Investing Amid Low Expected Returns

Elevate your game in the face of challenging market conditions with this eye-opening guide to portfolio management

Investing Amid Low Expected Returns: Making the Most When Markets Offer the Least provides an evidence-based blueprint for successful investing when decades of market tailwinds are turning into headwinds.

For a generation, falling yields and soaring asset prices have boosted realized returns. However, this past windfall leaves retirement savers and investors now facing the prospect of record-low future expected returns. Emphasizing this pressing challenge, the book highlights the role that timeless investment practices – discipline, humility, and patience – will play in enabling investment success. It then assesses current investor practices and the body of empirical evidence to illuminate the building blocks for improving long-run returns in today’s environment and beyond. It concludes by reviewing how to put them together through effective portfolio construction, risk management, and cost control practices.

In this book, readers will also find:

• The common investor responses so far to the low expected return challenge
• Extensive empirical evidence on the critical ingredients of an effective portfolio: major asset class premia, illiquidity premia, style premia, and alpha
• Discussions of the pros and cons of illiquid investments, factor investing, ESG investing, risk mitigation strategies, and market timing
• Coverage of the whole top-down investment process – throughout the book endorsing humility in tactical forecasting and boldness in diversification

Ideal for institutional and active individual investors, Investing Amid Low Expected Returns is a timeless resource that enables investing with serenity even in harsher financial conditions.

Foreword by Cliff Asness xiii

Part I: Setting the Stage 1

Chapter 1 Introduction 3

1.1. Serenity Prayer and Low Expected Returns 3

1.2. Outline of This Book 6

1.3. On Investment Beliefs 11

Chapter 2 The Secular Low Expected Return Challenge 15

2.1. Broad Context 15

2.2. Rearview-Mirror Expectations, Discount Rate Effect, and Low Expected Returns 17

2.3. How Low Are “Riskless” Long-term Yields from a Historical Perspective? 21

2.4. Decadal Perspective on Investment Returns 24

Chapter 3 Major Investor Types and Their Responses to This Challenge 27

3.1. Three Broad Investor Types 28

3.2. History of Institutional Asset Allocation 33

3.3. How Has the Low Expected Return Challenge Hurt Various Investor Types? 42

3.4. How Are Investors Responding to the Low Expected Return Challenge? 45

Part II: Building Blocks of Long-Run Returns 49

Chapter 4 Liquid Asset Class Premia 51

4.1. Riskless Cash Return 52

4.2. Equity Premium 55

4.3. Bond Risk Premium 69

4.4. Credit Premium 74

4.5. Commodity Premium 81

Chapter 5 Illiquidity Premia 87

5.1. Illiquid Alternative/Private Assets 88

5.2. Less Liquid Public Assets 101

5.3. Liquidity Provision Strategies 102

Chapter 6 Style Premia 105

6.1. Value and Other Contrarian Strategies 109

6.2. Momentum and Other Extrapolative Strategies 117

6.3. Carry and Other Income Strategies 124

6.4. Defensive and Other Low-Risk/ Quality Strategies 131

Chapter 7 Alpha and Its Cousins 139

7.1. Alpha and Active Returns 139

7.2. Reviewing the Classification of Portfolio Return Sources 146

7.3. Demystifying Hedge Funds, Superstars, and Other Active Managers 147

Chapter 8 Theories Explaining Long-run Return Sources 151

8.1. Rational Reward for Risk or Irrational Mispricing? 152

8.2. “Bad Returns in Bad Times” at the Heart of Risk Premia 153

8.3. Other Core Ideas for Rational Risk Premia and Behavioral Premia 155

8.4. Who Is on the Other Side? – and Related Crowding Concerns 158

Chapter 9 Sustaining Conviction and Patience on Long-run Return Sources 163

9.1. Patience: Sustaining Conviction When Faced with Adversity 164

9.2. Economic Rationale – and Has the World Changed? 169

9.3. Empirical Evidence – and Data Mining Concern 170

Chapter 10 Four Equations and Predictive Techniques 173

10.1. Four Key Equations and Some Extensions 173

10.2. Overview of Predictive Techniques 180

Part III: Putting It all Together 185

Chapter 11 Diversification – Its Power and Its Dark Sides 187

11.1. Outline of the Remainder of This Book 187

11.2. Ode to Diversification 188

11.3. Critics’ Laments 193

Chapter 12 Portfolio Construction 195

12.1. Top-down Decisions on the Portfolio 195

12.2. Mean-variance Optimization Basics and Beyond 200

12.3. Pitfalls with MVO and How to Deal with Them 204

Chapter 13 Risk Management 207

13.1. Broad Lens and Big Risks 208

13.2. Techniques for Managing Investment Risk 209

13.3. Managing Tail Risks: Contrasting Put and Trend Strategies 210

13.4. Managing Market Risks: Portfolio Volatility and Beyond 214

Chapter 14 ESG Investing 219

14.1. Booming ESG 220

14.2. How Does ESG Affect Returns? 221

14.3. ESG Impact of ESG Investing – a Case Study on Climate Change 224

Chapter 15 Costs and Fees 225

15.1. Trading Costs 226

15.2. Asset Management Fees 230

Chapter 16 Tactical Timing on Medium-term Expected Returns 235

16.1. Contrarian Timing of the US Equity Market 235

16.2. Beyond Contrarian Timing of Equities: Other Assets and Factors, Other Predictors 240

Chapter 17 Bad Habits and Good Practices 243

17.1. Multiyear Return Chasing 244

17.2. Other Bad Habits and Good Practices 246

Chapter 18 Concluding Remarks 249

Acknowledgments 253

Author Bio 255

Acronyms 257

References 259

Index 277

Boxes

3.1 Global Market Portfolio 39

4.1 A Brief History of Inflation 54

4.2 Weak Empirical Relationship Between GDP Growth and Equity Returns 67

5.1 Share of Illiquid Assets in Global Wealth 89

5.2 Calendar Strategies 103

6.1 The Size Premium 107

7.1 Systematic Versus Discretionary Investing 142

8.1 How to Make Sense of Flow Data When Every Buyer Has a Seller 161

10.1 Machine Learning 183

11.1 Rebalancing 192

12.1 Modern Portfolio Theory and Two-Fund Separation 202

13.1 Can Risk Management Enhance Returns? Volatility Targeting 216

15.1 Taxes 233

ANTTI ILMANEN, PHD, is Principal and Global Co-head of the Portfolio Solutions Group at AQR Capital Management. He advises institutional investors and develops AQR’s high-level investment ideas. He is the author of Expected Returns and a recipient of the Graham and Dodd award, the Harry M. Markowitz Special Distinction Award, and multiple Bernstein Fabozzi/Jacobs Levy awards.

In Investing Amid Low Expected Returns: Making the Most When Markets Offer the Least, renowned institutional investor advisor Dr. Antti Ilmanen delivers a timeless—and timely—treatment of strategic investment processes in times of low returns.

The author outlines the low expected return challenge now facing investors due to the past four-decade stretch that has seen markets with ever-increasing valuations and realized returns with falling yields. Assuming high realized returns will persist, especially in an era of low starting yields, is therefore complacent.

The key building blocks to improving long-run returns—including major asset class premia, illiquidity premia, style premia, and the always elusive alpha—are discussed as well, with extensive empirical evidence used to bolster the book’s exploration of the most reliable sources of investment returns.

Readers will learn how to construct an efficient portfolio from these building blocks as well as how to manage risk and control costs, informed by detailed descriptions of competing investment models and best practices amongst large institutional asset owners.

Perennial investing topics are explored at length, with fulsome discussions of the pros and cons of liquid vs. illiquid investments, active vs. passive management, as well as the merits of factor investing, ESG investing, macro-resilient portfolios, and tail hedging. Humble forecasting and bold diversification are emphasized throughout the book, as is the need for a combination of good investments with a patient approach.

With a foreword by Cliff Asness, managing and founding principal at AQR Capital Management, Investing Amid Low Expected Returns is a can’t-miss resource for institutional investors and active individual investors seeking an authoritative and eye-opening treatment of intelligent investing principles in the context of diminishing returns.

PRAISE FOR Investing Amid Low Expected Returns

“Call it secular stagnation, low neutral rates or hyper liquidity, we are in a very different interest rate era than most of us grew up in. Few, if any, financial questions are more important than what it all means for investment strategy. This important book is the best take that has yet appeared.”

— LAWRENCE H. SUMMERS, Charles W. Eliot University Professor and President Emeritus at Harvard University, Former Secretary of the Treasury and Director of the National Economic Council

“Don’t let the title sway you, this book is foundational investing in every return environment. It is filled with solid investment wisdom that will help all investors build a resilient portfolio and stay the course. The core tenets of investment beliefs, portfolio construction, managing risks, and minimizing costs have withstood the test of time. This is a book for all markets and all investors.”

—CHRISTOPHER AILMAN, Chief Investment Officer, CalSTRS

“Antti has earned the right to be called one of investing’s great practical empiricists. If a research paper has value, he has found it and incorporated it into his comprehensive, well-structured toolkit. He clearly states what is known well and where humility is required. Investment practitioners everywhere need this book.”

—JASE AUBY, Chief Investment Officer, Teacher Retirement System of Texas

“Timeless advice for uncertain times. A rare combination of being both erudite and accessible.”

— EDWIN CASS, Chief Investment Officer, Total Fund Management, Canada Pension Plan Investment Board

“Antti has written an important book addressing the most critical challenge to investing for retirement – low prospective returns for the key asset classes. Reviewing extensive histories with humility and experienced judgment, Antti comes up with a balanced and yet optimistic outlook. Reasonable return streams remain for investors to diversify into; however, patience and good risk control will be required. This book is an encouraging read for investors!”

— JEFFREY PICHET JAENSUBHAKIJ, Group CIO, GIC

“I often describe Antti’s previous book, Expected Returns, as the encyclopedia of empirical research of investment management. More than a decade later, Antti has once again written the quintessential guide to navigating the challenging low-return and high-volatility market environment that may lie ahead. He shares his deep understanding and insights into the various components driving returns and provides a clear framework to guide investors in constructing a portfolio to weather the storm.”

— YU (BEN) MENG, Chair of Asia-Pacific of Franklin Templeton and former CIO of CalPERS

“Antti provides a vital update to the canonical toolkit he presented in Expected Returns. The new book has even broader coverage, yet is more succinct. Investors who read this book will leave with a straightforward risk-return framework, a well-considered set of investment beliefs, a list of bad habits to avoid, and empirically good practices to follow. This book is the foundation of solid portfolio management for institutional and retail investors.”

— LARRY SWEDROE, Chief Research Officer, Buckingham Wealth Partners