Antti Ilmanen Describes a Harsh Winter for Expected Returns



The CFA Institute European Investment Conference is a focused, interactive conference for Europe’s leading investment professionals. The 2017 CFA Institute European Investment Conference will bring portfolio managers, analysts, chief investment officers, and CEOs together in Berlin on 16–17 November.

“I have got bad news as a starter,” Antti Ilmanen told the audience at the 2016 CFA Institute European Investment Conference. Ilmanen, who is a principal and researcher at hedge fund AQR, announced that “It is not only a low interest rate world, it is also a low expected return world on any long-only investment.” Low expected returns are going to anchor bad news for all of us for the rest of our working lifetimes, and maybe beyond.

Looking back to the rosier past, Ilmanen acknowledged the healthy 4% historic US equity risk premium, but points out that today that number is sitting at the bottom of its historic range. He suggested that for a balanced portfolio, the real return is heading down toward 1% per annum. And he is scathing about other asset classes, such as private equity and real estate. “Twenty percent — it ain’t realistic,” Ilmanen said.

“Everything is rich versus its own history, because everything has been pulled down by the common discount rate,” Ilmanen said. All long-only investments are expensive, and a rearview mirror approach extrapolating gains for the next twenty to thirty years is not going to work well.

During his presentation, Ilmanen outlined three distinct potential scenarios for the future:

  • Slow Pain: In this scenario, low yields persist for years, and there are no more windfalls from declining rates. Life insurance companies may suffer badly in this instance.
  • Fast Pain: Payback time for the boomer generation’s windfall gains. All assets’ real yields rise, so long-only institutional portfolios suffer across the board (although liability values fall).
  • 2008 Redux: Equity valuations fall, while bond yields also fall. A double whammy for underfunded pension plans with a duration mismatch.

Of these three possibilities, Ilmanen thought that the persistent low yields of the “slow pain” scenario would be most likely for the future.

Alternative Risk Premia to Navigate a Difficult Environment

What can investors do? Ilmanen was not inspired with the prevailing choice between cash or expensive assets. Taking on more equity risk, going down the credit curve, illiquid alternatives, or hedge funds — all of these have risks correlated with equities. And timing the market risks missing out on rising equities. Ilmanen’s preference was to consider factor timing using approaches such as smart beta and the application of long/short style premia.

Describing a pyramid representing the universe of sources of return, Ilmanen’s prescription was to harvest lots of different return sources across the entire structure. Cheap market risk premia is found at the base of his pyramid (standard equities and bond market beta). Above that sits the alpha.

In the middle of the pyramid are relatively well known and quite inexpensive style premia uncorrelated with markets: these include Value style or Carry style via long/short investing, which Ilmanen labels “alternative risk premia”. The top of the pyramid is the realm of higher cost and really proprietary alpha, which Ilmanen said was a bit of “a zero sum game.”

The Menu of Possibilities

After sketching out the current challenges, Ilmanen detailed what he saw as the menu of available options for investors. Taking an asset class, strategy style, and underlying risk perspective, institutional portfolios are commonly skewed toward stocks and growth whilst underweighting exposures to Trend, Volatility, Carry and Value styles.

Ilmanen explained that instead, his focus was on harvesting from 4-5 styles that have historically generated positive long-run risk-adjusted returns across a variety of asset groups and arguably deserve meaningful strategic allocations in investor portfolios. The styles were Value (relative cheapness), Momentum (recent winners versus losers), Carry (outperformance of high versus low yield assets) and Defensive (outperformance of lower-risk and higher-quality assets). These four are market neutral styles, but Ilmanen also favored one directional style: Trends (recent asset performance consistency relative to itself).

Ilmanen evaluated the empirical evidence on long-run returns of these styles. They have all given positive long-run returns, just like the better-known Equity Risk Premium, for various fundamental risk-based and behavioral reasons. However, he noted that they do have “some pretty persistent ugly windows.” Ilmanen pointed to the famous Fama–French US factor studies on Value and Momentum as well as AQR studies on Quality and Low Beta styles.

Bearing in mind that an investor’s time horizon may be shorter than the ultra-long studies, Ilmanen recommended diversification and combining signals as key approaches. “I think it is really dangerous to pick just one favorite style here and go for that,” he said, “because you are going to hit the three-to-four year window where you’ll find unpleasant performance and throw in the towel at the wrong time.”

Performance Across Environments and Implementation

“It is important to think about the windows where strategies do poorly” Ilmanen observed. Before the dotcom bubble, the Value style did poorly while less correlated strategies, such as Momentum and Quality, did better. Ilmanen suggested that the right number of approaches in an investor’s portfolio is probably around ten.

In terms of implementation, Ilmanen stated that he prefers the long/short method of investing. Smart beta portfolios, in contrast, often apply one style tilt in one asset class in long-only form. Ilmanen explained that he believes a multi-strategy, multi-asset approach can provide better diversification than a single-style/single-asset approach. He also thought that it could help reduce transaction costs and fees via netting, as well as enabling more patient style investing.

Ilmanen pointed to evidence that — at least in the past market-neutral styles — taking away equity and duration exposures have done very well in combination, irrespective of growth or inflation environments. However, he cautioned against a multiple manager, multi-silo approach in order to avoid managers trading against each other.

The Death of the “Virtuous Contrarian”

Setting aside the inherent limitations, Ilmanen’s forecast was for a hypothetical, gross Sharpe ratio of 2+ in a combined composite portfolio of long/short style components across asset groups. But this is before transaction costs, and considering lower future returns. A more conservative forecast might be a Sharpe ratio of 0.7 or 0.8. Market-neutral approaches also perform well in terms of tail risks and rising yield episodes. Although he admitted that he was once a “virtuous contrarian” investor himself, Ilmanen said that he has become increasingly convinced about the evidence for trend-following as a safe haven in severe market downturns.

Finally, Ilmanen countered criticism of data mining and over-fitting by suggesting that premia are unlikely to disappear, assuming that the risk-based and behavioral causes behind each style/factor premium are persistent and that there are limits to arbitrage forces. Low trading costs are another key element to success.

“Overcrowding concerns are overstated”, Ilmanen said. But why don’t more investors get involved if the Sharpe ratios of diversified factor exposures are so high? And could the field get crowded?

Ilmanen interpreted the data to suggest that factors are not crowded, allocations are as yet small, they represent switches from expensive active managers doing similar things implicitly, and also not all quants are doing the same thing (at least currently). Many investors, though, just don’t like leverage, shorting, and derivatives — they may not be allowed to take such exotic approaches.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: Courtesy of Martine Berendsen Photography

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