Book Review: Investing Amid Low Expected Returns
Book Review: Investing Amid Low Expected Returns by Antti Ilmanen
Dr. Ilmanen’s first book, “Expected Returns” is one of my favorites, and a book that I keep handy as a reference, so I was excited when I learned he wrote a second book. “Investing Amid Low Expected Returns” is more than an update of what has become a classic. In this smaller, but packed book, Ilmanen lays out his case for why it is reasonable to expect future investment returns to trail historical ones (the book was published in 2022) and what investors can do about it.
In the introduction, Ilmanen lays out his investment beliefs. Investors should consider their investing beliefs. I happen to agree with Ilmanen’s list of beliefs. The last line sums up the section: “In sum, my investment beliefs favor humble forecasts and bold diversification.”
The Case for Low Returns
The best predictor of an investment’s long-term return is its current yield – for fixed income that’s the effective interest rate and for stocks it’s the earnings yield. As of September 2021, both were lower than they had been in over a century. Ilmanen notes that after four decades of very good investment returns, investors have come to expect higher than normal returns instead of the lower than normal expected returns corresponding to today’s price levels.
The two main responses to a low expected return environment are to take more risk and to increase the savings rate. Ilmanen estimates that savings rates must be double what they used to be to support future spending goals. It is no surprise that many are stretching for extra return by taking more risk.
Investing Premia
Investing premia is what investors expect to earn for taking risk in an investment and is in excess of Treasury-Bills. Ilmanen starts with liquid asset classes – stocks, fixed income and commodities. Interestingly, he mentions the Fallen Angel bond strategy – a favorite of mine – and found that since it has become widely know, it has maintained the same 2.3% per year edge over the high yield index as it had before. Commodities have generated excess returns (vs. cash) of 3-4% per year since 1877, despite the average for a single commodity being 0%. This is the power of diversification!
Illiquidity Premia
Finance theory states that liquidity is preferable to illiquidity. It’s good to be able to get to your money when you want to. Because of this, investors should be compensated for tying up their money in investments that are costly or impossible to sell for a quickly. University endowments have famously used their very long timeframe to collect this extra premium on part of their portfolio. In this era of low expected returns, many investors are looking to illiquid (alternative) investments to boost their returns. Ilmanen examines how much is available. Alternatives are generally considered anything other than publicly traded stocks, bonds and cash. Ilmanen looks at the major alternative investment classes of Private Equity (including Venture Capital), Private Debt, and real estate (including residential and commercial real estate, farmland, timberland, infrastructure, etc.) Private investments have been rising in popularity for some time, as investors are wooed by their high and steady returns. Ilmanen examines whether the returns are truly as high as expected. At first, blush, the Sharpe ratio (a measure of return divided by risk) looks very high, but this is flattered by the lack of pricing transparency, which makes volatility (the proxy for risk) look artificially low. Stocks would look less risky if we only priced them four times per year and did so based on calculations rather than transactions. Conclusion: illiquid assets don’t do much better than liquid assets on average, but investors get shielded from the volatility by lack of pricing transparency. He also examines prospective returns vs. historical. For example, the Commercial Real Estate Index averaged a 5.4% real return[1] from 1978-2020. Most of that (5.1%) was from the net cash flow yield, which is now about half of what it was historically. Cash flow grew less than inflation, which was mostly offset by valuation increases. Assuming real estate valuations plateau at their historically high level (I’ll take the under), real estate investors can expect about 2.7% above inflation. The conclusion was the same for other alternative assets – current valuations leave little room for prospective returns in excess of public equity returns. The conclusion is that investors are tying up their money in exchange for a “return-smoothing service.” In other words, they don’t get paid extra for tying up their money, they just don’t have to watch the violent fluctuations because the investments rarely get repriced by market forces.
Style Premia – value-based stock selection is a contrarian strategy with almost two centuries of positive returns, but the last decade has seen the greatest drawdown on record. The author shows that this is explained by cheap stocks cheapening relative to median and expensive stocks. This should improve future returns of value investing, as the implied premium today is much higher. To avoid the risk of value traps, value is best paired with other factors. Momentum is an extrapolative strategy that takes advantage of the tendency of assets to trend over certain timeframes. It has worked across asset classes and has a low correlation with value. Carry is similar to value in that it buys assets with high current returns. While these tend to be riskier than lower-returning assets, the higher return on average compensates for the risk taken. The key to carry strategies is to diversify across many to diversify the risk of defaults and crashes. Defensive strategies such as low-beta and quality also work, which seems paradoxical to carry strategies working.
Next, Ilmanen looks at “alpha” the non-systematic return an investor earns through skill. He doesn’t look at mutual funds, but does look at Hedge Funds and a couple of very famous, successful investors. Most of Hedge Fund performance can be explained through systematic strategies. In other words, had a manager employed value, momentum, quality, trend (across assets), carry, etc., most of the alpha was earned before any individual security selection. Warren Buffett had alpha of 3.8%, which is great, but only part of his excess return over the years. He invested in value and low-beta, which both did well as systematic strategies. Soros had negative alpha after decomposing his return to his exposure to systematic strategy returns. (It’s not quite a fair comparison, as the style premia were not discovered yet when Buffett and Soros and other investors were using them as investment criteria.)
Why do Excess Return sources exist? Some argue that it is based on risk, and is simply compensation to investors for taking that risk. Others attribute the returns to behavioral sources – investors as a group act irrationally, creating opportunities for investors willing to go against the crowd. While the risk-based explanation is more promising for future returns, behavioral causes can also persist for a long time. Another explanation for some excess return sources is that they are compensation for investments that do worse than others in down markets. It’s not just how much an investment can lose, but when it loses. If it tends to go up when stocks are down and vice versa, it is an excellent diversifier, and should receive less compensation for its risk… in theory. The data supporting this are weak.
Diversification is a key tenet of good investing, and the book demonstrates how powerful it is. Even a good strategy will sometimes underperform for a decade. Having a mix of low correlated assets greatly reduces drawdowns. This is one pillar of risk management. Ilmanen also examines trend strategies vs. put buying for managing “tail risks”[2] From 1985-2020, put buying underperformed cash by 6.4% per year, while trend-following returned 8.7% per year more than cash. Buying puts is expensive!
Conclusion: This book is technical and packed with information that is very useful to people who construct portfolios and manage risk. Ilmanen makes the point that returns of almost all assets are likely to be lower in the future than they have been in the past. Investors can still try to enhance returns through capturing non-market sources of return, but should be careful. Not all risk premia are likely to continue to outperform public equities. Capturing style premia – value and momentum, and their cousins carry and trend, as well as quality and low volatility – still looks promising. Illiquid investments are likely to disappoint relative to past performance. And finally, we all should be saving more than people in the past saved, as we will probably not get to ride the wave of continuously richening asset valuations and may have to suffer through a reversion back to normal valuations, which would take a bite out of our investment returns.
[1] Real in this context means inflation-adjusted
[2] Tail risk is the risk of extreme outcomes. It comes from the typical bell curve that describes frequencies of events. The furthest left and right of the curve are called the tails. While people are ok with making far more money than expected, the left tail represents catastrophic loss and should be considered.