Investing in a World of Low Expected Returns with AQR's Antti Ilmanen

Episode Summary

Executive Summary: The episode examines why stocks, bonds, and 60/40 portfolios face unusually low expected returns, and how investors should respond with humility, patience, and better use of alternative premiums. AQR’s Antti Ilmanen explains expected-return frameworks, critiques mean reversion and illiquidity beliefs, and argues that long-short value, trend following, carry, and defensive strategies can improve outcomes when traditional assets are expensive.

Main Topics: Expected-return framework for asset classes (Priority: 5/5): Ilmanen explains that forward-looking returns are driven mainly by yields and growth for equities, yields plus roll-down for bonds, and long-run premiums for assets like commodities, rather than simple historical averages. Low expected returns in stocks, bonds, and 60/40 portfolios (Priority: 5/5): The conversation centers on the historically depressed outlook for both equities and government bonds, and how that combination has pushed 60/40 expected real returns to unusually low levels. How investors should use expected-return estimates (Priority: 5/5): Expected returns are framed as planning tools over 5-10 years, not reliable short-term market-timing signals; the emphasis is on humility, not dramatic allocation changes based on forecasts. Alternative premiums: value, momentum, carry, defensive (Priority: 5/5): Ilmanen argues these long-short styles are valuable diversifiers and return sources, especially when long-only asset class returns are low, and he discusses why they work and where they are vulnerable. Illiquidity and size premiums are weaker than commonly believed (Priority: 4/5): He is skeptical that private equity, direct real estate, and small caps reliably deliver strong extra returns after adjusting for risk, smoothing, leverage, and fees. Trend following and market stress (Priority: 4/5): Trend following is presented as one of Ilmanen’s favorite strategies because it can perform well in persistent market moves and equity drawdowns, though behaviorally it is hard for investors to stick with. Behavioral discipline: patience and humility (Priority: 5/5): The closing lesson is that investors should accept that many strategies suffer long droughts and should focus on systematic diversification rather than reacting to short-term discomfort.

Key Arguments: Expected returns should be estimated using forward-looking fundamentals like yield, growth, and discount rates, not just historical averages. Ilmanen does not build mean reversion in valuations into his core forecasts because evidence for it is weak and it can distort long-horizon estimates. Low real yields lower discount rates across many long-only assets, helping explain why many asset classes look expensive simultaneously. For equities, current expected returns are better than recent lows but still below long-run averages; bonds have also improved from very low levels but remain disappointing. The 60/40 portfolio is still better than at its trough, yet its expected real return remains low relative to historical norms. Expected-return estimates are useful for strategic planning, but they are poor tools for tactical market timing. Trend following is attractive because it can provide diversification and positive performance in equity bear markets, but it requires patience through underperformance. Long-short implementations capture style premiums more cleanly than long-only funds, which mostly deliver market beta with only a small style tilt. The illiquidity premium may be overstated because investors often trade away liquidity for smoothing and lower apparent volatility. The size premium has not been strong enough historically to rank with value, momentum, carry, and defensive premia. Value remains attractive because many valuation spreads are still wide, especially in U.S. equities versus growth. Defensive and quality-oriented exposures offer strong risk-adjusted returns and help in bad times, even if timing them is difficult.

Data Points: Long-run real equity return: ~6% - Ilmanen described the long-run real return of equities as around six percent. Recent expected real equity return low: 3.5%-3.6% - He said equity expected real return had fallen to about 3.5% to 3.6% before recovering. Current expected real equity return: 4% - He said cheapening of assets raised expected real equity return to about 4% over the next 5-10 years. Long-run real government bond return: 2%-3% - He cited the historical real return range for government bonds. Bond expected real return trough: ~ -1% - He noted bond expected real returns were negative for a long time and near minus 1%. Latest real bond return estimate: 0.2% - He said the latest government bond estimate was mildly positive at 0.2% real. Inflation expectations: -2.8% for next decade - He referenced bond yield minus expected inflation over the next ten years. Historical 60/40 expected real return: 4%-5% - He said the traditional 60/40 portfolio used to have 4% to 5% expected real return. Current 60/40 expected real return: above 2% - He said 60/40 has inched back above 2%, but remains disappointing. Expected return forecast horizon: 5-10 years - Most of the expected-return discussion was explicitly framed for a five- to ten-year horizon. US equity forecast cited earlier: 4% real forecast; later 14% real delivered - He said a prior forecast of 4% real US equity return was far too low versus realized 14% real return. CAPE ratio change: 20 to 40 - He said the Shiller CAPE for the S&P 500 doubled over a decade, creating windfall gains. Commodity futures premium: ~3% or a little more - He said diversified commodity futures portfolios have a positive long-run premium of around 3% or slightly higher. Trend following worst decade referenced: 2010s - He noted trend following struggled in the 2010s before rebounding strongly in the current inflationary environment. Book writing time: 3 years - Ilmanen said his first book took three years to write.

Pivotal Quotes: "God, grant me the serenity to accept the things I cannot change, courage to change the things I can, and the wisdom to know the difference." — Antti Ilmanen (via opening theme): The serenity prayer is used to frame investor discipline, patience, and realism about low expected returns. "Be humble and be patient." — Antti Ilmanen: His closing advice to investors emphasizes strategic discipline over forecasting confidence. "It is, and it’s a super naive strategy. It’s really favoring high yielders versus low yielders, and you can do it in pretty much everywhere." — Antti Ilmanen: He was defining carry as a broad, simple but historically powerful source of return.

Implications: Investors should assume lower returns from traditional assets, avoid overreacting with market timing, and lean more on diversified long-short style premia. Patience, process, and realistic assumptions matter more than chasing recent winners.