- Multi-Asset Strategist
United States, Institutional
Change
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In this quarter’s Top of Mind, I focus on two time horizons: the short term, which is very much on asset owners’ minds given the volatility of 2025, and the long term, where our capital market assumptions have changed quite a bit. Among the topics I address:
- Is there more volatility on the horizon and how should asset owners prepare?
- How should the decision to hedge in a volatile market be evaluated?
- How should equity allocations be adjusted if longer-term market expectations are shifting?
- What do fixed income, hedge funds, and active management have to offer in coming years?
The short term: A plan for volatility
The first half of this year turned out to be quite different from what many expected, with high levels of uncertainty and volatility, particularly following President Trump’s “Liberation Day” tariff announcement. In fact, average stock market volatility, as measured by the VIX, was up more than 30% in the first five months of 2025 versus the second half of 2024.1
In late May, we polled more than 100 institutional investors about how they’d responded to this period of elevated volatility and about half said they rebalanced their portfolio back to target weights, which we think is a valuable risk-management exercise. In addition, roughly a quarter of respondents said they made tactical asset allocation changes to take advantage of the environment, while a similar percentage took steps to increase liquidity.
Looking ahead, I want to offer four suggestions to help asset owners navigate the near term:
1. Prepare for more volatility — I expect volatility to remain elevated for several reasons. The Trump administration has demonstrated a willingness to move policy in unexpected directions and then to reverse course at times, and that seems likely to continue. More globally, the range of possible economic outcomes across regions, including in growth and inflation rates, is wider and less certain than in recent years. And geopolitical tensions, running high even before the recent Iran conflict, could boil over in any number of areas. From a market standpoint, high equity and credit valuations can amplify the impact of volatility-inducing events, as can certain strategies used by investors, such as those that rely on leverage or volatility targeting.
2. Adapt portfolios to thrive in a volatile backdrop — I've put together a checklist of ideas for addressing volatility (Figure 1), roughly ordered from the easiest to implement to the most complex. Asset owners should ensure board members/stakeholders are grounded in the idea that we’ve moved past the 2010 – 2020 era of market stability; maintain diversified portfolios; lean into dynamic strategies that can take advantage of volatility; and consider ways to “play defense” with allocation decisions. With respect to tail-risk hedging, there are pros and cons to consider, as I discuss below.
Figure 1
3. Be cautious in deciding whether to hedge — I believe asset owners should approach the hedging decision with a degree of skepticism. Hedging comes at a cost (which is currently higher than average, given the level of volatility in the market), so implementing a hedging program over time will result in a lower long-term total return. Hedging successfully also requires getting two decisions right: when to put the hedge on (before the market sells off) but also when to take it off (to avoid missing gains when the market bounces back).
That said, these trade-offs may be worthwhile to some asset owners, including those who have a specific liquidity need to meet (e.g., a big capital spending outlay) or a drawdown limit to avoid. Hedging may also be worthwhile for those who have high conviction around the timing of a sell-off and can therefore limit its cost. Asset owners may also be able to justify the cost of hedging if they are confident in their ability to redeploy hedge proceeds to pursue opportunistic ideas during a crisis — as these have the potential to generate especially compelling returns.
4. If you choose to hedge, hedge wisely — Members of our Solutions and Derivatives teams offer a few general takeaways for those who choose to pursue hedging:
- Go in with open eyes when it comes to cost. Understand exactly how much is being spent and concentrate on getting the maximum bang for the buck. Our Derivatives Team monitors costs of different forms of tail-risk protection across the world and across asset classes, and they can vary greatly.
- Have a deliberate strategy for monetization, which may include some scenario planning to help capture the gains if the markets do sell off.
- Recognize that tail-risk hedges are not a panacea and set reasonable expectations for the outcome.
The long term: Structuring portfolios for today’s capital markets
Let's pivot from the short term to the longer term. Every quarter at Wellington, we generate capital market assumptions (CMAs) for different investment horizons. They incorporate four core building blocks — the income and growth the asset class is expected to generate, any change in valuation, and the currency impact for a given investor — as well as shared economic drivers, such as GDP and inflation expectations. Over an “intermediate” horizon (think 7 – 10 years), we consider valuation, including some degree of mean reversion, a key building block.
Figure 2 features a subset of our intermediate CMAs (we publish more than 200 every quarter) as of 31 March 2025.
Figure 2
I’ll offer a few thoughts on the asset allocation implications of these assumptions:
1. While equity return expectations are lower than realized returns in recent years (gold oval in Figure 2), be wary of cutting equity risk sharply — After all, the path of returns matters. Equity markets could be strong for several years but still ultimately compound to a lower return. Figure 3 illustrates this point with hypothetical scenarios that would all lead to a 10-year annualized return of 5.4% (our global equity CMA). Mathematically speaking, the top row, with a 5.4% return each year, is one possible (though unlikely) path. We could also end up with something like scenarios 1, 2, or 3, with healthy returns for 9 years but a sell-off in year 10, or like scenarios 4 or 5, with even stronger returns initially but multi-year periods of negative returns on the back end. The point being that taking off a lot of equity risk could mean missing an extended run of positive returns —perhaps even creating pressure to put the risk back on sooner than expected and just as returns are actually about to decline. And note that even if the down years aren’t as back-end-loaded as the stylized examples in Figure 3, there could still be 2 – 5 years of strong equity returns ahead.
Figure 3
This is also a good reminder of the potential value of a tactical asset allocation process to complement strategic asset allocation. Having a process for leaning into equities when they are more attractive on a shorter-term basis may make it more palatable to reduce exposure when they are less attractive on a longer-term basis. Of course, we also need to be humble about the ability to know the path of future returns — there's ample room for error in a 10-year forecast.
2. Maintain or increase equity diversification — Our equity CMAs are significantly higher for non-US developed and emerging markets than for the US (purple oval in Figure 2). Importantly, this is not a growth story. In fact, as shown in Figure 4, we expect faster earnings growth in the US. However, we think the rest of the world will have a meaningful edge when it comes to income. We expect valuations to be a headwind for equities across the board, but particularly for the US. The current price-to earnings (P/E) ratio is modestly below the 20-year average in Japan (14.0 vs 15.1) and modestly above it in Europe (14.3 vs 13.2) and emerging markets (12.4 vs 11.4). In the US, however, the current P/E is well above the longer-term average (21.9 vs 16.5).2 In addition, on the basis of relative valuations, Europe, Japan and emerging markets are extremely cheap compared to the US — in the bottom decile relative to their history. Importantly, our CMAs do not assume “extreme” mean-reversion back to a 100-year average; we use a two business-cycle average to determine “normal” valuations for each region.
I would also note that our small-cap CMA is well above our large-cap CMA (blue oval in Figure 2). Several of our small-cap portfolio managers shared their perspectives on the outlook for the segment in this recent article.
Figure 4
3. Reconsider the role of fixed income — Our CMAs for fixed income are more compelling than they were 5 or 10 years ago, so the asset class may have more to offer as a return source going forward (green oval in Figure 2). Broadly speaking, however, bonds may not offer the same diversification benefit as in the recent past. From 2000 to 2020, the correlation between bonds and stocks was generally negative (shaded area in Figure 5). We’ve seen a marked change in that trend since 2020, more consistent with the pre-2000 period shown in the chart and suggesting that fixed income may not always be the diversification anchor many asset owners rely on — particularly in an era of potentially higher inflation.
Figure 5
Recent concerns about term premium risk may also prove valid over time. Given the growing fiscal challenges in the US and the possibility of capital outflows from the country, there is some risk that interest rates could rise over the medium term — another potential reason not to lean too far into fixed income, even with its more attractive return expectations.
4. Reconsider the role of hedge funds — At a time when fixed income’s scope for diversification may be reduced, hedge funds may be more compelling as a diversifier — and a return source (green oval in Figure 2). Figure 6 is from our recent paper, Goldilocks and the three drivers of hedge fund outperformance. It compares the returns of a 60% equity/40% fixed income portfolio (horizontal lines) and different types of hedge funds over time. In the 1990s and the 2000s, hedge funds outpaced the 60/40 portfolio, and in the current decade to date, they’ve held their own. They did not perform as well in the 2010s, however. As discussed in the paper, the 2010s were a “Goldilocks” period for traditional assets, with little macro volatility and equity dispersion and low interest rates. These conditions were challenging for hedge funds, but have all reversed in recent years, which we think bodes well for hedge fund investors.
Figure 6
5. Seek ways to add active management and alpha — Given the potential for lower equity returns suggested by our CMAs, I think this is a moment to consider pursuing alpha through active management. Figure 7 illustrates the impact of adding various levels of alpha to market returns over time. The first column shows the cumulative return of the S&P 500 over some of the weakest rolling 10-year periods since 1990, while the columns to the right add some alpha to the results. In the decade ending in 2009, for example, alpha could have been the difference between a positive and negative total return.
Figure 7
I recognize that some are skeptical about active management and perhaps understandably so. Over the past 20 years, the percentage of active managers outperforming the S&P 500 has declined from a range of 60% – 80% to about 40%.3 That said, based on our research, large-cap US stocks are one of the most efficient areas of the market. I would also argue that these results have a lot to do with the market backdrop during this particular period. It lacked key ingredients required for active management success in equities, including high market breadth and dispersion and low correlations between individual securities.
Our data suggests that correlation and dispersion metrics have moved in favor of active management over the last few years, but market breadth has not. (If anything, the market concentration of the “Magnificent Seven” era is the antithesis of breadth.) While concentration may remain elevated for some time to come, the environment for active management could improve if the level of concentration is no longer rising, as I discussed in a recent article with my colleague Equity Strategist Andy Heiskell. That, coupled with recent improvements in correlation and dispersion, could add up to an attractive backdrop for active management again.
It’s also worth noting that historically, alpha has tended to be available to investors when it’s needed most. As mentioned earlier, hedge funds have struggled in Goldilocks periods of relative economic stability, which tend to bring less dispersion in the performance of individual securities or different regional markets. In more challenging environments, such as recessions, the economic cycle can stress businesses, separating winners from losers in the market and creating opportunities for active management differentiation. So today, after an extended Goldilocks period from roughly 2010 to 2020, we may be entering a phase more conducive to alpha generation.
Summarizing the long and short of it
I’ll finish by bringing together some of the key takeaways from these short- and long-term insights:
- With volatility likely to remain high, consider allocations to defensive equity, absolute return, and opportunistic strategies, and take a disciplined, cost-conscious approach to hedging strategies.
- In considering the possibility of lower equity returns over the longer term, don’t rush to make big shifts in equity allocations and consider leaning into active management to close the gap.
- Given the potentially wide divergence between US and non-US equities, look for global diversification opportunities but understand the risks of doing so.
- Bonds and hedge funds may be more attractive than stocks in some respects, but don’t overlook the possibility that bonds will provide less diversification.
1Sources: Wellington Management, Refinitiv. Daily data from 14 May 2024 to 29 May 2025. | 2Sources: Wellington Management, Refinitiv. Monthly data from 31 March 2005 to 20 May 2025. Indices used: IBES MSCI USA for US, IBES MSCI Europe for Europe, IBES MSCI Japan for Japan, and IBES MSCI Emerging Markets for EM. | 3Source: eVestment, as of 31 March 2025, gross of fee, in USD. Managers had to have a preferred benchmark of S&P 500.
Important disclosures: Capital market assumptions
Intermediate capital market assumptions reflect a period of approximately 10 years. If we developed expectations for different time periods, results shown would differ, perhaps significantly. Additionally, assumed annualized performance and results shown do not represent assumed performance for shorter periods (such as the one-year period) within the 10-year period, nor do they reflect our views of what we think may happen in other time periods besides the 10-year period. Annualized returns represent our cumulative 10-year performance expectations annualized. Assumed returns shown do not reflect the potential for fluctuations and periods of negative performance.
This analysis is provided for illustrative purposes only. This material is not intended to constitute investment advice or an offer to sell, or the solicitation of an offer to purchase shares, strategies, or other securities. References to future returns are not promises or even estimates of actual returns a client may achieve. This material relies on assumptions that are based on historical performance and our expectations of the future. These return assumptions are forward-looking, hypothetical, and are not representative of any actual portfolio, or the results that an actual portfolio may achieve. Note that asset-class assumptions are market or beta only (i.e., they ignore the impact of active management, transaction costs, management fees, etc.).
The expectations of future outcomes are based on subjective inputs (i.e., strategist/analyst judgment) and are subject to change without notice. As such, this analysis is subject to numerous limitations and biases and the use of alternative assumptions would yield different results. Expected return estimates are subject to uncertainty and error. Future occurrences and results will differ, perhaps significantly, from those reflected in the assumptions. ACTUAL RESULTS MAY DIFFER SIGNIFICANTLY AND AN INVESTMENT CAN LOSE VALUE. Indices are unmanaged and used for illustrative purposes only. Investments cannot be made directly into an index.
This illustration does not consider transaction costs, management fees, or other expenses. It also does not consider liquidity (unless otherwise stated), or the impact associated with actual trading. These elements, among others, associated with actual investing would impact the assumed returns and risks, and results would likely be lower (returns) and higher (risk).
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