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Bogleheads on Investing with Antti Ilmanen – Episode 49

Post on: August 25, 2022 by Rick Ferri

Our Episode 49 guest is Antti Ilmanen, Ph.D. Antii is a Principal and Global Co-head of the Portfolio Solutions Group at AQR Capital Management. Antti is the author of Expected Returns (Wiley, 2011), a broad synthesis of the central issues in investing, and Investing Amid Low Expected Returns (Wiley, 2022), which addresses the challenges facing investors amid the prospect of record-low future expected returns. 

Antti Ilmanen

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 Rick Ferri: Welcome everyone to the 49th edition of Bogleheads on Investing. Today our special guest is Antti Ilmanen. He is the principal and global head of the portfolio solutions group at AQR capital management and the author of a new book "Investing Amid Low Expected Returns: Making the Most When Markets Offer The Least".

Hi everyone. My name is Rick Ferri, and I'm the host of Bogleheads on Investing. This episode, as with all episodes, is brought to you by the John C Bogle Center for Financial Literacy, a 501(c)3 nonprofit organization dedicated to helping people make better financial decisions. Visit our newly designed website at boglecenter.net to find valuable information and to make a tax deductible contribution.

And don't forget about our Bogleheads conference, coming up this October 12th through the 14th, featuring many speakers that I've had on this podcast, and more.

Today our special guest is Antti Ilmanen. Antti is Principal and Global Head of the Portfolio Solutions Group at AQR and develops AQR's high level investment ideas. Antti received his PhD from the University of Chicago and is the recipient of many awards, including the Graham and Dodd award, the Harry M Markowitz special distinction award, and multiple Bernstein-Fabozzi/Jacobs-Levy awards.

He is the author of two books, "Expected Returns" and most recently "Investing Amid Low Expected Returns: Making the Most When Markets Offer The Least". This podcast is a review of his latest book. It's a little less than one hour long but not nearly enough time. I could have spent ten hours talking with Antti about all the concepts in this book. It is quite fascinating but very easy to read.

We discussed nominal expected returns of asset classes and investment strategies, real returns which are before the inflation rate, how an asset class or strategy may have a negative expected real return but still be useful to the portfolio because it smooths the return of the portfolio. You may find yourself going back and listening to this podcast two or three times, and every time you do, you're going to catch something new.

One more comment before we begin. I bring many guests on this podcast who have many different ideas. It doesn't necessarily mean you should use everything that you hear, but it does add to your body of knowledge, and that's important. So with no further ado, I am very pleased to have with us Antti Ilmanen. Welcome to Bogleheads on Investing.

Antti Ilmanen: Thanks Rick, looking forward to this.

Rick Ferri: You've got quite a prestigious career, but maybe like a lot of our listeners, I'm not as familiar with you because you spent a lot of time in the institutional space. So could you tell us a little bit about yourself and go as far back as you like.

Antti Ilmanen: Sure. I'll try to make it pretty brief. So I'm originally Finnish and started my working career as a young portfolio manager in Finnish Central Bank investing the country's reserves. And then I got a lucky break and I met Ken French who was teaching us in 1989, and that basically gave me, I would say, a fast track window to come to the University of Chicago to do my PhD. And that was just a wonderful time, for a few years learning a lot, and I got both Fama and French as my dissertation advisors, got to know my future colleagues at AQR – my wife as well. So just wonderful. 

Rick Ferri: Wherever you meet your wife is like your life has changed.

Antti Ilmanen: Yeah absolutely. And well, she happens to be German and that's why I am talking from Germany now. And so I've always had an international role but German home base, then for her.

Anyway, after the PhD I  went to work for Salomon Brothers as a bond strategist and bond researcher for a decade. Turned into prop trading and so I was always fixed income oriented. I converted into macro strategies and was in macro hedge fund Brevan Howard for seven years, 2004 to 2011, which was a very interesting time. But it's a discretionary place and I have a pretty systematic heart. So it was a matter of time when I would join AQR.

Rick Ferri: Could you explain the difference between systematic and discretionary.

Antti Ilmanen: Sure. So a discretionary investor makes judgmental decisions whereas systematic is basically rules based. You try to--I mean you use discretion to come up with the rules--but then you really try to stick with them. Whereas a discretionary manager basically looks whether it's stock picking or macro environment, tries to just look at the specifics in that situation without caring about particular rules. 

Rick Ferri: So this question, I mean Warren Buffett.

Antti Ilmanen: That would be a good example, yes, yes. And then AQR since 2011, and I've been there now 10 years in my natural home.

Rick Ferri: I would say you did your PhD at the University of Chicago and your dissertation advisors were both Gene Fama and Ken French, correct?

Antti Ilmanen: Yes. Yeah, no. Source of pride, yes.

Rick Ferri: And also I was reading in your book that when Gene Fama won the Nobel Prize you were in Stockholm. and you were there when he accepted it.

Antti Ilmanen: I had been advising some Swedish investors in my role and I asked if they could help get a ticket to attend the ceremony. And I could, and then could attend some events also with the other professors who were joining Fama. And it was just wonderful.

Rick Ferri: What's it like to be in a room where somebody gets a Nobel Prize?

Antti Ilmanen: So yeah, you are high up in the balconies. It's a very serious but warm atmosphere there. I think there are only happy people in the hall. But there's also a reception then separately where you meet people a little bit more comfortably than in that main event.

Rick Ferri: Well that must have been a very unique experience to be there.

Antti Ilmanen: Absolutely.

Rick Ferri: Yeah. Okay, in addition to your work, your day job at AQR, you have also written a couple of books. And the first book you wrote was Expected Returns, and that was back in 2010, came out 2011. So ten years ago, and what was the reasoning for doing that book?

Antti Ilmanen: Yeah. I think I had already seen earlier when I was a bond researcher, I had seen that maybe the best thing I can do is to be some kind of bridge between academia and the practitioner world. Sort of describing some relatively complex ideas, like yield curve analysis was my first  area where I wrote about. And I got--I don't know, I guess I made a name in that niche audience with some writings I did then--and I thought that okay, I have broadened my perceptions on markets. I had been advising Norway's oil fund for several years and I had really thought about all kinds of asset classes and all kinds of good investing.

I felt I have read a lot. I have got, I think, a good story to tell of the key components of investing and how to think about this important issue of expected returns on pretty much any asset class or strategy that investors consider. So it became sort of my passion project for many years and turned out to be a basically 600 page book.

Rick Ferri: And the premise of this book was to look at various asset classes and try to draw from that where expected returns come from. I mean you were looking at the cash markets, equity markets, bond markets, credit markets – which are corporate bonds. And also you got into risk premia, like value, momentum, so forth. So talk a little bit about that. And then right after that we'll get into, well, so what has changed.

Antti Ilmanen: Yeah. So I think when you think of expected returns of any asset or strategy, you want to think about theoretical arguments. Why there should be a premium, and it could be risk-based or behavioral. You want to think about historical average returns, often the long run average return is an anchor you think about. But then you want to think about forward-looking measures. So current market conditions--it could be starting yields--which is often the case, or valuations that guide you on current expected return. So I try to give basically multiple perspectives to that expected return question, and then draw on both the literature and lots of empirical analysis that I did myself on all of these return sources, highlighting the most important ones.

Rick Ferri: Then you – call it an update of your book, call it an add-on to that book, which is the one that just came out earlier this year called Investing Amid Low Expected Returns. So obviously your analysis between 2011 or 2010, 2020 -  2021 when you wrote this book, was that going forward the returns from asset classes, risk premia, style premia, perhaps we don't know, we'll get into it in a second, but particularly asset classes are going to be lower going forward. Was that the premise of what you were trying to put out with the second book?

Antti Ilmanen: Yeah, yeah. Like you said, first partly an update. I did feel like the world had changed somewhat and there was new research. But I especially had this feeling that this question on low expected returns on major investments is almost like a generational challenge that has been under-appreciated partly because realized returns have been quite benign. So in some sense the key thesis I have there is that lower and lower bond yields in recent decades, including the last one, have been helping all other assets get to lower starting yields. And those low starting yields - which you can also think of high valuations - they basically promise us low future returns.

We don't know quite when, whether it's going to be fast or slow, but that challenge is there. But because while the required yields were falling--that at the same time basically gave richer, those assets, we got pretty nice realized returns on bonds and on stocks and on anything. Really all major asset classes during this time. And that made me worried that investors don't see the challenge because they look at the rear view mirror of realized returns.

Rick Ferri: Back in 1980 the 10-year treasury bond had a yield of about 16% and 40 years later 2020 it was less than 1%. So this fall of interest rates from 16 to less than one on a 10-year Treasury, and also of rapid decline, fairly similar in fact, probably larger on T Bills which is considered the risk-free rate. This caused a very large excess return among asset classes, stocks, bonds, real estate over a 40-year period of time. And as a baby boomer I mean this has been great, right. We have really benefited. But that has ended and now we're back to reality.

Antti Ilmanen: Yeah that's the key theme and while I say this is not only bonds it's all asset classes, but it emanates from bonds. And just to show the parallel there to other asset classes, if we take the discount rate for equities, like a simple way of thinking of the equity markets--it would be to look at the Shiller earnings yield. So this is the inverse of the CAPE ratio so one can think of that as the discount rate for the S&P 500 and that was basically ten percent forty years ago and then it came down to three percent, and that gave very nice returns as the repricing happened. 

But prospectively that sort of guarantees us problems for the future. And I think a good way of thinking of this situation is that all asset classes, whether we talk of bond, stocks, or housing, you can think of them as basically priced through estimating expected future cash flows and discounting them by your common discount rate, which would be this, let's say real treasury yield and then some asset specific premium. And when that common discount rate was so low as it became a negative real yield, that made everything expensive at the same time. We've had this sort of everything bubble in a sense. And one way you're thinking of this is that while 40 years ago we were having high expected returns but cheap valuations, now we have low expected returns and high valuations. Effectively we have sort of borrowed returns from the future by pricing all these assets so expensively.

Rick Ferri: Yeah let's get into that just for a second. About 2021 when the stock market went way up unexpectedly but interest rates did come down to, as I said below 1% for the 10-year treasury, that in effect, with real estate and with equity, and with bonds, we were borrowing returns from the future.

Antti Ilmanen: Yeah, yeah. So when people think of the cushy returns that they have been getting in recent years it's not something that in some way you should certainly expect to be repeated. But in some sense you should expect that in the future you will get something less because those higher prices you got for your assets brought the starting yields lower and the starting yields on any investment, they are a heavy anchor. They do matter for those expected returns. That's most obvious for bonds, but this is again, it's very true also for those other asset classes – equities, housing, etc.

And so I do not know whether the low expected returns will materialize through what I call the slow pain of staying in this world of high valuations and low starting yields where we just clip ever smaller coupons and dividends, rents, or whether we get a repricing, which now has happened in 2022. That I call the fast pain. So I said sort of pretty unhappily that we can sort of expect that it's going to be either a slow pain or fast pain or some combination of those two.

It turns out that we get quite a bit of fast pain this year, but not enough it turns out that it would have solved the problem. We have seen assets cheap and somewhat, but not nearly enough to get them back to sort of long-run average levels.

Rick Ferri: We had this sell-off in the equity market and in the fixed income market this year 2022 but now we've had a rebound of equity prices and interest rates have fallen. Not nearly as low as what they were in 2021, but they have come back. But that's not enough you don't think. You think that it's going to go more--even though we've had this fast correction, get some asset prices closer to perhaps where they should be--that probably we still have more to go. And the question is, is it going to be ripping the band-aid off and getting it all done all at once, or is it just going to be sort of a slow bleeding.

Antti Ilmanen: Yeah. Basically the starting yields-- if you think of government bonds real yields they were sort of minus one percent when when they were very low last year, and they got to near zero now, and so there's been about 1% move on that front. For equities I would say that the change has been less than that, maybe 0.5%. And both of them are a couple of percentage points away from the long-run historical average. What you could get, so if we get to those averages, there would be much more to happen. But maybe we don't get there. And so my short term view, and this is getting to the speculative punditry, is that the inflation problem is serious enough and that's going to basically force more monetary policy tightening than markets discount now. And that I think maybe the young generation of investors don't really understand what it means when the Fed is tightening seriously because that has not happened often and not really in their investment lifetime. But I think some pain will be needed for asset owners before this inflation genie is taken care of.

Rick Ferri: I want to talk about the risk free rate, which is called the Treasury bill, which all of these valuation models and equations stem from. You know, what is the risk-free rate?  T-bills. And historically, globally, not just the US but globally, the T-bill rate has basically been the inflation rate. Now it hasn't been true in the United States over the last several years. The T-bill rate was actually a little higher as we came off, as inflation dropped, and then it took a while for interest rates to come back down. But now going forward, over the next 40 years let's say, it seems reasonable to assume that the risk-free rate and the inflation rate will be close. Do you agree with that?

Antti Ilmanen: Yeah, yeah. And so it is maybe one detail that one can debate whether the risk-free rate that's relevant for long-run investors is the T-bill rate or the long term bond rate. And there's some term premium between those but all of these came to very low levels. And I would say that roughly speaking short term right now, short term cash, long-term bonds, expected 10-year inflation, they are sort of similar level, near a little under three percent or so.

Rick Ferri: So let's then move to equities. So equities have an expected real risk premium over the risk-free rate. Historically in the US it's been higher than it has globally. Globally it's been about 5%, but in the US it's been higher, over 6%. This is compounded. Can we reasonably expect globally that it should continue to be five percent?

Antti Ilmanen: Yeah that's probably optimistic. I think it is likely that the equity risk premium will be thinner. So I think total expected real returns on equities, ballpark of 4%, probably a little less than that in the US, a little above that outside the US. And then you can add the expected inflation on top of that to get the total return estimate.

Rick Ferri: Fair enough. I want to get into the components of the real return. Four percent, that can be broken down to a real growth rate of our earnings per share, and then dividends. Can you break that down, and then for coming up with your number?

Antti Ilmanen: Yes, sure, So I think a good way of thinking of-- if we focus on equities--is this idea of just dividend discount model, where you are earning some real yield and real growth and then maybe inflation, if you think of that. But let's just focus on real yield, real growth and it could be both, by the way, ballpark 2% each. And then there's a question whether there's a change in valuations. So when you look at the realized returns, the last decade had much higher returns because the valuations basically doubled. Shiller PE went from 20 to 40. So realized returns were much more. But sort of roughly 4% expected return, half from real compound growth and half from starting yield. And you can think of dividend yield and a little bit from net buybacks. Those other components.

Rick Ferri: How does that all work into a global GDP growth?

Antti Ilmanen: Equity market returns. So are they higher than what you get on a GDP growth, which has been typically 2% to 2.5% or something like that, partly because equity is sort of a levered exposure to economic growth. There's that nice intuition there but that doesn't mean that there's a tight correlation between economic GDP growth and equity returns. It turns out that there's almost zero correlation. So this is one of these things I highlighted in the book. That when you look at these numbers in the US over time, or you compare across countries, you find very modest relations between GDP growth and equity returns, even though we intuitively think that equities are sort of participating in the real economy.

Rick Ferri: And I read that, and I understand on a country by country basis you can't say GDP growth is this, therefore earnings per share growth is that. Therefore you take some multiple, and therefore this is what the price of the stock market should be. On a country by country basis, I understand that. But globally, looking at global GDP growth, isn't it more highly correlated? The global equity market to global GDP growth?

Antti Ilmanen: Contemporaneously there's almost nothing. But equity markets tend to predict next year's growth, so that way you do get something, and I think there it is true, and so certainly when equity markets are predicting next year recession then you have got low return. So yeah, I think that correlation becomes when you take, not looking at monthly returns, but you'll look at let's say annual returns, and in a forward-looking sense you do find some decent relation. And so the intuition, I think, is right that equity returns are both somehow participation in global growth and they are vulnerable to any hiccups or something more serious to that global growth. And that's the big risk then in equity markets.

Rick Ferri: So the real expected return of equity using the simple model of a 2% dividend yield, or earning a dividend yield real, and 2% real growth comes out to 4%, and then you add on to that your inflation number. And now you come up with, well if you're going to use the Fed's inflation number of 2%, then you're at about a 6% nominal long-term expected return for equity. This is a reasonable number to plan for?

Antti Ilmanen: Good numbers. Yeah, yeah I think so. It's a good point estimate. But then we have to sort of recognize that we can debate each of those 2% numbers, however much. And so fair, sort of humility, or sense of uncertainty around them. But as point estimates that's what I would use.

Rick Ferri: So that's one side of the equation, right. We're talking about a 60/40 portfolio-- 60% equity, 40% fixed income--as an example. Now we've got to go to the fixed income side. So we have an expected long-term return on equities of 6% nominally, 4% real. Now we go to the fixed income side and we've got choices there between Treasury bonds and corporate bonds. So let's start out with Treasury bonds, intermediate term Treasury bonds. There has been a premium paid for going out on the yield curve to the 10-year mark, where you've picked up more than just the inflation rate. And that we’ve agreed that T-bills in the US have yielded a little bit more than inflation, but let's say going forward that T-bills are going to give us inflation. So now inflation plus something for Treasury bonds, for longer term, say 10-year Treasuries. I mean what, historically, what's it‘s been, and what do you think it might be going forward?

Antti Ilmanen: Yeah so it's, well it's the realized return has been quite benign because again we got these windfall gains when bond yields were falling, and that is probably not fair to think in a forward looking sense what we should expect to get. Our cash has become in some sense stingier, and the intuition is that government bonds used to have an extra term premium partly because of the high inflation uncertainties of inflation risk premium, and that probably was bid down to near zero in the stable inflation decades after 2000. And then government bonds further turned into a safe haven asset when stock bond correlation turned negative.

So simple capital asset pricing model intuition says that if you have got a negative beta investment which basically really smooths equity returns, then that could even justify your negative premium. And I think that has helped government bonds become more expensive and in a forward-looking sense then, we really may have even justified a negative premium. And again, realized returns turned out to be very good because of the surprisingly benign picture on both falling inflation expectations and falling real yields.

Looking ahead I think there will be some mildly positive term premium, but less than the over 1% that people were earning. So I would expect something half to one percent maybe, extra over cash. And so roughly that amount of real return on intermediate and 10 year bonds.

Rick Ferri: That's very interesting, that it's come down. What about the Fed's balance sheet? In the Fed letting these bonds roll off, and so there's going to be more supply out there. I mean wouldn't that have an effect of pushing up the yield, the real yield?

Antti Ilmanen: Yeah so besides the inflation risk premium, safe haven premium, we said supply-demand factors are the next thing and and that clearly was helpful during the time of quantitative easing. And now it's going to give you some headwinds during quantitative tightening. That's why I chose to talk about 10 years, where I sort of hope these things don't play out anymore. The quantitative tightening story is hopefully there for the next couple of years and then that issue is over.

Rick Ferri: So we're looking at somewhere between a half a percent to one percent perhaps over the risk-free rate over T-bills. Realistically, I mean you're going to get paid something for taking term risk.

Antti Ilmanen: Exactly.

Rick Ferri: Not as much as it was.

Antti Ilmanen: Yes, and very short term there is this question what happens with inflation. And we--if  the Fed has to be more aggressive because of that-- and that that may tell a more bearish story for the next couple of years.

Rick Ferri: So let's move on then to another premium in the fixed income market, and this is credit risk. Instead of being in Treasuries we're going to be in intermediate term corporate bonds or mortgages or high yield versus investment grade corporate bonds. We're going to take credit risk. And here I found interesting in your book, because you changed your mind on this. You were kind of negative on investment grade corporate bonds, but you seem to have changed your mind here in this book. So talk about credit risk, and then talk about what caused you to change your mind.

Antti Ilmanen: Sure, sure. Well first, so I would say empirical evidence that says that you do earn some of the credit spread but you don't you don't tend to earn all of it. It's roughly speaking historically you've earned about half of the spread, and we may return to that a little later. But then there's a question, like are credits worth including when they have an odd blend between government bonds and equities. And it  might be that they are sort of a superfluous asset there.

And I was leaning towards this idea in my first book that maybe you really don't need them. And in the second book, I was leaning the other way. Well I'm sort of notoriously a two-handed economist, that I don't have very black and white views. But so certainly I did lean more positive. And the argument's  volatility-more positive on credits--where partly just from having a strong decade, like after 2010 we had just in a relatively bad decade for credits. And now is our strong decade so that more importantly I looked at some historical research from many decades back, which was telling a more positive story on credit performance, and it's sort of extra benefit you get beyond government points and equities.

However, actually I've been called on this topic many times and people are saying you really shouldn't trust too much the data from the 1930s to 1960s in credit markets. The data just sucks so badly that evidence is relatively weak. And then arguably the last decade evidence, again, should be discounted because the Fed obviously had a big role in also pushing credit asset prices higher during that period. So I would still lean mildly more positively. But you hear very weak views.

Rick Ferri: But you--do you, are or you were positive--in your view of double B rated bonds, so-called fallen angels. And I'd like to hear if you're still positive on that. And the reason I say that is because individual investors sometimes take a position in a Vanguard high-yield corporate bond fund. Now I don't own this fund, so I'm not touting it. I do talk about it in some of my books for the exact reason that you've talked about it in your books. But this double-B rated area, where the fallen angels are, does tend to seem to have an extra kick to it. So you talk about that, and you think if that does have any benefit potentially to a portfolio.

Antti Ilmanen: Yes I think so. I mean it is a micro story. But it is in credit markets, it is the best pocket, and the intuition. So fallen angels now refers to bonds that are downgraded from investment grade to speculative grade, so typically triple-B to double-B. And many institutions have got rules that they have to sell bonds during the next month to stick with their mandates and there is effectively a fire sale. And I already wrote about it in my first book and I basically checked the evidence for the second book. Is the effect still there? And it is still there through the 2010s and so on. It has been very costly for investors to sell those fallen angels in these fire sales. Indeed if you look at the long run performance, how much of the overall credit spread investment grade investors earned in excess return over treasury it's ballpark is about half, and there's not much default loss that happens there.

So there are some technical effects. And this is the most important technical effect. Even broadly speaking we are eating up a meaningful part of this extra credit spread. Investors lose a meaningful part of the average credit spread by participating in that fire sale. So by selling those fallen angels, within the first month.

Rick Ferri: You're talking about investment grade credit spread--by selling the fallen angels, they lose a lot of total credit spread.

Anti Ilmanen: Yes those bonds that are downgraded, they lose a lot of value in that next month. If you even would wait six months that would help meaningfully, but ideally just try to stick with those because they have got as good performance historically as any other credit investments.

Rick Ferri: Under liquid asset class premia you do list commodities and there you talk not only about individual commodities but about commodity strategies. So could you go into commodities.

Antti Ilmanen: Sure. Many investors think that there is no reward for commodity investing, and it turns out that that's true in the long run, if you think of a single, especially single spot commodity. But if you think of a diversified portfolio of commodity futures, you actually have earned something like 3%. And a little bit of that comes from the futures part, the roll effect in the long run, historically. But the bigger part is so-called diversification return. This is something that Fama and Booth already discussed with equities in the early ‘90s and it's a very small effect in equities, but basically with commodities it's important and worth 3%.

The intuition is that a single commodity is very volatile, often 30% or more volatility, and that gives a drag, volatility drag to the compound return. It takes down the compound return, geometric mean, but those individual commodities are also very lowly correlated with each other. So you can diversify across them in very simple ways and you can reduce portfolio volatility and reduce that volatility drag. And that gets the average return from typical single commodity zero over cash, to about 3% over cash, just thanks to this effect that you are reducing portfolio volatility.

Rick Ferri: I'm going to push back a little bit here.

Antti Ilmanen: Please.

Rick Ferri: That is a trading strategy. That's not a premium on an asset class, correct. I mean, as you said, if you just bought the asset class and held it buy and hold, and basically you get maybe the inflation rate. But what you're talking about is a trill…

Antti Ilmanen: No.

Rick Ferri:  Okay, go ahead.

Antti Ilmanen: You really get the 3% by naive diversification. It's true that you have to buy--I mean in theory you might do it with spot commodities, by the way, but nobody could do that because you don't want to buy your pork bellies.

Rick Ferri: No. I understand you're doing one month futures or something.

Antti Ilmanen: Yeah. So, but it is really, the only thing you are doing here, you are rolling every month to a quarter, something. So it is none of the things that you-- it is not a momentum strategy--roll strategy, this part that will be extra. This is saying that just by reducing portfolio volatility and the volatility drag you are generating positive return. It's a complicated thing.

Rick Ferri: I understand. But it's not a market weighted or capitalization weighted strategy at all. It is basically an equal weighted strategy. So you have to come up with your equal weighted index that you're going to target and then every month you have to trade the portfolio to get it back to the equal weight. So I mean it's an active strategy.

Antti Ilmanen: It is but it can be a very simple strategy.

Rick Ferri: That means you’ve got to pay somebody to do this. I mean somebody, some active managers.

Antti Ilmanen: So yeah. It's a futures trading strategy. Somebody will have to do that. It can be at a very low cost or you can try to add some of those extras, carry and momentum type of strategies on top of that. But if you want to keep it simple, it is very modest cost. But it's true that it's not total buy and hold when you use futures.

Rick Ferri: Let's talk about gold for a second. You did talk about gold and your view on that was?

Antti Ilmanen: Zero real return in the long run. It is low compared to many other assets but it makes sense mechanically because you are not earning any coupons or dividends. And logically it sort of makes sense because gold has been a sort of safe haven or hedge. An admittedly imperfect one, but against a variety of yields it has tended to do relatively well both in rising inflation scenarios or in equity market drawdowns. Not very reliably. For example this year we had both of those and gold hasn't shown.

Rick Ferri: Interesting. Okay so those are the asset classes: cash, equities, Treasury bonds, corporate bonds including fallen angel high-yield bonds, and commodities. So those are the asset classes and the risk premia. Now let's get into the second part of your book, style premia. Things like value investing, momentum investing, quality investing. And then you have carry.

Antti Ilmanen: Yeah, yeah. So there are some styles where I think the consensus of researchers has converged to saying that there is a long run premium which looks pretty much empirically as good as equity premium.

Rick Ferri: This is a long-short or just long only?

Antti Ilmanen: And this can be both. Any of these strategies can be applied as long only portfolios where you tilt a little more. While you already favor last year's winners in momentum; favor more boring good quality or low beta stocks in defensive or high dividend yield stocks in carry.

Or you can do a long-short strategy in all of these cases, and you could also apply them outside stock selection, do this, use this in country allocation. And if you do this, so both of these are useful – the latter approach long-short is more aggressive. It will give wonderful diversification benefits because then you have got many different return sources. But it has got problems because they are unconventional and they will challenge investor patience much more than equities, if you have a bad window for these strategies.

Rick Ferri: I think that most individual investors, if they're going to do style premia factor investing it's going to be long only, and it's going to be in one fund. So it's a multi-factor fund. How do you feel about multi-factor?

Antti Ilmanen: Oh thank you. I clearly like it because again, I like diversification and many of these styles relative to each other are very lowly correlated. Even value and momentum as activities are negatively correlated. And sometimes some others. But you get really nice benefits when you combine these strategies. So I think anybody who chooses to use only single, one style, has to have a really strong conviction that this is the one thing I believe in, as opposed to the other ones. Because again, there are these three, four, five things which all seem like quite good complements to each other, as well.

Rick Ferri: You find that there's a higher value premium in small cap rather than large cap.

Antti Ilmanen: I think for many of these premiums we find that on paper thel small segment is a better fishing pond, which is also higher premium there, and again that's on paper and it could be that after trading costs much of that goes away. So in general I think we tend to find as good opportunities after costs in large cap and small cap segments. So I don't have a strong view on this, as I know many other people do.

Rick Ferri: The last item that you put in style premia is called carry, where carry is a long-short strategy. And the simplest way of describing it is what looks expensive you sell and what looks cheap you buy. So you're selling very low yielding country bonds and you're buying very high yielding country bonds. Is that a fair assessment of carry?

Antti Ilmanen: Well I think when you say cheap and expensive, I would call that the value strategy, whereas for carry I would just call it high yielding and low yielding. And in some cases carry and value sort of go hand in hand, and I like dividend yield strategies and book to price strategies are highly correlated, but they can be--so I would say in equities the carry strategy would be using dividend yield, or a broader payout yield metric, to favor certain stocks over others. But then if you think of some other asset contexts, the most famous carry strategy perhaps is currency carry. And then basically currency carry strategy of favoring high yielding currencies is very different from a currency value strategy, where you look for currencies that look cheap based on purchasing power parity.

Rick Ferri: It's strictly a yield concept. Buy the high yields, sell the low yield.

Antti Ilmanen: Yes.

Rick Ferri: And it could be across any asset class.

Antti Ilmanen: Yes.

Rick Ferri: So this is what carry means. Okay, but it is long-short. I mean it's not just long only?

Antti Ilmanen: Yes. It can be both. Again, you can do long only favoring high dividend yielders. It's not a great strategy but it's a mildly positive Sharpe Ratio strategy.

Rick Ferri: The next area is what's called illiquidity premia. And here can be divided up into the three major categories, which are real estate, private equity, and then private loans or private credit. Let's start out with real estate. A lot of people just own a home or they have rental property or they buy a REIT fund.

Antti Ilmanen: Sure. Well first, people may extrapolate too much when you look at real estate prices in recent decades. I think with this illiquid asset it's also helpful to take this dividend discount model idea. That you ask what's the expected return through expected yield, expected real growth, and maybe expected change in valuation. Empirical evidence suggests that with real estate you pretty much get the yield, but you shouldn't expect changing valuations, and the real growth you can debate whether it's been positive or negative in the long run. That I think zero is a very reasonable number.

So I will say basically I think that you are going to earn your yield and the relevant yield for real estate is basically something, free cash flow yield. So if you are thinking of a bigger number like rent to price ratio, rental yield, that's all too high because you have to subtract expenses which are often one third of that. So my reading is if there's 4% rental yield nowadays then you get something like 2.5% expected real return. More than bonds but less than equities. And the intuition is that you don't get any real growth.

Rick Ferri: And give me your views on REITs.

Antti Ilmanen: Sure. Lots of thinking about illiquidity premia, because like I sometimes say illiquidity premia are overrated, and one intuition just is that people really like the smoothing feature. That it's sort of painful to lock your money for a long time, but it's really nice to get the lack of mark to market. And those two features could offset each other. And so one place where you can measure illiquidity premium arguably pretty well is in real estate where you compare listed REITs to direct real estate, which is much less liquid. And it turns out that when you look at this pretty long history--we've got 45 years of data in the US--we find that actually there's been an inverse illiquidity premium. REITs have outperformed.

And then the counter argument will be that they are not really comparable. That REITs have got lots of beta and leverage. And it's true that when researchers have adjusted for those beta and leveraged differences you get some of that negative illiquidity premium away, but you never get a positive illiquidity premium in any analysis that I've seen. So again the evidence is very modest on the idea that there is a great illiquidity premium in private assets.

Rick Ferri: That's very interesting. And the other two which I don't really want to spend that much time on are private equity and private credit. Most individual investors really don't have access to good private equity.

Antti Ilmanen: They are recently sort of institutional favorites, but I think that institutions tend to be over optimistic on them. And partly they really like the smoothing feature, but also I think they have got higher expectations, I think, because of this growing investor interest in that space. I think even if there was an extra return, I think much of that has been beat down. And again, another logic is that the smoothing has taken it down. So I think it's a pretty reasonable thing to think that you get pretty similar returns from private equity as public equity after all fees, which are much higher in private equity.

And likewise private credit versus public credit. Net returns could be very similar on both sides. So I don't think investors are missing much by not having access to this, but there are lots of dream sellers out there who tell a different story.

Rick Ferri: Well let's talk about the active managers and alpha, which is the fourth category that you have. And there we've got managers that are trying to pick stocks, not systematic, but trying to pick stocks. And talk about alpha decay, should investors be seeking alpha?

Antti Ilmanen: Yeah. I mean that is the holy grail which is so lovely but so elusive. And I think it's good to be realistic about it and expect very little on that. Obviously there's a lot of marketing for it, and there is to be--to be clear--there is some evidence, you know, mutual fund evidence is not good on managers generally providing net positive alpha. But institutional managers, hedge funds, private equity may have collectively outperformed.

But that's again, it has come down. You mentioned this concept of alpha decay, that evidence from more recent data is questioning even whether there is, there has been net outperformance. Obviously some managers will outperform and then you can question whether it's been luck or skill and so on. And this is one of these eternal debates. And yet it is interesting that so many investors still like to do either their own active investing, or traditional active managers and pay decent fees. And that is somehow telling of the both marketing success and over confidence that we have.

Rick Ferri: So that's the technical side of your book. But then you have a whole different side of the book. It had to do with behavior and being patient and sustaining a conviction. And so could you talk about why you wrote this side of the book and the main points on what you were trying to get across.

Antti Ilmanen: Yeah. I think if I have to pick one sort of bad habit from investors it tends to be related to impatience. And you can also think a flip side of that can be chasing the last three, up to five year returns and capitulating after three to five bad years. But basically statistical evidence after a few years is very weak. It could be that if somebody has got a very good or very bad performance it is more likely to be random luck than really a sign of some wonderful skill. And so investors chasing those returns and being impatient after bad returns is a very costly tendency.

And I try to then highlight the more specific, what could be the costs. And they include things like you may miss out on long-run returns--could be equity premium, could be any of these other premia--where you get a disappointing draw and you leave that strategy. You will miss out on the long run premium.

Rick Ferri: Opportunity cost.

Antti Ilmanen: Yeah, so that's the opportunity cost indeed. And then there's the actual course, basically trading out of those positions and all kinds of friction from related trading. And then to the extent that there is something like three to five year mean reversion, and to the extent that investors tend to chase returns just like at those frequencies, then that is particularly costly. So Cliff Asness, my boss, has sometimes said that there is this unfortunate tendency of investors to act like momentum investors at reversal horizons. So chasing three-year returns when you look at historical market data there's a greater tendency to see mean reversion over three-year horizons.

So all of those possible costs are there. And so my goal then is to highlight the costs and then discuss ways if investors buy the idea that patience is good, it's a virtue, it will make better long run results. What kind of strategies you can use to make yourself more patient, cultivate personal or organizational patience.

Rick Ferri: So discipline tools is what you talked about. Education. Review broadly and infrequently. Make a bigger organizational commitment and I put in parentheses the  Bogleheads, in other words, just keep going to the Bogleheads site to remind yourself. Move slowly into new ideas. Avoid complexity and a few others as well.

Antti Ilmanen: Yeah, yeah. And I think anything that enhances patience tends to be good. So equities are forgiven a bad decade or at least a bad few years. Nothing else will stay in investor portfolios with such a long disappointing period. So the conviction that investors have because of the evidence and theories on equity premium are helpful. And I think just a mere conventionality, people are so used to it. So that is great.

I would, you know I'm cautious about illiquids, but I would say smoothing makes people more patient. With styles diversification can help, but in general I confess that with the things that I love the most, some of the style premia, the unconventionality, it makes them challenging from a patience perspective.

Rick Ferri: You talked about just doing simple rebalancing versus doing tactical market timing. Could you just touch on that.

Antti Ilmanen: Yeah. Well, so rebalancing really tries to stick with some long-run targets. So market timing, especially contrarian timing, I sometimes say is a proactively contrarian strategy, if markets fall and become cheap you want to buy more than normally, whereas with rebalancing you are sort of defensively contrarian. You just want to get back to your target weights. So I think the key idea with rebalancing is that you've got some idea what's a good long run portfolio for you asset class weights or risk targets. And you want to basically stick relatively near to those and you rebalance back towards those targets. And that's good for keeping the risk level that you like and maintaining diversification.

And then there might be some extra return enhancement that comes either from the kind of thing I mentioned earlier that with commodities, is reducing portfolio volatility. That can help to some extent, but especially if there are some mean reversion patterns that you could catch that would be icing on the cake.

Rick Ferri: In your last chapter, one of the last chapters 17, you talked about good and bad habits of investors. And the bad habits are selling losers and buying the winners, over extrapolation, meaning, you know, just too much complexity-- call it mood trading--where hey I think this is good, let's buy this, or I think this is bad let's buy that. Overconfidence in your ability. And these are the bad habits that people have. A good habit to be disciplined, and be very thoughtful about your asset allocation decision and don't take too much or too little risk in various asset classes, and invest strategically, and keep your costs down. If you have any more you'd like to add to the good and bad habits.

Antti Ilmanen: That is the key list, that again, the first one I said is related to impatience. So sort of multi-year return chasing, I sometimes call the premier bad habit, and maybe overconfidence. I think the important implication of that is over trading, and that of course, has been historically quite costly. And maybe I do mention something beyond this. I tell a few times in the book, okay I'm envious towards various, I don't know, discretionary investors and other, well, active managers who have got great stories, whether it's a stock picker or macro.

And I think when I'm a systematic investor and I've got this factor investing diversification, they don't lend themselves well to great stories. But so then I say that at some point, I say that actually it could be that stories are really bad. That they cater to some biases that we have. Like they cater certainly to our hindsight bias. They make the future seem more predictable than it is. And another concept is so-called base rate neglect. So we we think too much of the salient cases rather than apply probabilistic thinking. So really I think stories, while they are humanly so important, they also can be reasons for some bad investment practices. And so I'm trying to defend this kind of quanti-statistically oriented mindset and claim that there are some advantages.

Rick Ferri: Oh let's hold, Antti, and you also have your stories, right. I mean every DFA advisor out there is saying we have Nobel Prize winning economists giving us our information. I mean so they have their stories too.

Antti Ilmanen: Yeah. But the stories tend to be--let's say that they well, by the way I of course, I believe in more of these stories--but they are maybe more boring and abstract and we rarely have a colorful story to tell.

Rick Ferri: Well Cliff Asness wrote the forward on the book and he reiterated something that you wrote in the book, which is investors really have three options for dealing with this low expected return. He came up with these three things and number one, he said you could take more risk. Basically you take more equity risk. And which means you have to deal with more volatility. That is one way in which you can increase your expected return. So instead of doing 60/40 you do 70/30 or 80/20. But knowing that you're going to be having more risk, more volatility. So that's one thing.

Secondly he said you could incorporate other sources of return, such as style premia, multi-factor model, multi-factor fund of some sort which is what you had suggested. And then he said the third thing is you could do the John Bogle argument, which is stay the course, ride it out, accept the lower return no matter what.

But I'll also add to that something that you put in the book. It also means you need to save more money because according to your data since the expected returns have fallen people actually need to save more. And in fact the data that you had in your book was that instead of saving 10% per year you really need to try to save 20% per year. So comment on all that please.

Antti Ilmanen: Yeah. No, that's a good summary and I would say that most investors have seem, apparently, taking the take more risk approach, and it can be more equity, so then they go private equity with a smoothing advantage. And so that I think, and that somehow I found from historical data, that it is so common when expected returns fall, investors are used to earning what they want, to keep earning what they are used to, and then they adjust their portfolios and that could end in tears. I like more the diversification story, but also I do like the last story, this Jack Bogle idea, like just humbly accept that markets are now offering less and let's just do the best we can in that situation.

Rick Ferri: Antti thank you so much for coming on Bogleheads on Investing, and we greatly appreciate your insight. Really love the work that you're doing and keep on writing, it's very interesting stuff.

Antti Ilmanen: Thanks Rick. Very enjoyable conversation.

Rick Ferri: This concludes this edition of Bogleheads on Investing.  Join us each month as we interview a new guest. In the meantime visit Boglecenter.net, Bogleheads.org the Bogleheads Wiki, Bogleheads twitter.  Listen live each week to Bogleheads Live on Twitter Spaces, the Bogleheads Youtube channel, Bogleheads Facebook, Bogleheads Reddit. Join one of your local Bogleheads chapters and get others to join. Thanks for listening.

About the author 

Rick Ferri

Investment adviser, analyst, author and industry consultant



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