Antti Ilmanen: Investing Amid Low Expected Returns
Antti Ilmanen’s Investing Amid Low Expected Returns updates his 2011 Expected Returns, a volume considered by many the definitive work on the subject.
Alas, like many classic reference sources, the 2011 volume was a doorstop, weighing in at over 600 pages; its new successor is less than half its size and thus much more easily digested. Better yet, while a writer’s prose rarely blossom in late-middle age, Ilmanen’s clearly has. One shouldn’t expect a book about the risk-free rate, the burgeoning zoo of risk premiums, and portfolio construction to be a piece of chocolate cake, but this one goes down remarkably easily.
The expected returns of investments, it turns out, have been falling for a long, long time. Four thousand years ago, the wealthy citizen of Nippur or Uruk with a few extra pounds of silver could lend them out at 20% per annum – a rate limited by statute – to merchants who might, for example, want to purchase grain and hire ships to sail down the Persian Gulf to Dilmun (roughly, modern-day Bahrain) to trade for copper, whose ores were absent on the alluvial Mesopotamian plain.
Or better yet (at least from the lender’s perspective), one could loan seed grain to needy farmers at zero interest with the expectation that a certain percentage of them would default, in which case they’d seize them and their families as highly valued slaves.
It’s been downhill from there for investment returns; as documented by economic historians like Sydney Homer, Richard Sylla, and Paul Schmelzing, the return on loan capital has fallen, in fits and starts, to today’s negative real rates on government debt, as measured by those offered on inflation-protected bonds.
The long-term trend of expected stock returns is less certain for the simple reason that their track record is far more sparse than for debt; trading on the Amsterdam exchange began only 400 years ago; before 1800, only two companies traded regularly on it, and only three traded in enough volume to record in London. Data from the twentieth century in a few dozen nations suggests an equity risk premium of around 4% on top of today’s near-zero government bond rate.
Why the fall in returns? Imagine a subsistence level environment such as that in the city-states of Sumeria, plodding along at the precipice of starvation. Such a society has little excess capital – nearly every last basket of grain, head of capital, and piece of silver is consumed for food and shelter. Even subsistence societies, though, need capital for seed, implements, and housing, and its owners can charge the earth for it.
And that’s not the only reason for the high investment returns in the ancient world (and in the modern world’s less developed societies until the mid-nineteenth century). Millennia ago, generally starving and poorly housed populations with short life expectancies were highly “impatient” for capital and consumption and thus demanded high returns for their capital than did better-fed, better-housed, and longer-lived modern populations, who must squirrel away enough for retirements that may be longer than their working careers. To liberally paraphrase Samuel Johnson, a man who is to be hung in a fortnight demands a high rate of interest on his funds. By contrast, a world of “patient” capital aimed at consumption decades in the future demands a correspondingly lower rate of return.
Finally, over the past several centuries, intermediation costs for both stocks and bonds have fallen, a process that has accelerated dramatically in the past several decades to the point of nearly zero cost. A world in which a widely diversified portfolio of the entire planet’s stocks and bonds can be purchased with a few keystrokes and a few one hundredths of a percent annual expense makes those securities more widely available and thus drives prices up and returns down. Today’s investors cannot expect the same return as their grandfathers, who had to pay brokers a fortune to trade even a single share, wrestle with stock certificates, and clip individual coupons.
Thus, today’s savers and the nation’s pension funds will get – if they’re fortunate enough not to be slammed with the mean reversion of historically high stock and bond valuations – a real return of about 2% on a conventional diversified portfolio. What to do?
Ilmanen and his book are here to help. The author starts out by reciting St. Augustine’s Serenity Prayer:
God, grant me the serenity to accept the things I cannot change,
the courage to change the things I can,
and the wisdom to know the difference.
He quickly identifies what cannot be changed, namely that,
Historically low bond yields and high asset valuations point to a low expected return world. Meanwhile, many investors have gotten used to strong realized returns as rich assets have grown even richer. Several market observes, myself included, have asked investors to acknowledge this disconnect and to adjust spending plans and investment plans accordingly.
And that’s the good news; at the close of Chapter 2, he opines that “the general asset richening, disinflationary trend [of the 2010s], and growth stock outperformance will reverse in the 2020s.”The past several decades have seen, in the famous words of Elroy Dimson, Paul Marsh, and Mike Staunton, “the triumph of the optimists.” I suspect, however, that Ilmanen’s dour Finnish outlook will be more in tune with the realities of the next few decades.
The third chapter reprises the iron math of pension and retirement savings: The lower the expected and realized returns, the more that must be saved. Pension fund managers are well aware of this, and the author describes what might be called an “Ilmanen spiral,” a vicious cycle in which higher pension savings drive valuations up and expected returns down, which stimulates yet more saving and buying. Pension fund managers are at least cognizant of this dynamic; most defined contribution participants, lulled by the beer-and-pizza stock and bond markets of the past several decades and blissfully unaware that low current expected returns and likely low future realized returns will place their golden years at grave financial risk, are not.
Ilmanen proceeds through the major asset classes. Stocks? In the good old days of 3% real GDP growth, half of that lagniappe got eaten up by share dilution. Now, buybacks have shrunk that dilution to zero, but economic growth has also halved, leaving per-share earnings and dividend growth at around 1.5%, which, added to stocks’ current yield, gives shareholders an expected real return of around 3%.
Bonds, as forecast by TIPS, will at best produce a zero real return. Credit risk may add a small bump to that, but at the cost of dialing in equity risk in drag. My own calculations, for example, show that on a mean-variance (return/volatility) basis, investment-grade corporate bonds behave about the same risk as a 90/10 mix of Treasury bonds/stocks. One of the major insights, however, of Ilmanen’s prior book is that all volatility is not equal. The worst form of volatility is “bad returns in bad times,” a concept amplified in his current volume. In the above case, while corporates and the equivalent 90/10 Treasury/stock mix may have the same overall volatility, the former bit you far harder when you could least afford it: in the teeth of the credit rout in late 2008.
The above consideration goes double – no, quadruple – for junk bonds, which Ilmanen estimates offer a few percent return premium over Treasury bonds, but which he also observes currently have historically low yield spreads.
Neither is the author wildly optimistic about commodities futures, which, because they’ve become a “crowded trade” among mainstream investments, have nearly uniformly negative roll returns. If you must deploy them, he advises, diversify widely among commodity categories, and rebalance the exposures religiously back to your policy weights.
Illiquidity premiums from non-listed real estate and private equity? Meh. The former returns the same as publicly traded REITS, while the latter seems to match up nicely with small value (or perhaps leveraged mid-cap value) stocks, which can be owned more cheaply.
The book’s section on various return premiums, such as “quality,” “low risk,” momentum, and value, will be the most intensely read, particularly the last one: Given its miserable past decades, is value dead? Ilmanen argues against the most prevalent narrative about value, that it is like commodities futures, an overly popular crowded trade; were that true, he points out, the growth/ value valuation gap would have narrowed. In fact, the opposite has occurred, making it more likely to be a coiled spring poised to greatly reward its adherents in the coming decades (as may have already started to happen during the past 18 months).
The last half of the book deals with the nuts and bolts of factor-based long/short portfolio, and will appeal mainly to institutional and hedge fund investors. But even these sections are studded with gems – the section on investor impatience is worth the purchase price alone, particularly that participants often “act like momentum investors at reversal horizons.” That is, money managers most frequently throw in the towel on a strategy after several years, precisely the point at which reversal (mean reversion) provides the most upside.
I have a few minor disagreements. Ilmanen, for example, is enthusiastic about “risk parity,” a strategy that posits that since 90% of the risk in a 60/40 portfolio happens on the equity side, asset managers should equalize a portfolio’s risk budget by leveraging up its bond component. This recommendation reminds one of the hoary swipe at physicists that starts with “Consider a spherical cow.” Risk parity makes sense in the same way. Humans, alas, are not spherical cows. In an adjacent section, Ilmanen waxes eloquently about portfolio survival, one of the biggest threats to which is capitulation in bad times, particularly inflationary bad times, exactly the point at which T-bills provide the ultimate elixir of equanimity. For the past few decades, Berkshire Hathaway’s biggest holding was in fact its 20% position in short Treasury securities. It’s not a bad example to follow.
Minor quibbles like this aside, Investing Amid Low Expected Returns provides a highly readable guide to investing history and to its future and is essential reading for professional asset managers.
William J. Bernstein is a neurologist, co-founder of Efficient Frontier Advisors, an investment management firm, and has written several titles on finance and economic history. He has contributed to the peer-reviewed finance literature and has written for several national publications, including Money Magazine and The Wall Street Journal. He has produced several finance titles, and four volumes of history, The Birth of Plenty, A Splendid Exchange, Masters of the Word, and The Delusions of Crowds about, respectively, the economic growth inflection of the early 19th century, the history of world trade, the effects of access to technology on human relations and politics, and financial and religious mass manias. He was also the 2017 winner of the James R. Vertin Award from CFA Institute.