growth of 5.5% a year and a P/E ratio expected to fall from 18 today to 17 at the end of five years.
For an emerging equity market, Kowal uses the Singer-Terhaar approach. The market's volatility is 20%, its correlation with the global investable market is 0.7, the global market's Sharpe ratio is 0.30, she judges the market to be 60% integrated with global markets, and she adds an illiquidity premium of 0.5%.
For short-term rates in that country, Kowal applies the Taylor rule. She estimates the neutral real policy rate at 1.0%, expected inflation at 4.0% against a 2.0% target, and an output gap of +1.0%; she uses weights of 0.5 on both the inflation and output gaps.
Kowal also wants a more stable covariance matrix for Aldine's 12 asset classes than the one estimated from 60 months of history.