Antti Ilmanen, AQR – Investing Amid Low Expected Returns: Making the Most When Markets Offer the Least | #413

Episode Summary

Executive Summary: AQR’s Antti Ilmanen argues that decades of falling rates, cheap valuations, and richening assets have likely ended, leaving investors with unusually low expected returns across stocks, bonds, and many alternatives. He advocates humility, realistic goal-setting, global diversification, value, trend, and other systematic diversifiers, while warning that private assets, home-country bias, and 60/40 portfolios may be more vulnerable than commonly assumed.

Main Topics: Low expected returns across asset classes (Priority: 5/5): Ilmanen says starting yields and valuations across equities, bonds, real estate, and private equity suggest future returns are likely much lower than investors are used to, because prior tailwinds have turned into headwinds or disappeared. Humility, serenity, and process-driven investing (Priority: 5/5): The book’s framework emphasizes accepting what cannot be forecast, focusing on long-term process rather than short-term outcomes, and lowering expectations to improve decision quality and emotional discipline. Limitations of 60/40 and traditional diversification (Priority: 5/5): The discussion argues that both stocks and bonds now look expensive at the same time, challenging the reliability of the classic balanced portfolio and suggesting the need for broader sources of return and diversification. Value, trend, and systematic strategies (Priority: 5/5): Ilmanen favors value and especially trend-following as long-run diversifiers with positive expected returns, noting trend’s defensive properties in bad equity markets and value’s unusually attractive current spread versus growth. Private assets, illiquidity, and fees (Priority: 4/5): He is skeptical that private equity or real estate reliably deliver an illiquidity premium, arguing that smoothing, delayed marks, and high fees can mask true risks and reduce the premium investors receive. Home-country bias and global allocation (Priority: 4/5): The conversation critiques concentration in U.S. assets, arguing that U.S. outperformance has recently been driven largely by valuation expansion and that investors should consider global exposure instead of assuming domestic exceptionalism. Commodities and inflation protection (Priority: 3/5): Commodities are presented as a difficult but valuable inflation hedge. Even if single commodities have weak long-run returns, a diversified commodity portfolio can have positive returns and improve portfolio resilience.

Key Arguments: Expected returns are low because valuations are rich and starting yields are poor across most asset classes, especially after a decade of asset price richening. Past 10-year realized returns can be misleading because they were boosted by valuation expansion, not necessarily by sustainable fundamentals. Humility is essential: valuation is useful for 10-year forecasting, not for one-year timing, and forecast errors are inevitable. Investors often talk diversification but remain overly concentrated in equities, home markets, or familiar strategies due to career risk and comfort. Private equity and other illiquid assets are not guaranteed to provide an illiquidity premium; smoothing and fee drag can absorb much of it. Trend-following is a favored diversifier because it can help in sustained drawdowns and has positive average returns over time. Value remains compelling because the spread between cheap and expensive assets is unusually wide, even after recent improvement. U.S. stock outperformance has been heavily driven by recent valuation richening, which is inherently less sustainable than earnings growth. Commodities are among the few assets that can help with inflation shocks and may offer positive long-run returns when held as a diversified portfolio. A robust portfolio should align with the investor’s actual beliefs and constraints; otherwise allocations are unlikely to survive bad periods.

Data Points: US equities expected real return: ~4% - Cited as AQR’s prior estimate based on starting yields before the last decade’s outcome. US equities realized return over the last 10 years: ~14% real/annualized (as discussed) - Ilmanen contrasts forecasted returns with the much higher realized outcome. Valuation change in U.S. equities: P/E from just above 20 to about 40 - Used to explain how valuation expansion added a large share of returns. Return impact from valuation doubling: ~7% annual return contribution - Approximate boost from richening valuations over the decade. U.S. outperformance vs foreign stocks: ~2% per year over 120 years - Referenced from Dimson-style long-run data on U.S. equity premium. Long-run commodity futures return: ~3% to 4% - Diversified commodity portfolio return after volatility reduction, despite individual commodities averaging near cash. Single-commodity long-run return: Around 0% over cash - Average historical result for many individual commodities over very long horizons. Portfolio volatility of individual commodities: ~30% - Used in the variance-drag argument for why diversification boosts compound returns. Classic portfolio anchor: 60/40 - Discussed as a historical convention that arose gradually and no longer looks sufficient on its own. Equity market share of portfolio risk: ~90% - Ilmanen argues that even diversified portfolios often remain dominated by equity directional risk. Value spread compared with history: Comparable to 1999-2000 levels - He describes current value vs growth opportunity as one of the widest in decades. Private equity volatility claim: ~4% reported vol (critique) - Used to illustrate how infrequent marking can make private assets look artificially stable. Drawdown examples: 20%, 40%, 50%+ - Used throughout the discussion to describe normal market drawdown ranges and investor behavior. Two-year yield during 1987 episode: ~9.5% falling to 7.5% - Ilmanen recounts buying bonds during the 1987 crash in Finland as yields moved rapidly.

Pivotal Quotes: "Savers and investors have enjoyed benign tailwinds for many decades, but the question now is between headwinds and no winds." — Antti Ilmanen: Core framing for the book’s thesis on lower forward returns. "I am improving the readers' happiness by lowering their expectations, because happiness is the difference between reality and expectations." — Antti Ilmanen: His explanation of why setting lower expectations can help investors emotionally and behaviorally. "Many investors talk diversification, but walk concentration." — Antti Ilmanen: A summary of his critique of common portfolio construction habits.

Implications: Investors should expect lower returns, diversify beyond stocks and bonds, and consider systematic diversifiers like value, trend, and commodities. The biggest risk is staying concentrated in yesterday’s winners and assuming recent history will repeat.