Bogleheads® on Investing Podcast 049: Antti Ilmanen on investing amid low expected returns

00:00:00.000 | [MUSIC PLAYING]

00:00:09.880 | Welcome, everyone, to the 49th edition

00:00:11.920 | of "Bogleheads on Investing."

00:00:14.160 | Today, our special guest is Antti Ilmenen.

00:00:16.920 | He is the principal and global head of the Portfolio

00:00:19.680 | Solutions Group at AQR Capital Management

00:00:22.360 | and the author of a new book, "Investing

00:00:24.320 | Amid Low Expected Returns--

00:00:25.900 | Making the Most When Markets Offer the Least."

00:00:28.240 | [MUSIC PLAYING]

00:00:37.060 | Hi, everyone.

00:00:37.820 | My name is Rick Ferry, and I'm the host

00:00:39.440 | of "Bogleheads on Investing."

00:00:41.200 | This episode, as with all episodes,

00:00:43.400 | is brought to you by the John C. Bogle Center

00:00:45.800 | for Financial Literacy, a 501(c)(3) nonprofit organization

00:00:50.520 | dedicated to helping people make better financial decisions.

00:00:53.760 | Visit our newly designed website at boglecenter.net

00:00:57.520 | to find valuable information and to make

00:01:00.160 | a tax-deductible contribution.

00:01:02.320 | And don't forget about our Bogleheads conference

00:01:05.240 | coming up this October 12 through the 14,

00:01:08.480 | featuring many speakers that I've

00:01:09.960 | had on this podcast and more.

00:01:12.280 | Today, our special guest is Antti Ilmenen.

00:01:15.280 | Antti is principal and global head of the Portfolio

00:01:18.600 | Solutions Group at AQR and develops AQR's

00:01:22.000 | high-level investment ideas.

00:01:24.000 | Antti received his PhD from the University of Chicago

00:01:27.480 | and is the recipient of many awards,

00:01:30.080 | including the Graham and Dodd Award, the Harry M. Markowitz

00:01:33.520 | Special Distinction Award, and multiple Bernstein-Fabozzi

00:01:36.920 | Jacobs-Levy Awards.

00:01:38.600 | He is the author of two books, "Expected Returns,"

00:01:41.640 | and most recently, "Investing Amid Low Expected Returns--

00:01:45.520 | Making the Most When Markets Offer the Least."

00:01:47.840 | This podcast is a review of his latest book.

00:01:51.440 | It's a little less than one hour long, but not nearly enough

00:01:54.480 | time.

00:01:55.240 | I could have spent 10 hours talking

00:01:56.760 | with Antti about all of the concepts in this book.

00:01:59.680 | It is quite fascinating, but very easy to read.

00:02:03.840 | We discussed nominal expected returns of asset classes

00:02:07.080 | and investment strategies, real returns, which

00:02:10.080 | are before the inflation rate, how an asset class or strategy

00:02:14.760 | may have a negative expected real return,

00:02:17.800 | but still be useful to the portfolio

00:02:20.320 | because it smooths the return of the portfolio.

00:02:23.920 | You may find yourself going back and listening to this podcast

00:02:28.040 | two or three times, and every time you do,

00:02:30.680 | you're going to catch something new.

00:02:32.560 | One more comment before we begin.

00:02:35.280 | I bring many guests on this podcast

00:02:37.960 | who have many different ideas.

00:02:41.400 | It doesn't necessarily mean you should use everything

00:02:45.680 | that you hear, but it does add to your body of knowledge,

00:02:48.680 | and that's important.

00:02:50.240 | So with no further ado, I am very

00:02:52.400 | pleased to have with us Antti Ilmenen.

00:02:55.720 | Welcome to Bogleheads on Investing.

00:02:57.840 | Thanks, Rick.

00:02:58.720 | Looking forward to this.

00:03:00.280 | You've got quite a prestigious career,

00:03:02.440 | but maybe a lot of our listeners are not as familiar with you

00:03:06.280 | because you spent a lot of time in the institutional space.

00:03:10.040 | So could you tell us a little bit about yourself

00:03:12.200 | and go as far back as you like?

00:03:13.920 | Sure, I'll try to make it pretty brief.

00:03:16.160 | So I'm originally Finnish and started my working career

00:03:20.360 | as a young portfolio manager in Finnish Central Bank,

00:03:23.600 | investing the country's reserves.

00:03:25.720 | And then I caught the lucky break,

00:03:27.080 | and I met Ken French, who was teaching us in 1989.

00:03:30.440 | And that basically gave me a, I would say,

00:03:32.360 | fast track window to come to University of Chicago

00:03:35.480 | to do my PhD.

00:03:36.760 | And that was just a wonderful time for a few years,

00:03:39.280 | learning a lot.

00:03:40.120 | And I got both Fama and French as my dissertation advisors,

00:03:44.360 | got to know my future colleagues at AQR,

00:03:48.080 | my wife as well.

00:03:49.000 | So just wonderful.

00:03:50.880 | Wherever you meet your wife, your life has changed.

00:03:54.160 | Yeah, absolutely.

00:03:55.680 | And well, she happens to be German,

00:03:57.240 | and that's why I am talking from Germany now.

00:04:00.000 | And so I've always had an international role,

00:04:02.400 | but German home base then for her.

00:04:05.680 | Anyway, so then after the PhD,

00:04:08.840 | I went to work for Salomon Brothers as a bond strategist

00:04:12.040 | and bond researcher for a decade.

00:04:14.800 | Turned into prop trading,

00:04:16.800 | and so I was always fixed income oriented,

00:04:20.080 | converted into macro strategies,

00:04:22.320 | and was in macro hedge fund, Brevin Howard,

00:04:24.560 | then seven years, 2004 to '11,

00:04:27.320 | which was very interesting time.

00:04:29.360 | But it's a discretionary place,

00:04:30.960 | and I have got a pretty systematic heart.

00:04:33.560 | So it was sort of matter of time when I would join AQR.

00:04:38.120 | Could you explain the difference between systematic

00:04:41.440 | and discretionary?

00:04:44.200 | Sure.

00:04:45.040 | So a discretionary investor makes judgmental decisions,

00:04:50.040 | whereas systematic is basically rules-based.

00:04:52.800 | You try to, I mean, you use discretion

00:04:55.040 | to come up with the rules,

00:04:56.360 | but then you really try to stick with them.

00:04:58.920 | Whereas a discretionary manager basically looks,

00:05:01.880 | whether it's stock picking or macro environment,

00:05:04.760 | tries to just look at the specifics in that situation

00:05:07.800 | without caring about particular rules.

00:05:10.400 | So discretionary, I mean, Warren Buffett.

00:05:12.640 | That would be a good example, yes, yes.

00:05:15.760 | And then AQR, since 2011,

00:05:18.240 | and I've been there now 10 years,

00:05:20.080 | in my natural home, I would say.

00:05:22.240 | You did your PhD at the University of Chicago,

00:05:26.720 | and your dissertation advisors were both Gene Fama

00:05:29.960 | and Ken French, correct?

00:05:31.600 | Yes, yeah.

00:05:33.360 | Source of pride, yes.

00:05:35.200 | And also I was reading in your book

00:05:37.760 | that when Gene Fama won the Nobel Prize,

00:05:41.960 | you were in Stockholm,

00:05:44.040 | and you were there when he accepted it.

00:05:46.280 | I had been advising some Swedish investors in my role,

00:05:51.320 | and I asked if they could help get the ticket

00:05:55.240 | to attend the ceremony.

00:05:56.920 | And I could, and then could attend some events also

00:06:00.920 | with the other professors who were joining Fama,

00:06:04.760 | and it was just wonderful.

00:06:08.280 | What's it like to be in a room

00:06:10.120 | where somebody gets a Nobel Prize?

00:06:12.880 | So yeah, you are high up in the balcony,

00:06:15.560 | and it's very serious,

00:06:18.680 | serious but warm atmosphere there.

00:06:21.160 | I think like there are only happy people in the hall.

00:06:25.000 | But there's also a reception then separately

00:06:26.960 | where you meet people a little bit more comfortably

00:06:30.400 | than in that big event.

00:06:33.160 | That must have been a very unique experience to be there.

00:06:36.960 | Absolutely.

00:06:38.400 | Okay, in addition to your work, your day job at AQR,

00:06:43.400 | you have also written a couple of books,

00:06:46.080 | and the first book you wrote was "Expected Returns."

00:06:49.640 | And that was back in 2010, came out 2011,

00:06:54.360 | so 10 years ago.

00:06:56.680 | And what was the reasoning for doing that book?

00:07:00.840 | Yeah, I think I had already seen earlier

00:07:02.880 | when I was a Bond researcher,

00:07:06.040 | I had seen that maybe the best thing I can do

00:07:09.400 | is to be some kind of bridge

00:07:11.360 | between academia and practitioner world,

00:07:13.720 | sort of describing some relatively complex ideas,

00:07:17.400 | like yield curve analysis was my first area

00:07:20.360 | where I wrote about, and I got, I don't know,

00:07:22.640 | I guess I made a name in that niche audience

00:07:25.680 | with some writings I did then.

00:07:27.240 | And I thought that, okay,

00:07:29.120 | I have broadened my perceptions on markets.

00:07:33.360 | I had been advising Norway's, this oil fund,

00:07:36.480 | for several years, and I had really thought

00:07:38.320 | about all kinds of asset classes

00:07:40.720 | and all kinds of good investing.

00:07:42.560 | I felt I have read a lot,

00:07:45.000 | I have got, I think, a good story to tell

00:07:48.240 | of the key components of investing

00:07:51.880 | and how to think about this important issue

00:07:54.240 | of expected returns on pretty much any asset class

00:07:57.360 | or strategy that investors consider.

00:07:59.720 | So it became sort of my passion project for many years

00:08:02.640 | and turned out to be basically a 600-page book.

00:08:05.720 | - And the premise of this book

00:08:07.200 | was to look at various asset classes

00:08:10.840 | and try to draw from that where expected returns come from.

00:08:15.840 | I mean, you were looking at the cash markets,

00:08:18.600 | equity markets, bond markets,

00:08:20.520 | credit markets, which is corporate bonds,

00:08:22.760 | and also you got into risk premia,

00:08:24.760 | like value, momentum, and so forth.

00:08:28.120 | So talk a little bit about that,

00:08:29.480 | and then right after that, we'll get into,

00:08:30.880 | so what has changed?

00:08:32.560 | - Yeah, so I think when you think of expected returns

00:08:36.080 | of any asset or strategy,

00:08:38.800 | you want to think about theoretical arguments

00:08:41.480 | why there should be a premium,

00:08:42.880 | and it could be risk-based or behavioral.

00:08:45.400 | You want to think about historical average returns,

00:08:47.760 | often long-run average return is an anchor you think about,

00:08:50.840 | but then you want to think about forward-looking measures,

00:08:53.520 | so current market conditions.

00:08:54.800 | It could be starting yields,

00:08:56.400 | which is often the case,

00:08:57.360 | or valuations that guide you on current expected returns.

00:09:01.440 | So I try to give basically multiple perspectives

00:09:05.080 | to that expected return question,

00:09:06.680 | and then draw on both the literature

00:09:09.640 | and lots of empirical analysis that I did myself

00:09:12.720 | on all of these return sources,

00:09:14.800 | highlighting the most important ones.

00:09:17.320 | - Then you call it an update of your book,

00:09:20.480 | kind of an add-on to that book,

00:09:22.160 | which is the one that just came out earlier this year

00:09:24.640 | called "Investing Amid Low Expected Returns."

00:09:28.360 | So obviously your analysis between 2011 or 2010,

00:09:33.360 | and 2020, 2021, when you wrote this book,

00:09:38.520 | was that going forward,

00:09:40.840 | the returns from asset classes,

00:09:44.040 | risk premia, style premia perhaps,

00:09:46.480 | we don't know, we'll get into it in a second,

00:09:48.200 | but particularly asset classes

00:09:50.840 | are going to be lower going forward.

00:09:53.720 | Was that the premise of what you were trying

00:09:55.600 | to put out with the second book?

00:09:57.400 | - Yeah, yeah.

00:09:58.240 | Like you said, first, partly an update.

00:10:00.240 | I did feel like the world had changed somewhat

00:10:02.960 | and there was new research,

00:10:04.280 | but especially I had this feeling

00:10:05.760 | that this question on low expected returns

00:10:08.360 | on major investments is almost like a generational challenge

00:10:12.120 | that has been underappreciated,

00:10:14.320 | partly because realized returns have been quite benign.

00:10:17.320 | So in some sense, a key thesis I have there

00:10:19.560 | is that lower and lower bond yields in recent decades,

00:10:23.480 | including the last one,

00:10:25.440 | have been helping all other assets

00:10:28.280 | get to lower starting yields.

00:10:30.240 | And those low starting yields,

00:10:32.120 | which you can also think of high valuations,

00:10:35.000 | they basically promise us low future returns.

00:10:38.360 | We don't know quite when,

00:10:39.240 | whether it's going to be fast or slow,

00:10:40.960 | but that challenge is there.

00:10:43.360 | But because while the required years were falling,

00:10:48.360 | that at the same time basically gave,

00:10:50.720 | richened those assets.

00:10:52.480 | We got pretty nice realized returns on bonds

00:10:55.520 | and on stocks and on anything really,

00:10:57.240 | all major asset classes during this time.

00:11:00.720 | And that made me worried

00:11:02.880 | that investors don't see the challenge

00:11:05.800 | because they look at the rear view mirror

00:11:07.720 | of realized returns.

00:11:09.640 | Back in 1980, the 10-year treasury bond

00:11:14.280 | had a yield of about 16%.

00:11:18.640 | And 20 years later, 2020,

00:11:23.320 | it was less than 1%.

00:11:25.840 | So this fall of interest rates

00:11:28.240 | from 16 to less than one on a 10-year treasury,

00:11:32.280 | and also a rapid decline,

00:11:34.640 | fairly similar, in fact, probably larger on T-bills,

00:11:38.120 | which is considered the risk-free rate.

00:11:41.240 | This caused a very large excess return

00:11:45.000 | among asset classes, stocks, bonds, real estate,

00:11:49.400 | over a 40-year period of time.

00:11:51.720 | And as a baby boomer, I mean, this has been great, right?

00:11:54.840 | We have really benefited, but that has ended.

00:11:58.640 | And now we're back to reality.

00:12:00.840 | - Yeah, that's a key theme.

00:12:03.680 | And while I say this is not only bonds,

00:12:06.760 | it's all asset classes,

00:12:07.720 | but it emanates from bonds.

00:12:09.680 | And just to show the parallel there to other asset classes,

00:12:13.240 | if we take the discount rate for equities,

00:12:15.600 | like a simple way of thinking

00:12:16.960 | of the equity market's discount rate

00:12:18.480 | would be to look at the Shiller earnings yield.

00:12:20.960 | So this is the inverse of the CAPE ratio.

00:12:24.760 | One can think of that as the discount rate for S&P 500.

00:12:29.400 | And that was basically 10% 40 years ago,

00:12:31.880 | and then it came down to 3%.

00:12:33.880 | And that gave very nice returns as the repricing happened.

00:12:38.720 | But prospectively, that sort of guarantees us

00:12:42.080 | problems for the future.

00:12:43.600 | And I think a good way of thinking of this situation

00:12:46.960 | is that all asset classes,

00:12:48.520 | whether we talk of bonds, stocks, or housing,

00:12:51.160 | you can think of them as basically priced

00:12:53.560 | through estimating expected future cash flows

00:12:57.280 | and discounting them by your common discount rate,

00:13:00.600 | which would be this, let's say, real treasury yield.

00:13:03.480 | And then some asset-specific premia.

00:13:06.360 | And when that common discount rate is so low

00:13:09.520 | as it became negative real yield,

00:13:11.600 | that made everything expensive at the same time.

00:13:13.800 | We've had this sort of everything bubble, in a sense.

00:13:17.000 | And one way of thinking of this is that while 40 years ago

00:13:20.720 | we were having high expected return but cheap valuations,

00:13:24.840 | now we have got low expected returns and high valuations.

00:13:29.320 | Effectively, we have sort of borrowed returns

00:13:31.760 | from the future by pricing all these assets so expensively.

00:13:36.520 | - Yeah, let's get into that just for a second.

00:13:37.960 | About 2021, when the stock market went way up unexpectedly

00:13:42.960 | but interest rates did come down to, as I said,

00:13:46.440 | below 1% for the 10-year treasury.

00:13:49.600 | That, in effect, with real estate and with equity

00:13:54.520 | and with bonds, we were borrowing returns from the future.

00:13:59.520 | - Yeah, yeah.

00:14:01.040 | So when people think of the cushy returns

00:14:04.920 | that they have been getting in recent years,

00:14:07.800 | it's not something that, in some way,

00:14:10.360 | you should certainly expect to be repeated.

00:14:12.200 | But in some sense, you should expect that in the future

00:14:15.200 | you will get something less

00:14:17.680 | because those higher prices you get for your assets

00:14:21.880 | brought the starting yields lower.

00:14:24.240 | And the starting yields on any investment,

00:14:26.160 | they are a heavy anchor.

00:14:28.080 | They do matter for those expected returns

00:14:30.920 | that's most obvious for bonds.

00:14:32.120 | But this is, again, it's very true also

00:14:34.640 | for those other asset classes, equities, housing, et cetera.

00:14:38.080 | And so I do not know whether the low expected returns

00:14:42.160 | will materialize through what I call the slow pain

00:14:45.600 | of staying in this world of high valuations

00:14:49.080 | and low starting yields

00:14:51.600 | where we just clip ever smaller coupons and dividends,

00:14:55.680 | friends, or whether we get a repricing,

00:14:59.200 | which now has happened in 2022, that I call the fast pain.

00:15:02.520 | So I said sort of pretty, pretty unhappily told

00:15:07.280 | that we can sort of expect that it's gonna be

00:15:09.600 | either a slow pain or fast pain

00:15:11.320 | or some combination of those two.

00:15:13.160 | It turns out that we got quite a bit of fast pain this year,

00:15:16.000 | but not enough, it turns out,

00:15:18.280 | that it would have solved the problem.

00:15:20.040 | We have seen assets cheap and somewhat,

00:15:22.480 | but not nearly enough to get them back

00:15:24.240 | to sort of long-run average levels.

00:15:27.040 | We had this sell-off in the equity market

00:15:30.080 | and in the fixed income market this year, 2022,

00:15:35.080 | but now we've had a rebound of equity prices

00:15:39.520 | and interest rates have fallen,

00:15:41.920 | not nearly as low as what they were in 2021,

00:15:45.240 | but they have come back.

00:15:47.280 | But that's not enough, you don't think.

00:15:49.240 | You think that it's gonna go more,

00:15:52.200 | even though we've had this fast correction,

00:15:54.720 | get some asset prices closer

00:15:57.240 | to perhaps where they should be,

00:16:00.280 | that probably we still have more to go.

00:16:03.040 | And the question is, is it going to be

00:16:05.600 | ripping the Band-Aid off

00:16:07.040 | and getting it all done all at once,

00:16:09.120 | or is it just gonna be sort of a slow bleeding?

00:16:12.840 | Yeah, basically the starting yields,

00:16:14.760 | if you think of government bonds, real yields,

00:16:17.120 | they were sort of minus 1%

00:16:21.000 | when they were very low last year,

00:16:22.840 | and they got to near zero now.

00:16:25.120 | And so there's been about 1% move on that front.

00:16:29.160 | For equities, I would say that the change

00:16:31.360 | has been less than that, maybe half a percent.

00:16:34.320 | And both of them are a couple of percentage points away

00:16:39.320 | from long-run historical averages, what you could get.

00:16:43.040 | So if we get to those averages,

00:16:45.080 | there would be much more to happen,

00:16:47.000 | but maybe we don't get there.

00:16:48.600 | So my short-term view,

00:16:49.880 | and this is getting to the speculative punditry,

00:16:53.160 | is that the inflation problem is serious enough.

00:16:55.600 | And that's gonna basically force

00:16:59.080 | more monetary policy tightening than markets discount now.

00:17:02.840 | And that, I think, maybe the young generation of investors

00:17:06.120 | don't really understand what it means

00:17:07.760 | when Fed is tightening seriously,

00:17:09.600 | because that has not happened often

00:17:12.200 | and not really in their investment lifetime.

00:17:14.560 | But I think some pain will be needed for asset owners

00:17:19.680 | before this inflation genie is taken care of.

00:17:24.680 | - I wanna talk about the risk-free rate,

00:17:27.160 | which is called the Treasury Bill,

00:17:29.080 | which all of these valuation models and equations

00:17:33.920 | stem from what is the risk-free rate, T-bills.

00:17:38.600 | And historically, globally, not just the U.S.,

00:17:43.600 | but globally, the T-bill rate

00:17:47.160 | has basically been the inflation rate.

00:17:49.840 | Now, that hasn't been true in the United States.

00:17:52.000 | Over the last several years,

00:17:53.400 | the T-bill rate was actually a little higher

00:17:56.120 | as we came up, as inflation dropped,

00:17:59.160 | and then it took a while

00:18:00.000 | for interest rates to come back down.

00:18:01.400 | But now, going forward over the next 40 years, let's say,

00:18:06.400 | it seems reasonable to assume

00:18:09.320 | that the risk-free rate and the inflation rate will be close.

00:18:15.520 | Do you agree with that?

00:18:17.520 | - Yeah, yeah, and so it is.

00:18:19.680 | So one maybe detail is that one can debate

00:18:23.440 | whether the risk-free rate that's relevant

00:18:25.600 | for long-run investors is the T-bill rate

00:18:27.920 | or the long-term bond rate.

00:18:29.240 | And there's some term premium between those.

00:18:32.880 | But all of these came to very low levels.

00:18:36.000 | And I would say that, roughly speaking,

00:18:38.520 | short-term, right now, short-term cash, long-term bonds,

00:18:43.360 | expected 10-year inflation,

00:18:44.920 | they are sort of similar level,

00:18:46.920 | near, a little under 3% or so.

00:18:49.160 | - So let's then move to equities.

00:18:50.760 | So equities have an expected real risk premium

00:18:55.360 | over the risk-free rate.

00:18:58.800 | Historically, in the U.S.,

00:19:01.800 | it's been higher than it has globally.

00:19:03.520 | Globally, it's been about 5%,

00:19:05.160 | but in the U.S., it's been higher, over 6%.

00:19:08.800 | This is compounded.

00:19:10.600 | Can we reasonably expect globally

00:19:13.720 | that it should continue to be 5%?

00:19:17.680 | - Yeah, that's probably optimistic.

00:19:20.200 | I think it is likely that the equity risk premium

00:19:22.320 | will be thinner.

00:19:23.640 | So I think total expected real returns on equities,

00:19:28.040 | ballpark of 4%, probably a little less than that.

00:19:31.640 | In the U.S., a little above that.

00:19:34.400 | Outside the U.S., and then you can add

00:19:37.160 | the expected inflation on top of that

00:19:39.720 | to get the total return estimate.

00:19:42.240 | - Fair enough.

00:19:43.240 | I want to get into the components of the real return 4%.

00:19:48.240 | That can be broken down to a real growth rate

00:19:53.600 | of earnings per share, and then dividends.

00:19:58.600 | Ko, you break that down,

00:19:59.680 | and then for coming up with your number.

00:20:02.760 | - Sure.

00:20:03.600 | So I think a good way of thinking of,

00:20:05.960 | if we focus on equities,

00:20:07.520 | is this idea of just dividend discount model

00:20:10.360 | where you are earning some real yield and real growth,

00:20:15.360 | and then maybe inflation, if we think of that.

00:20:17.960 | But let's just focus on real yield, real growth.

00:20:21.280 | And it could be both, by the way, ballpark 2% each.

00:20:24.240 | And then there's a question

00:20:25.080 | whether there's a change in valuations.

00:20:27.120 | So when you look at the realized returns,

00:20:29.080 | like last decade had much higher returns

00:20:31.840 | because the valuations basically doubled.

00:20:34.840 | Shiller PE went from 20 to 40.

00:20:36.760 | So realized returns were much more.

00:20:39.200 | But sort of roughly 4% expected return,

00:20:42.840 | half from real compound growth

00:20:46.640 | and half from starting yield.

00:20:48.240 | And you can think of dividend yield

00:20:49.560 | and a little bit from net buybacks.

00:20:51.640 | Those are the components.

00:20:53.440 | - How does that all work into a global GDP growth?

00:20:58.440 | - Equity market returns.

00:21:00.400 | So they are higher than what you get on a GDP growth,

00:21:04.960 | which has been typically 2 to 2.5% or something like that,

00:21:09.040 | partly because equity is sort of a levered exposure

00:21:11.680 | to economic growth.

00:21:13.040 | There's that nice intuition there.

00:21:14.960 | But that doesn't mean that there's a tight correlation

00:21:21.000 | between economic GDP growth and equity returns.

00:21:26.200 | It turns out that there's almost zero correlation.

00:21:29.040 | So this is one of these things I highlight in the book

00:21:31.560 | that when you look at these numbers in the US over time,

00:21:36.080 | or you compare across countries,

00:21:37.960 | you find very modest relations

00:21:40.160 | between GDP growth and equity returns,

00:21:45.160 | even though we intuitively think that equities

00:21:47.360 | are sort of participation in the real economy.

00:21:50.320 | - And I read that.

00:21:52.040 | And I understand on a country by country basis,

00:21:54.520 | you can't say GDP growth is this,

00:21:56.720 | therefore earnings per share growth is that,

00:21:58.800 | therefore you take some multiple,

00:22:00.560 | and therefore this is what the price

00:22:02.200 | of the stock market should be.

00:22:03.320 | On a country by country basis, I understand that.

00:22:07.040 | But globally, looking at global GDP growth,

00:22:11.320 | isn't it more highly correlated,

00:22:13.640 | the global equity market to global GDP growth?

00:22:18.320 | - Contemporaneously, there's almost nothing.

00:22:20.760 | But equity markets tend to predict next year's growth.

00:22:24.160 | So that way you do get something.

00:22:26.640 | And I think it is true.

00:22:28.080 | But certainly when equity markets

00:22:29.800 | are predicting next year recession,

00:22:32.200 | then you have got low returns.

00:22:34.160 | So yeah, I think that correlation becomes

00:22:36.240 | when you take, not looking at monthly returns,

00:22:38.600 | but you look at, let's say, annual returns,

00:22:40.240 | and in a forward looking sense,

00:22:41.880 | you do find some decent relation.

00:22:45.800 | And so the intuition, I think, is right,

00:22:48.000 | that equity returns are both somehow participation

00:22:52.680 | in global growth, and they are vulnerable

00:22:55.240 | to any hiccups or something more serious

00:22:58.120 | to that global growth.

00:23:00.680 | And that's the big risk then in equity markets.

00:23:03.000 | - So the real expected return of equity

00:23:07.360 | using the simple model of a 2% dividend yield or earning,

00:23:12.360 | dividend yield, real, and 2% real growth comes out to 4%,

00:23:18.040 | and then you add on to that your inflation number,

00:23:23.640 | and now you come up with,

00:23:25.120 | well, if you're gonna use the Fed's inflation number of 2%,

00:23:29.240 | then you're at about a 6% nominal long-term

00:23:33.600 | expected return for equity.

00:23:35.840 | This a reasonable number to plan for?

00:23:39.040 | - Good numbers, yeah.

00:23:40.760 | Yeah, I think so.

00:23:42.240 | I think it's a good point estimate.

00:23:44.200 | But then we have to sort of recognize

00:23:47.240 | that we can debate each of those 2% numbers however much.

00:23:52.200 | And so fair sort of humility

00:23:54.960 | or sense of uncertainty around them,

00:23:56.640 | but as point estimates, that's what I would use.

00:24:00.960 | - So that's one side of the equation, right?

00:24:02.880 | We're talking about a 60/40 portfolio,

00:24:05.280 | a 60% equity, 40% fixed income as an example.

00:24:08.320 | Now we've got to go to the fixed income side.

00:24:10.680 | So we have an expected long-term return

00:24:14.480 | on equities of 6%, nominally, 4% real.

00:24:18.560 | Now we go to the fixed income side,

00:24:20.160 | and we've got choices there

00:24:22.000 | between treasury bonds and corporate bonds.

00:24:25.120 | So let's start out with treasury bonds,

00:24:27.640 | intermediate-term treasury bonds.

00:24:29.440 | There has been a premium paid

00:24:32.760 | for going out on the yield curve to the 10-year mark

00:24:36.520 | where you've picked up more than just the inflation rate.

00:24:39.640 | And we have agreed that T-bills in the U.S.

00:24:42.200 | have yielded a little bit more than inflation,

00:24:44.440 | but let's say going forward

00:24:45.800 | that T-bills are gonna give us inflation.

00:24:48.600 | So now inflation plus something for treasury bonds,

00:24:53.480 | for longer-term, say, 10-year treasuries.

00:24:55.600 | I mean, historically, what's it been,

00:24:58.240 | and what do you think it might be going forward?

00:25:00.160 | - Yeah, well, the realized return has been quite benign

00:25:04.320 | because, again, we got these windfall gains

00:25:06.440 | when bond yields were falling,

00:25:08.000 | and that is probably not fair to think.

00:25:10.200 | In a forward-looking sense,

00:25:12.040 | what we should expect to get over cash

00:25:14.800 | has been becoming, in some sense, stingier,

00:25:18.280 | and the intuition is that government bonds

00:25:21.280 | used to have a extra term premium,

00:25:24.160 | partly because of the high inflation uncertainty,

00:25:26.800 | sort of inflation risk premium,

00:25:28.520 | and that probably was beat down to near zero

00:25:30.800 | in the stable inflation decades after 2000.

00:25:34.240 | And then government bonds further turned

00:25:36.760 | into a safe haven asset

00:25:38.240 | when stock-bond correlation turned negative.

00:25:40.800 | So simple capital asset pricing model intuition says

00:25:44.680 | that if you have got a negative beta investment,

00:25:47.400 | which basically really smooths equity returns,

00:25:50.440 | then that could even justify a negative premium,

00:25:53.480 | and I think that has helped government bonds

00:25:56.560 | become more expensive, and in a forward-looking sense,

00:25:59.280 | then we really may have even justified a negative premium.

00:26:03.240 | And again, realized returns turned out to be very good

00:26:05.640 | because of the surprisingly benign picture

00:26:08.480 | on both falling inflation expectations

00:26:11.040 | and falling real yields.

00:26:12.720 | Looking ahead, I think there will be

00:26:14.960 | some mildly positive term premium,

00:26:17.880 | but less than the over 1% that people were earning.

00:26:22.880 | So I would expect something half to 1%,

00:26:26.320 | maybe extra over cash.

00:26:28.320 | So roughly that amount of real return

00:26:33.320 | on intermediate and 10-year bonds.

00:26:35.600 | - That's very interesting that it's come down.

00:26:39.080 | What about the Fed's balance sheet

00:26:41.040 | and the Fed letting these bonds roll off,

00:26:43.520 | and so there's gonna be more supply out there.

00:26:46.320 | I mean, wouldn't that have an effect

00:26:47.640 | of pushing up the yield, the real yield?

00:26:49.720 | - Yeah, so besides the inflation risk premium,

00:26:52.360 | safe haven premium, we said supply-demand factors

00:26:55.240 | are the next thing, and that clearly was helpful

00:26:58.240 | during the time of quantitative easing,

00:27:00.480 | and now it's gonna give some headwinds

00:27:02.120 | during quantitative tightening.

00:27:04.280 | That's why I chose to talk about 10 years

00:27:07.400 | where I sort of hope these things don't play out anymore.

00:27:10.720 | The quantitative tightening story is hopefully there

00:27:12.760 | for the next couple of years,

00:27:13.920 | and then that issue is over.

00:27:16.000 | - So we're looking at somewhere between a half a percent

00:27:21.080 | to 1%, perhaps, over the risk-free rate or over T-bills.

00:27:25.360 | - Yeah, yeah. - Realistically.

00:27:26.680 | I mean, you're gonna get paid something

00:27:28.080 | for taking turns. - Exactly.

00:27:30.000 | - Not as much as it was.

00:27:31.360 | - Yes, and very short-term, there is this question,

00:27:34.160 | what happens with inflation,

00:27:35.840 | and if Fed has to be more aggressive because of that,

00:27:39.120 | and that may tell a more bearish story

00:27:43.000 | for the next couple of years.

00:27:45.120 | - So let's move on, then, to another premia

00:27:48.200 | in the fixed-income market, and this is credit risk.

00:27:51.000 | Instead of being in treasuries,

00:27:52.800 | we're going to be in intermediate-term corporate bonds

00:27:57.160 | or mortgages or high-yield

00:27:59.880 | versus investment-grade corporate bonds.

00:28:02.920 | We're gonna take credit risk,

00:28:04.600 | and here I found interesting in your book

00:28:07.760 | because you changed your mind on this.

00:28:10.760 | You were kind of negative

00:28:12.680 | on investment-grade corporate bonds,

00:28:14.680 | but you seem to have changed your mind here in this book.

00:28:17.400 | So talk about credit risk,

00:28:19.080 | and then talk about what caused you to change your mind.

00:28:21.880 | - Sure, sure.

00:28:23.360 | Well, first, so I would say empirical evidence

00:28:26.320 | that says that you do earn some of the credit spread,

00:28:30.360 | but you don't tend to earn all of it.

00:28:32.280 | It's, roughly speaking, historically,

00:28:34.120 | you've earned about half of the spread,

00:28:36.800 | and we may return to that a little later.

00:28:40.400 | But then there's a question like,

00:28:41.560 | are credits worth including?

00:28:43.800 | They have an odd blend

00:28:45.040 | between government bonds and equities,

00:28:48.200 | and it might be that they are

00:28:49.840 | sort of a superfluous asset there,

00:28:52.200 | and I was leaning towards this idea in my first book

00:28:54.880 | that maybe you really don't need them,

00:28:57.160 | and in the second book, I was leaning the other way.

00:28:59.600 | Well, I'm sort of notoriously two-handed economist

00:29:03.400 | that I don't have very black-and-white views,

00:29:06.520 | but so certainly, I did lean more positive,

00:29:09.360 | and the arguments why I leaned more positive on credits

00:29:13.160 | were partly just from having a strong decade,

00:29:17.280 | like after 2010, we had just seen

00:29:20.360 | a relatively bad decade for credits,

00:29:21.920 | and now we saw a strong decade,

00:29:23.000 | so that more importantly,

00:29:24.240 | I looked at some historical research of many decades back,

00:29:28.600 | which was telling a more positive story

00:29:30.960 | on credit performance and its sort of extra benefit

00:29:35.040 | you get beyond government bonds and equities.

00:29:38.680 | However, I actually, I've been called on this topic

00:29:43.680 | many times, and people are saying

00:29:45.200 | that you really shouldn't trust too much

00:29:47.000 | the data from 1930s to 1960s in credit markets.

00:29:51.040 | The data just sucks so badly

00:29:52.760 | that that evidence is relatively weak,

00:29:56.880 | and then arguably, the last decade evidence, again,

00:30:00.040 | should be discounted because Fed obviously had a big role

00:30:02.880 | in pushing also credit asset prices higher

00:30:07.000 | during that period.

00:30:08.560 | So I would still lean mildly more positively,

00:30:11.200 | but you hear very weak views.

00:30:14.840 | - But you do, you are, or you were positive

00:30:20.200 | in your view of double B-rated bonds,

00:30:23.840 | so-called fallen angels, and I'd like to hear this

00:30:27.560 | if you're still positive on that,

00:30:29.480 | and the reason I say that is because individual investors

00:30:32.760 | sometimes take a position in a vanguard

00:30:37.440 | high-yield corporate bond fund.

00:30:38.720 | Now, I don't own this fund, so I'm not touting it.

00:30:42.040 | I do talk about it in some of my books

00:30:43.960 | for the exact reason that you've talked about it

00:30:46.360 | in your books, but this double B-rated area

00:30:50.480 | where the fallen angels are does tend to seem

00:30:52.680 | to have an extra kick to it.

00:30:54.520 | So you talk about that, and you think if that,

00:30:56.480 | does that have any benefit potentially to a portfolio?

00:30:59.760 | - Yes, I think so.

00:31:01.640 | I mean, it is, it's a micro story,

00:31:03.800 | but it is, in credit markets, it is the best pocket,

00:31:06.600 | and the intuition, so fallen angels now refers

00:31:09.560 | to bonds that are downgraded from investment grade

00:31:14.560 | to speculative grade, so typically triple B to double B,

00:31:19.240 | and many institutions have got rules

00:31:21.960 | that they have to sell bonds during the next month

00:31:25.720 | to stick with their mandates,

00:31:27.480 | and there is effectively a fire sales,

00:31:29.640 | and I already wrote about it in my first book,

00:31:31.520 | and I basically checked the evidence

00:31:33.520 | for the second book, is the effect still there,

00:31:36.560 | and it is still there through 2010,

00:31:38.520 | so it has been very costly for investors

00:31:42.720 | to sell those fallen angels in this fire sales.

00:31:46.360 | Indeed, if you look at the long run performance,

00:31:49.120 | how much of the overall credit spread

00:31:53.640 | investment grade investors earned

00:31:55.840 | in excess return over treasury?

00:31:59.360 | It's ballpark is about half,

00:32:01.360 | and there's not much default loss that happens there,

00:32:05.160 | so there are some technical effects,

00:32:06.600 | and this is the most important technical effect.

00:32:08.680 | Even broadly speaking, we are eating up a meaningful part

00:32:13.200 | of this extra credit spread.

00:32:16.320 | Investors lose a meaningful part

00:32:20.480 | of the average credit spread

00:32:22.640 | by participating in that fire sales,

00:32:25.720 | so by selling those fallen angels within the first month.

00:32:30.440 | - You're talking about investment grade credit spread

00:32:32.440 | by selling the fallen angels,

00:32:33.920 | they lose a lot of total credit spread.

00:32:36.520 | - Yes, those bonds that are downgraded,

00:32:38.840 | they lose a lot of value in that next month.

00:32:41.600 | If you even would wait six months,

00:32:43.880 | that would help meaningfully,

00:32:45.600 | but ideally just try to stick with those,

00:32:49.160 | because they have got as good performance historically

00:32:52.440 | as any other credit investments.

00:32:54.880 | - Under liquid asset class premia, you do list commodities,

00:32:59.280 | and there you talk not only about individual commodities,

00:33:04.280 | but about commodity strategies,

00:33:06.760 | so could you go into commodities?

00:33:09.320 | - Sure.

00:33:11.560 | Many investors think that there is no reward

00:33:13.560 | for commodity investing,

00:33:15.160 | and it turns out that that's true in the long run

00:33:17.800 | if you think of a single,

00:33:19.440 | especially single spot commodity,

00:33:21.480 | but if you think of a diversified portfolio

00:33:24.520 | of commodity futures,

00:33:26.200 | you actually have earned something like 3%,

00:33:29.280 | and a little bit of that comes from the futures part,

00:33:32.440 | the role effect in the long run historically,

00:33:35.400 | but the bigger part is so-called diversification return.

00:33:39.920 | This is something that Farmer and Booth

00:33:42.160 | already discussed with equities in early '90s,

00:33:45.880 | and it's a very small effect in equities,

00:33:48.080 | but basically with commodities,

00:33:49.800 | it's important and worth 3%.

00:33:52.240 | The intuition is that a single commodity is very volatile,

00:33:55.640 | often 30% or more volatility,

00:33:58.000 | and that gives a volatility drag to the compound return.

00:34:02.200 | It takes down the compound return geometric mean,

00:34:04.880 | but those individual commodities

00:34:08.000 | are also very lowly correlated with each other,

00:34:11.080 | so you can diversify across them in very simple ways,

00:34:14.680 | and you can reduce portfolio volatility

00:34:17.120 | and reduce that volatility drag,

00:34:19.600 | and that gets the average return

00:34:22.800 | from typical single commodity zero over cash

00:34:26.960 | to about 3% over cash,

00:34:29.280 | just thanks to this effect

00:34:30.840 | that you are reducing portfolio volatility.

00:34:34.040 | - I'm gonna push back a little bit here.

00:34:36.120 | - Please.

00:34:36.960 | - That is a trading strategy.

00:34:38.240 | That's not a premia on a asset class, correct?

00:34:43.240 | As you said, if you just bought the asset class

00:34:45.840 | and held it, buy and hold,

00:34:47.800 | basically, you get maybe the inflation rate,

00:34:50.800 | but what you're talking about is a--

00:34:52.000 | - No, no.

00:34:52.840 | - Okay, go ahead.

00:34:53.840 | - You really get the 3% by naive diversification.

00:34:57.880 | It's true that you have to buy,

00:35:00.720 | I mean, in theory, you might do it with spot commodities,

00:35:04.560 | by the way, but nobody could do that

00:35:05.960 | because you don't wanna buy their pork bellies.

00:35:08.040 | - No, I understand.

00:35:09.000 | You're doing one-month futures or something.

00:35:10.840 | - Yeah, but it is really the only thing you are doing here.

00:35:14.920 | You are rolling every month or quarter something.

00:35:18.480 | So it is none of the things that you,

00:35:20.040 | it is not momentum strategy, roll strategy.

00:35:24.280 | This part, that will be extra.

00:35:26.520 | This is saying that just by reducing portfolios volatility

00:35:31.400 | and the volatility drag, you are generating positive return.

00:35:36.400 | It's a complicated thing.

00:35:37.640 | - I understand, but it's not a market-weighted

00:35:41.040 | or capitalization-weighted strategy at all.

00:35:43.880 | It is basically an equal-weighted strategy.

00:35:47.240 | So you have to come up with your equal-weighted index

00:35:50.720 | that you're going to target.

00:35:53.520 | And then every month, you have to trade the portfolio

00:35:57.880 | to get it back to the equal weight.

00:36:01.080 | So, I mean, it's an active strategy.

00:36:03.120 | - It is, but it can be a very simple strategy.

00:36:06.920 | - That means you gotta pay somebody to do this.

00:36:09.360 | I mean, somebody, some active manager,

00:36:11.720 | some asset manager.

00:36:12.960 | So, yeah, it's a futures trading strategy.

00:36:17.400 | Somebody will have to do that.

00:36:18.800 | It can be at a very low cost,

00:36:20.440 | or you can try to add some of those,

00:36:22.720 | some extras carry and momentum type of strategies

00:36:25.720 | on top of that.

00:36:26.760 | But if you want to keep it simple,

00:36:28.800 | it is very modest, modest cost.

00:36:33.800 | But it's true that it's not total buy and hold

00:36:37.920 | when you use futures.

00:36:39.120 | - Let's talk about gold for a second.

00:36:41.240 | You did talk about gold and your view on that was...

00:36:44.360 | - Zero real return in the long run.

00:36:47.320 | It is low compared to many other assets,

00:36:49.640 | but it makes sense mechanically

00:36:51.160 | because you are not earning any coupons or dividends.

00:36:54.520 | And logically, it sort of makes sense

00:36:56.120 | because gold has been a sort of safe haven or hedge,

00:37:00.920 | an admittedly imperfect one,

00:37:02.920 | but against a variety of ills.

00:37:04.520 | It has tended to do relatively well,

00:37:06.120 | both in rising inflation scenarios

00:37:08.640 | or in equity market drawdowns.

00:37:10.360 | Not very reliably, for example,

00:37:11.920 | this year we had both of those and gold hasn't shown.

00:37:15.520 | - Interesting.

00:37:16.400 | Okay, so those are the asset classes,

00:37:18.560 | cash, equities, treasury bonds, corporate bonds,

00:37:23.240 | including fallen angel, high yield bonds and commodities.

00:37:27.640 | So those are the asset classes in the risk premium.

00:37:29.880 | Now let's get into the second part of your book,

00:37:33.520 | style premium, things like value investing,

00:37:36.080 | momentum investing, quality investing,

00:37:38.720 | and then you have carry.

00:37:41.000 | - Yeah, yeah.

00:37:42.360 | So there are some styles where I think

00:37:46.080 | the consensus of researchers has converged

00:37:50.760 | to saying that there is a long run premium,

00:37:53.440 | which looks pretty much empirically

00:37:56.880 | as good as equity premium.

00:37:59.800 | - This is long, short, or just long only?

00:38:02.840 | - And this can be both.

00:38:04.680 | Any of these strategies can be applied

00:38:07.680 | as long only portfolios where you tilt a little more

00:38:11.360 | and you already favor last year's winners in momentum,

00:38:15.200 | favor more boring, good quality or low beta stocks

00:38:18.160 | in defensive or high dividend yield stocks in carry.

00:38:23.080 | Or you can do a long, short strategy in all of these cases.

00:38:25.840 | And you could also apply them outside stock selection,

00:38:28.200 | do this, use this in country allocation.

00:38:30.560 | And if you do this, so both of these are useful.

00:38:32.960 | The latter approach, long, short, is more aggressive.

00:38:36.160 | It will give wonderful diversification benefits

00:38:39.520 | because then you have got many different return sources,

00:38:42.200 | but it has got problems because they are unconventional

00:38:45.160 | and they will challenge investor patients

00:38:47.600 | much more than equities if you have a bad window

00:38:52.600 | for these strategies.

00:38:54.400 | - I think that most individual investors,

00:38:56.400 | if they're going to do style premium factor investing,

00:39:00.920 | it's going to be long only.

00:39:03.120 | And it's going to be in one fund.

00:39:05.920 | So it's a multi-factor fund.

00:39:07.720 | How do you feel about multi-factor?

00:39:09.640 | - Oh, thank you.

00:39:11.440 | I clearly like it because, again, I like diversification.

00:39:15.080 | And many of these styles relative to each other

00:39:19.120 | are very lowly correlated.

00:39:20.520 | Even value and momentum as active tilts

00:39:23.040 | are negatively correlated.

00:39:24.880 | And sometimes some others.

00:39:26.520 | But you get really nice benefits

00:39:28.880 | when you combine these strategies.

00:39:30.600 | So I think anybody who chooses to use only single one style

00:39:35.320 | has to have a really strong conviction

00:39:37.240 | that this is the one thing I believe in

00:39:40.200 | as opposed to the other ones.

00:39:41.560 | Because, again, there are these three, four, five things

00:39:45.000 | which all seem like quite good complements

00:39:47.920 | to each other as well.

00:39:49.400 | - Do you find that there's a higher value premium

00:39:52.240 | in small cap rather than large cap?

00:39:55.040 | - I think for many of these premia,

00:39:58.120 | we find that on paper, small segment

00:40:02.280 | is a better fishing pond, which is a higher premium there.

00:40:06.560 | And again, that's on paper.

00:40:08.480 | And it could be that after trading costs,

00:40:10.120 | much of that goes away.

00:40:11.600 | So in general, I think we tend to find

00:40:14.840 | as good opportunities after costs

00:40:18.520 | in large cap and small cap segments.

00:40:21.840 | So I don't have a strong view on this

00:40:24.920 | as I know many other people do.

00:40:26.760 | - The last item that you put in style premia

00:40:30.040 | is called carry, where carry is a long, short strategy.

00:40:35.040 | And the simplest way of describing it

00:40:38.880 | is what looks expensive, you sell,

00:40:41.960 | and what looks cheap, you buy.

00:40:43.200 | So you're selling very low-yielding country bonds

00:40:48.200 | and you're buying very high-yielding country bonds.

00:40:50.720 | Is that a fair assessment of carry?

00:40:52.480 | - Well, I think when you said cheap and expensive,

00:40:55.680 | I would call that a value strategy.

00:40:57.600 | Whereas for carry, I would just call it

00:40:59.520 | high-yielding and low-yielding.

00:41:01.480 | And in some cases, carry and value sort of go hand-in-hand.

00:41:05.280 | And like dividend yield strategies

00:41:07.080 | and book-to-price strategies are highly correlated.

00:41:10.120 | But they can be, so I would say in equities,

00:41:14.560 | the carry strategy would be using dividend yield

00:41:16.920 | or a broader payout yield metric

00:41:19.160 | to favor certain stocks over others.

00:41:22.440 | But then if you think of some other asset contexts,

00:41:26.000 | the most famous carry strategy perhaps is currency carry.

00:41:29.840 | And then basically, currency carry strategy

00:41:32.240 | of favoring high-yielding currencies

00:41:35.000 | is very different than currency value strategy,

00:41:38.320 | where you look for currencies that look cheap

00:41:41.040 | based on purchasing power parity.

00:41:43.080 | - It's strictly a yield concept,

00:41:45.760 | buy the high yield, sell the low yield.

00:41:48.080 | - Yes.

00:41:48.920 | - And it could be across any asset class.

00:41:50.720 | So this is what carry means.

00:41:53.400 | Okay, but it is long/short.

00:41:55.120 | I mean, it's not just long only.

00:41:57.240 | - Yes, can be both again.

00:41:59.560 | You can do long only favoring high dividend yielders.

00:42:03.280 | It's not a great strategy,

00:42:04.280 | but it's a mildly positive share price strategy.

00:42:07.160 | - The next area is what's called illiquidity premia.

00:42:11.160 | And here can be divided up into the three major categories,

00:42:15.440 | which is real estate, private equity,

00:42:19.160 | and then private loans or private credit.

00:42:22.600 | Let's start out with real estate.

00:42:23.600 | A lot of people just own a home,

00:42:25.360 | or they have rental property,

00:42:27.080 | or they buy a REIT fund.

00:42:29.080 | - Sure.

00:42:29.920 | Well, first, people may extrapolate too much

00:42:32.800 | when you look at real estate prices in recent decades.

00:42:36.520 | I think with these illiquid assets,

00:42:38.600 | it's also helpful to take this dividend discount model idea

00:42:41.320 | that you ask what's the expected return

00:42:44.200 | through expected yield, expected real growth,

00:42:48.320 | and maybe expected change in valuation.

00:42:50.720 | Empirical evidence suggests that with real estate,

00:42:55.000 | you pretty much get the yield.

00:42:56.640 | So you shouldn't expect changing valuations.

00:43:00.440 | And the real growth,

00:43:02.000 | you can debate whether it's been positive or negative

00:43:04.840 | in the long run.

00:43:05.680 | And I think zero is a very reasonable number.

00:43:08.000 | So I would say basically,

00:43:09.160 | think that you are going to earn your yield.

00:43:12.160 | And the relevant yield for real estate

00:43:16.200 | is basically something like free cash flow yield.

00:43:18.160 | So if you are thinking of a bigger number,

00:43:20.080 | like rent to price ratio, rental yield,

00:43:22.560 | that's sort of too high

00:43:23.640 | because you have to subtract expenses,

00:43:25.880 | which is often one third of that.

00:43:27.800 | So my reading is if there's 4% rental yield nowadays,

00:43:32.400 | then you get something like 2.5% expected real return.

00:43:35.840 | More than bonds, but less than equities.

00:43:38.480 | And the intuition is that you don't get any real growth.

00:43:41.320 | - And give me your views on REITs.

00:43:43.880 | - Sure.

00:43:44.800 | Lots of thinking about illiquidity premium,

00:43:46.920 | because like I sometimes say,

00:43:48.240 | illiquidity premium are overrated.

00:43:50.560 | And one intuition just is that

00:43:52.640 | people really like the smoothing feature,

00:43:55.360 | that it's sort of painful to lock your money for a long time,

00:43:58.680 | but it's really nice to get the lack of mark to market.

00:44:00.960 | And those two features could offset each other.

00:44:03.280 | And so one place where you can measure

00:44:05.520 | illiquidity premium arguably pretty well

00:44:08.240 | is in the real estate,

00:44:09.520 | where you compare listed REITs to direct real estate,

00:44:14.360 | which is much less liquid.

00:44:16.040 | And it turns out that

00:44:17.000 | when you look at this pretty long history,

00:44:18.760 | we've got 45 years of data in the US,

00:44:21.120 | we find that actually

00:44:22.560 | there's been inverse illiquidity premium.

00:44:25.040 | REITs have outperformed.

00:44:27.160 | And then the counter argument will be that

00:44:29.200 | they are not really comparable,

00:44:30.520 | that REITs have got lots of beta and leverage.

00:44:33.480 | And it's true that when researchers have adjusted

00:44:36.000 | for those beta and leverage differences,

00:44:38.400 | you get some of that negative illiquidity premium away,

00:44:41.520 | but you never get a positive illiquidity premium

00:44:44.280 | in any analysis that I've seen.

00:44:45.960 | So again, the evidence is very modest

00:44:48.560 | on the idea that there are great illiquidity premium

00:44:50.920 | in private assets.

00:44:52.320 | - That's very interesting.

00:44:53.480 | And the other two,

00:44:54.320 | which I don't really want to spend that much time on

00:44:55.840 | is private equity and private credit.

00:44:58.720 | Most individual investors

00:45:00.040 | really don't have access to good private equity.

00:45:02.440 | - They are recently,

00:45:03.400 | they are sort of institutional favorites,

00:45:06.360 | but I think that institutions

00:45:07.800 | tend to be over-optimistic on them.

00:45:09.600 | And partly they really like the smoothing feature,

00:45:12.320 | but also I think they have got higher expectations.

00:45:14.800 | So I think because of this growing investor interest

00:45:19.800 | in that space,

00:45:21.160 | I think even if there was an extra return,

00:45:25.720 | I think much of that has been beat down.

00:45:28.360 | And again, another logic is that the smoothing

00:45:31.520 | has taken it down.

00:45:32.560 | So I think it's a pretty reasonable thing to think that

00:45:36.880 | you get pretty similar returns from private equity

00:45:40.360 | as public equity after all fees,

00:45:42.600 | which are much higher in private equity.

00:45:44.640 | And likewise, private credit versus public credit,

00:45:48.320 | net returns could be very similar on both sides.

00:45:51.400 | So I don't think investors are missing much

00:45:54.600 | by not having access to this,

00:45:56.320 | but there are lots of dream sellers out there

00:45:58.160 | who tell a different story.

00:45:59.680 | - Well, let's talk about the active managers and alpha,

00:46:05.280 | which is the fourth category that you have.

00:46:08.160 | And there we've got managers that are trying to pick stocks,

00:46:14.520 | not systematic, but trying to pick stocks.

00:46:16.560 | And talk about alpha, alpha decay,

00:46:21.560 | should investors be seeking alpha?

00:46:25.360 | - Yeah, I mean, that's the holy grail,

00:46:28.320 | which is so lovely, but so elusive.

00:46:31.480 | And I think it's good to be realistic about it

00:46:35.280 | and expect very little on that.

00:46:38.080 | Obviously there's a lot of marketing for it.

00:46:40.280 | And there is, to be clear,

00:46:42.000 | there is some evidence, mutual fund evidence

00:46:45.400 | is not good on managers generally

00:46:48.080 | providing net positive alpha.

00:46:50.400 | But institutional managers, hedge funds, private equity

00:46:53.440 | may have collectively outperformed.

00:46:55.160 | But that's again, it has come down.

00:46:57.760 | You mentioned this concept of alpha decay,

00:47:00.080 | that evidence from more recent data is questioning

00:47:04.520 | even that whether there has been net outperformance.

00:47:07.800 | Obviously some managers will outperform

00:47:10.080 | and then you can question whether it's been luck

00:47:11.800 | or skill and so on.

00:47:12.760 | And this is one of these eternal debates.

00:47:16.040 | And yet it is interesting that so many investors

00:47:20.040 | still like to do either own active investing

00:47:22.320 | or traditional active managers and pay decent fees.

00:47:26.360 | And that is somehow telling of the both marketing success

00:47:29.680 | and overconfidence that we have.

00:47:31.720 | - So that's the technical side of your book,

00:47:35.360 | but then you have a whole different side of the book.

00:47:38.120 | It had to do with behavior and being patient

00:47:42.320 | and sustaining a conviction.

00:47:44.840 | And so could you talk about why you wrote this side

00:47:48.040 | of the book and the main points

00:47:50.480 | on what you were trying to get across?

00:47:51.880 | - Yeah, I think if I have to pick one sort of bad habit

00:47:56.600 | from investors, it tends to be related to impatience.

00:48:00.240 | And you can also think the flip side of that

00:48:01.920 | can be chasing last three to five year returns

00:48:05.040 | and capitulating after three to five bad years.

00:48:07.520 | But basically statistical evidence

00:48:10.040 | after a few years is very weak.

00:48:12.120 | It could be that if somebody has got very good

00:48:15.280 | or very bad performance,

00:48:16.240 | it is more likely to be random luck

00:48:19.560 | than really sign of some wonderful skill.

00:48:22.960 | And so investors chasing those returns

00:48:26.160 | and being impatient after bad returns

00:48:28.520 | is a very costly tendency.

00:48:31.960 | And I try to then highlight the more specific

00:48:34.520 | what could be the costs.

00:48:35.560 | They include things like you may miss out

00:48:37.800 | on long run returns.

00:48:39.120 | Could be equity premium, could be any of these other premia

00:48:42.000 | where you get a disappointing draw

00:48:43.760 | and you leave that strategy.

00:48:45.600 | You will miss out on the long run premium.

00:48:47.680 | - Opportunity cost?

00:48:49.320 | - Yeah, yeah, yeah.

00:48:50.160 | So that's opportunity cost indeed.

00:48:52.320 | And then there's the actual cost

00:48:53.760 | of basically trading out of those positions

00:48:55.640 | and all kinds of friction from related trading.

00:49:00.080 | And then to the extent that there is something

00:49:03.160 | like three to five year mean reversion

00:49:05.400 | and to the extent that investors tend to chase returns

00:49:08.320 | just like at those frequencies,

00:49:10.520 | then that is particularly costly.

00:49:12.520 | So Cliff Asness, my boss has sometimes said

00:49:15.200 | that there is this unfortunate tendency of investors

00:49:18.720 | to act like momentum investors at the reversal horizons.

00:49:22.960 | So chasing three year returns,

00:49:24.800 | when you look at historical market data,

00:49:27.040 | there's a greater tendency to see mean reversion

00:49:29.400 | over three year horizons.

00:49:31.320 | So all of those possible costs are there.

00:49:34.200 | And so my goal then is to highlight the costs

00:49:37.840 | and then discuss ways if investors buy the idea

00:49:42.600 | that patience is good, it's a virtue,

00:49:45.240 | it will give better long run results,

00:49:47.440 | what kind of strategies you can use

00:49:49.960 | to make yourself more patient,

00:49:52.480 | cultivate personal or organizational patience.

00:49:56.120 | - So discipline tools is what you talked about.

00:49:58.560 | Education, review broadly and infrequently.

00:50:04.560 | Make a bigger organizational commitment.

00:50:07.000 | And I put in parentheses, the Bogleheads.

00:50:08.960 | In other words, just keep going to the Boglehead site

00:50:10.640 | to remind yourself.

00:50:11.720 | Move slowly into new ideas.

00:50:15.320 | Avoid complexity.

00:50:17.160 | And a few others as well.

00:50:18.880 | - Yeah, yeah.

00:50:19.920 | And I think anything that enhances patience

00:50:22.520 | tends to be good.

00:50:23.360 | So equities are forgiven a bad decade

00:50:27.080 | or at least a bad few years.

00:50:28.920 | Nothing else will stay in investor portfolios

00:50:32.360 | with such a long disappointing period.

00:50:34.240 | So the conviction that investors have

00:50:36.720 | because of the evidence and theories

00:50:39.200 | on equity premia are helpful.

00:50:40.720 | And I think just the mere conventionality.

00:50:42.960 | People are so used to it.

00:50:44.080 | So that is great.

00:50:45.080 | I would, you know, I'm cautious about illiquids,

00:50:48.480 | but I would say smoothing makes people more patient.

00:50:52.520 | With styles, diversification can help.

00:50:54.560 | But in general, I confess that with the things

00:50:56.840 | that I love the most, some of the style premia,

00:50:59.160 | the unconventionality makes challenging

00:51:02.120 | from patient's perspective.

00:51:03.960 | - You talked about just doing simple rebalancing

00:51:07.520 | versus doing tactical market timing.

00:51:09.840 | Could you just touch on that?

00:51:11.600 | - Yeah.

00:51:12.480 | Well, so rebalancing really tries to stick

00:51:15.920 | with some long run targets.

00:51:18.800 | So market timing, especially contrarian timing,

00:51:21.560 | I sometimes say is a proactively contrarian strategy.

00:51:25.280 | If markets fall and become cheap,

00:51:27.320 | you wanna buy more than normally.

00:51:29.320 | Whereas with rebalancing, you are sort of

00:51:32.080 | defensively contrarian.

00:51:33.440 | You just wanna get back to your target weights.

00:51:35.840 | So I think the key idea with rebalancing

00:51:38.000 | is that you've got some idea

00:51:39.920 | of what's a good long run portfolio for you,

00:51:42.240 | asset class weights or risk targets,

00:51:45.560 | and you wanna basically stick relatively near to those

00:51:49.280 | and you rebalance back towards those targets.

00:51:51.720 | And that's good for keeping the risk level that you like

00:51:55.760 | and maintaining diversification.

00:51:58.000 | And then there might be some extra return enhancement

00:52:01.760 | that comes either from the kind of thing

00:52:04.440 | I mentioned earlier there with commodities,

00:52:07.440 | is reducing portfolio volatility

00:52:09.720 | that can help to some extent,

00:52:11.720 | but especially if there are some mean reversion patterns

00:52:14.600 | that you could catch that would be icing on the cake.

00:52:17.760 | - In your last chapter, one of the last chapters, 17,

00:52:21.560 | you talked about good and bad habits of investors

00:52:25.680 | and the bad habits are selling losers and buying the winners,

00:52:29.400 | over extrapolation, meaning just too much complexity.

00:52:34.280 | I call it mood trading where,

00:52:36.000 | hey, I think this is good, let's buy this.

00:52:37.600 | Or I think this is bad, let's buy that.

00:52:39.320 | Overconfidence in your ability.

00:52:42.000 | And these are the bad habits that people have.

00:52:44.520 | Good habits is a discipline

00:52:46.560 | and be very thoughtful about your asset allocation decision.

00:52:50.800 | And don't take too much or too little risk

00:52:53.880 | in various asset classes.

00:52:55.800 | And invest strategically and keep your costs down.

00:52:59.320 | Do you have any more you'd like to add

00:53:00.560 | to the good and bad habits?

00:53:03.120 | - That is the key list.

00:53:04.240 | And again, the first one I said is related is impatience.

00:53:07.760 | So sort of multi-year return chasing,

00:53:09.480 | I sometimes call the premier bad habit.

00:53:11.640 | And maybe overconfidence,

00:53:13.480 | I think the important implication of that is over trading.

00:53:17.240 | And that of course has been historically quite costly.

00:53:20.320 | And maybe I do mention something beyond this.

00:53:23.280 | I tell a few times in the book,

00:53:25.960 | okay, I'm envious towards various,

00:53:28.800 | I don't know, discretionary investors and other,

00:53:31.440 | well, active managers who have got great stories,

00:53:34.200 | whether it's a stock picker or macro.

00:53:35.920 | And I think when I'm a systematic investor

00:53:37.760 | and I've got this factor investing diversification,

00:53:40.440 | they don't lend themselves well to great stories.

00:53:45.440 | So then I say that, at some point I say that,

00:53:49.240 | actually, it could be that stories are really bad

00:53:52.960 | but they cater to some biases that we have.

00:53:55.680 | Like they cater certainly to our hindsight bias.

00:53:58.360 | They make future seem more predictable than it is.

00:54:01.320 | And another concept is so-called base rate neglect.

00:54:04.960 | So we think too much of the salient cases

00:54:07.440 | rather than apply probabilistic thinking.

00:54:10.160 | So really, I think stories,

00:54:12.480 | while they are humanly so important,

00:54:16.600 | they also can be reasons for some bad investment practices.

00:54:20.840 | And so, I'm trying to defend this kind of

00:54:25.160 | quanti-statistically-oriented mindset

00:54:29.880 | and claim that there are some advantages.

00:54:32.800 | - Let's hold on.

00:54:33.640 | I mean, you also have your stories, right?

00:54:35.080 | I mean, every DFA advisor out there is saying,

00:54:37.800 | "We have Nobel Prize-winning economists

00:54:41.480 | giving us our information."

00:54:43.800 | I mean, so they have their stories too, Andi.

00:54:46.200 | - Yeah, but the stories tend to be,

00:54:47.840 | let's say that they, well, by the way,

00:54:49.640 | of course I believe in more of these stories,

00:54:51.360 | but they are maybe more boring and abstract.

00:54:54.480 | And we rarely have a colorful story to tell.

00:54:57.720 | - Well, Cliff Asness wrote the foreword on the book

00:55:00.160 | and he reiterated something that you wrote in the book,

00:55:02.960 | which is, "Investors really have three options

00:55:07.560 | for dealing with this low expected return."

00:55:11.960 | He came up with these three things.

00:55:13.600 | And number one, he said, "You could take more risk."

00:55:17.000 | Basically, you take more equity risk.

00:55:19.360 | And which means you have to deal with more volatility.

00:55:22.840 | That is one way in which you can increase

00:55:24.800 | your expected return.

00:55:26.520 | So instead of doing 60/40, you do 70/30 or 80/20,

00:55:30.800 | but knowing that you're going to be having more risk,

00:55:34.520 | more volatility.

00:55:35.440 | So that's one thing.

00:55:37.320 | Secondly, he said, "You could incorporate

00:55:40.280 | other sources of return, such as style premium,

00:55:45.280 | multi-factor model, multi-factor fund of some sort."

00:55:48.880 | Which is what you had suggested.

00:55:51.160 | And then he said, "The third thing is,

00:55:52.840 | you could do the John Bogle argument,

00:55:55.000 | which is stay the course, write it out,

00:55:58.400 | accept the lower return, no matter what."

00:56:00.600 | But I'll also add to that,

00:56:01.840 | something that you put in the book,

00:56:03.400 | it also means you need to save more money.

00:56:06.320 | Because according to your data,

00:56:08.120 | since the expected returns have fallen,

00:56:10.820 | people actually need to save more.

00:56:14.440 | And in fact, the data that you had in your book

00:56:16.400 | was that instead of saving 10% per year,

00:56:19.920 | you really need to try to save 20% per year.

00:56:22.280 | So comment on all that, please.

00:56:25.000 | - Yeah, yeah, no, it's a good summary.

00:56:28.320 | And I would say that most investors

00:56:32.080 | have apparently taken a take more risk approach,

00:56:35.120 | and it can be more equity.

00:56:36.160 | So then they go private equity

00:56:37.760 | with a smoothing advantage and so on.

00:56:39.600 | So that I think is, and that somehow I found

00:56:43.800 | from historical data that it is so common

00:56:46.320 | when expected returns fall,

00:56:47.600 | investors are used to earning what they,

00:56:50.560 | they wanna keep earning what they are used to.

00:56:52.520 | And then they adjust their portfolios

00:56:54.920 | and that could end in tears.

00:56:57.800 | I like more the diversification story,

00:56:59.880 | but I also, I do like the last story,

00:57:01.640 | this Jack Bogle idea.

00:57:03.040 | Just humbly accept that markets are now offering less

00:57:06.080 | and let's just do the best we can in that situation.

00:57:09.040 | - Antti, thank you so much

00:57:10.160 | for coming on "Bogleheads Uninvested,"

00:57:11.640 | and we greatly appreciate your insight.

00:57:13.960 | Really love the work that you're doing.

00:57:15.960 | And keep on writing, it's very interesting stuff.

00:57:18.200 | - Thanks Rick, very enjoyable conversation.

00:57:21.040 | - This concludes this edition of "Bogleheads Uninvesting."

00:57:23.960 | Join us each month as we interview a new guest.

00:57:26.880 | In the meantime, visit boglecenter.net, bogleheads.org,

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00:57:41.520 | Join one of your local "Bogleheads" chapters

00:57:44.400 | and get others to join.

00:57:45.760 | Thanks for listening.

00:57:46.920 | (upbeat music)

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Bogleheads® on Investing Podcast 049: Antti Ilmanen on investing amid low expected returns

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