When one of the investment industry’s best known quants begins his new book with a prayer, you know the world has changed.
To be fair, it’s not “Please God, save my portfolio and I promise to be good ”. Instead, Antti Ilmanen’s Investing Amid Low Expected Returns recommends that investors ground themselves with the “serenity prayer”, recognizing what they can and cannot change.
What investors cannot change is the low prospective returns on all major asset classes. The chart below, taken from the website of Ilmanen’s employer AQR Capital Management, tells the story succinctly. At the end of last year the prospective inflation-adjusted return on a simple portfolio of U.S. stocks, bonds and housing was the lowest in 60 years.
Why hath we investors been forsaken? Well, uh, we hathn’t really.
The value of any asset – regardless of what your real estate broker, crypto-trading nephew or Elon Musk says – is the sum of its expected future cash flows, discounted to the present with an appropriate interest rate. The relentless fall in those interest rates that took place from the 1990’s through 2021 predictably drove up the value of all assets. Low future returns are the price we must now pay for the exceptional realized returns we have already earned.
So, returns aren’t gonna be great, deal with it…that’s the message? No, but Ilmanen’s point is that we’ll make better initial decisions, and more thoughtfully evaluate those decisions later on, if we first anchor ourselves realistically.
Ok, now that we’re anchored, what can be done? Ilmanen’s framework is based on a pyramid of long-run return sources, the foundation of which is real yield on cash. Here low interest rates combined with higher inflation means a very low starting point.
As we move up the return pyramid by taking risk, the first layer we encounter is the major asset markets – government and corporate bonds, equities and commodities. The story with bonds and stocks is predictably pessimistic – forward looking returns on both are low and neither do well in environments of high inflation. But…commodities might offer a ray of light. How?
First, commodities do hedge inflation risk and that will be a very valuable – uhm – commodity, in the future. Second, they are not correlated with stocks and bonds, so they can add a fairly independent source of returns. Ilmanen thinks a reasonable expectation for those long-run returns is around 3% per year above cash. I know, I know, not world beating (please repeat serenity prayer). Still, an inflation hedge that adds a solid return while lowering risk ain’t bad either.
Turning Water Into Wine
Diversification is absolutely critical to capturing these benefits. Why? Because when looked at in isolation, long-run returns to most individual commodities are no better than cash. However, commodity returns are both highly volatile and fairly independent. This creates ideal conditions for a diversified basket to earn extra returns through disciplined rebalancing – a strategy Ilmanen calls “defensively contrarian”.
Imagine starting off each year with an equal-weighted portfolio. Since commodity returns are so volatile – around double the S&P 500 – the winners and losers each year will tend to be large. At the end of the year the portfolio gets back to equal weights by systematically selling the (big) winners and buying the (also big) losers. Over time this can add a lot value – in the case of commodities around 3% per year.
Because this seems like magic, some call it “turning water into wine”. But it’s a well-known effect that is driven by the mathematics of high volatility and low correlation. It’s not a guarantee – if either or both of those things change the effect can break down. Earning the “commodity risk premium” is really about taking the risk that some structural force will emerge to make commodity prices move more in tandem in the future then they have in the past.
Decanting Your Stock Portfolio
Another way to enhance returns that Ilmanen analyzes is holding equity funds that do not simply invest according to market weights. This effect isn’t as strong as commodity rebalancing – not so much turning water into wine as opening a decent bottle and letting it breath before consuming, a pleasant but not life-altering improvement.
There are two particular strategies he discusses that make sense for most investors. The first is often called the “low risk effect” but is better thought of as the tendency for stocks (or assets) with the highest past risk to do poorly in the future. Creating a portfolio that avoids them has proven to be superior to just holding the market.
I’ve studied (and traded) these portfolios extensively. Over a long horizon I think you can reasonably expect to beat a market index like the S&P 500 by around 1% per year on average with this strategy. It’s still an equity portfolio, so when the market falls it will too, but drawdowns will be a little less severe.
The other strategy – much maligned recently due to an extended run of lackluster results – value. If you find it hard to get excited about an approach that (until this year) has been so out of favor, take a look at some of Ilmanen’s long-term data. In one graph he breaks down value stock selection returns by decade. The stinker from 2010 shows up clearly, but the pattern that really jumps out is the long-term consistency of good results. It seems a solid bet that the next decade will bring value results either in-line or better than historical averages.
For Nerds’ Eyes Only?
Much of the book involves further ways to improve returns that are mainly available to professionals or sophisticated individuals. These include investing in certain long/short strategies, the use of leverage in portfolio construction and a very careful focus on trading costs. Indeed, while Ilmanen’s writing is absolutely digestible by anyone interested in markets – and I’d particularly recommend it to finance students – the target audience is professionals. This is one book that is worth reading online – the graphics on his many charts and tables really pop when viewed in color. Of course, whichever version you choose, the prayer is black and white.
Listen To My Interview With Antti Ilmanen
Top Traders Unplugged is one of the longest running and most popular investing podcasts. I’m honored to be joining their team as host of the The Ideas Lab, where I’ll talk with authors of new books and research to uncover ways to make us all better investors. Click on the link above to hear my conversation with Antti Ilmanen.