Welcome, everyone, to the 49th edition of "Bogleheads on Investing." Today, our special guest is Antti Ilmenen. 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 Ferry, 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 12 through the 14, featuring many speakers that I've had on this podcast and more. Today, our special guest is Antti Ilmenen. 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 10 hours talking with Antti about all of 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 Ilmenen. Welcome to Bogleheads on Investing. Thanks, Rick. Looking forward to this. You've got quite a prestigious career, but maybe a lot of our listeners are 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? 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 caught the lucky break, and I met Ken French, who was teaching us in 1989.

And that basically gave me a, I would say, fast track window to come to 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. Wherever you meet your wife, your life has changed. 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, so then 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, converted into macro strategies, and was in macro hedge fund, Brevin Howard, then seven years, 2004 to '11, which was very interesting time. But it's a discretionary place, and I have got a pretty systematic heart. So it was sort of matter of time when I would join AQR.

Could you explain the difference between systematic and discretionary? 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.

So discretionary, I mean, Warren Buffett. 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, I would say. You did your PhD at the University of Chicago, and your dissertation advisors were both Gene Fama and Ken French, correct?

Yes, yeah. Source of pride, yes. 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. I had been advising some Swedish investors in my role, and I asked if they could help get the 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. What's it like to be in a room where somebody gets a Nobel Prize? So yeah, you are high up in the balcony, and it's very serious, serious but warm atmosphere there.

I think like 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 big event. That must have been a very unique experience to be there. Absolutely. 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 10 years ago.

And what was the reasoning for doing that book? 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 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, this 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 basically a 600-page book. - 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 is corporate bonds, and also you got into risk premia, like value, momentum, and so forth.

So talk a little bit about that, and then right after that, we'll get into, so what has changed? - 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 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 returns. 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.

- Then you call it an update of your book, kind of 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, and 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? - Yeah, yeah. Like you said, first, partly an update. I did feel like the world had changed somewhat and there was new research, but especially I had this feeling that this question on low expected returns on major investments is almost like a generational challenge that has been underappreciated, partly because realized returns have been quite benign.

So in some sense, a 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 years were falling, that at the same time basically gave, richened 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. Back in 1980, the 10-year treasury bond had a yield of about 16%. And 20 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 a 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. - Yeah, that's a 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 market's discount rate would be to look at the Shiller earnings yield.

So this is the inverse of the CAPE ratio. One can think of that as the discount rate for S&P 500. And that was basically 10% 40 years ago, and then it came down to 3%. 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 bonds, 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 premia. And when that common discount rate is so low as it became 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 of thinking of this is that while 40 years ago we were having high expected return but cheap valuations, now we have got low expected returns and high valuations.

Effectively, we have sort of borrowed returns from the future by pricing all these assets so expensively. - 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. - 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 get 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, et cetera. 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, friends, or whether we get a repricing, which now has happened in 2022, that I call the fast pain.

So I said sort of pretty, pretty unhappily told that we can sort of expect that it's gonna be either a slow pain or fast pain or some combination of those two. It turns out that we got 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. 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 gonna 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 gonna be sort of a slow bleeding?

Yeah, basically the starting yields, if you think of government bonds, real yields, they were sort of minus 1% 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 half a percent.

And both of them are a couple of percentage points away from long-run historical averages, 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. So my short-term view, and this is getting to the speculative punditry, is that the inflation problem is serious enough.

And that's gonna 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 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.

- I wanna talk about the risk-free rate, which is called the Treasury Bill, which all of these valuation models and equations stem from what is the risk-free rate, T-bills. And historically, globally, not just the U.S., but globally, the T-bill rate has basically been the inflation rate. Now, that 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 up, 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? - Yeah, yeah, and so it is. So one maybe detail is 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 3% or so. - So let's then move to equities. So equities have an expected real risk premium over the risk-free rate. Historically, in the U.S., it's been higher than it has globally.

Globally, it's been about 5%, but in the U.S., it's been higher, over 6%. This is compounded. Can we reasonably expect globally that it should continue to be 5%? - 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 U.S., a little above that. Outside the U.S., and then you can add the expected inflation on top of that to get the total return estimate. - Fair enough. I want to get into the components of the real return 4%. That can be broken down to a real growth rate of earnings per share, and then dividends.

Ko, you break that down, and then for coming up with your number. - 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 we 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, like 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 are the components. - How does that all work into a global GDP growth?

- Equity market returns. So they are 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 highlight 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 participation in the real economy.

- 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? - 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 it is true. But certainly when equity markets are predicting next year recession, then you have got low returns.

So yeah, I think that correlation becomes when you take, not looking at monthly returns, but you 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. - So the real expected return of equity using the simple model of a 2% dividend yield or earning, 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 gonna use the Fed's inflation number of 2%, then you're at about a 6% nominal long-term expected return for equity.

This a reasonable number to plan for? - Good numbers, yeah. Yeah, I think so. I think 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.

- So that's one side of the equation, right? We're talking about a 60/40 portfolio, a 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 we have agreed that T-bills in the U.S. have yielded a little bit more than inflation, but let's say going forward that T-bills are gonna give us inflation.

So now inflation plus something for treasury bonds, for longer-term, say, 10-year treasuries. I mean, historically, what's it been, and what do you think it might be going forward? - Yeah, well, 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 over cash has been becoming, in some sense, stingier, and the intuition is that government bonds used to have a extra term premium, partly because of the high inflation uncertainty, sort of inflation risk premium, and that probably was beat 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 a 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 1%, maybe extra over cash.

So roughly that amount of real return on intermediate and 10-year bonds. - That's very interesting that it's come down. What about the Fed's balance sheet and the Fed letting these bonds roll off, and so there's gonna be more supply out there. I mean, wouldn't that have an effect of pushing up the yield, the real yield?

- Yeah, so besides the inflation risk premium, safe haven premium, we said supply-demand factors are the next thing, and that clearly was helpful during the time of quantitative easing, and now it's gonna give 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. - So we're looking at somewhere between a half a percent to 1%, perhaps, over the risk-free rate or over T-bills. - Yeah, yeah. - Realistically. I mean, you're gonna get paid something for taking turns.

- Exactly. - Not as much as it was. - Yes, and very short-term, there is this question, what happens with inflation, and if Fed has to be more aggressive because of that, and that may tell a more bearish story for the next couple of years. - So let's move on, then, to another premia 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 gonna 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. - 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 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? 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 two-handed economist that I don't have very black-and-white views, but so certainly, I did lean more positive, and the arguments why I leaned more positive on credits were partly just from having a strong decade, like after 2010, we had just seen a relatively bad decade for credits, and now we saw a strong decade, so that more importantly, I looked at some historical research of many decades back, which was telling a more positive story on credit performance and its sort of extra benefit you get beyond government bonds and equities.

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

So I would still lean mildly more positively, but you hear very weak views. - 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 this 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 that have any benefit potentially to a portfolio? - Yes, I think so. I mean, it is, it's 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 sales, 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 2010, so it has been very costly for investors to sell those fallen angels in this 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 sales, so by selling those fallen angels within the first month. - You're talking about investment grade credit spread by selling the fallen angels, they lose a lot of total credit spread.

- 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. - 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?

- 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 role effect in the long run historically, but the bigger part is so-called diversification return.

This is something that Farmer and Booth already discussed with equities in 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 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.

- I'm gonna push back a little bit here. - Please. - That is a trading strategy. That's not a premia on a asset class, correct? As you said, if you just bought the asset class and held it, buy and hold, basically, you get maybe the inflation rate, but what you're talking about is a-- - No, no.

- Okay, go ahead. - 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 wanna buy their pork bellies. - No, I understand.

You're doing one-month futures or something. - Yeah, but it is really the only thing you are doing here. You are rolling every month or quarter something. So it is none of the things that you, it is not momentum strategy, roll strategy. This part, that will be extra. This is saying that just by reducing portfolios volatility and the volatility drag, you are generating positive return.

It's a complicated thing. - 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. - It is, but it can be a very simple strategy. - That means you gotta pay somebody to do this. I mean, somebody, some active manager, some asset manager. 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, some extras carry and momentum type of strategies on top of that.

But if you want to keep it simple, it is very modest, modest cost. But it's true that it's not total buy and hold when you use futures. - Let's talk about gold for a second. You did talk about gold and your view on that was... - 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 ills. 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. - 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 in the risk premium. Now let's get into the second part of your book, style premium, things like value investing, momentum investing, quality investing, and then you have carry.

- 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. - This is long, short, or just long only? - And this can be both.

Any of these strategies can be applied as long only portfolios where you tilt a little more and 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 patients much more than equities if you have a bad window for these strategies.

- I think that most individual investors, if they're going to do style premium 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? - 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 active tilts 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. - Do you find that there's a higher value premium in small cap rather than large cap? - I think for many of these premia, we find that on paper, small segment is a better fishing pond, which is a 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.

- 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? - Well, I think when you said cheap and expensive, I would call that a 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 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 than currency value strategy, where you look for currencies that look cheap based on purchasing power parity.

- It's strictly a yield concept, buy the high yield, sell the low yield. - Yes. - And it could be across any asset class. So this is what carry means. Okay, but it is long/short. I mean, it's not just long only. - Yes, 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 share price strategy. - The next area is what's called illiquidity premia. And here can be divided up into the three major categories, which is 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. - Sure. Well, first, people may extrapolate too much when you look at real estate prices in recent decades. I think with these illiquid assets, 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. So you shouldn't expect changing valuations. And the real growth, you can debate whether it's been positive or negative in the long run. And I think zero is a very reasonable number. So I would say basically, think that you are going to earn your yield.

And the relevant yield for real estate is basically something like free cash flow yield. So if you are thinking of a bigger number, like rent to price ratio, rental yield, that's sort of too high because you have to subtract expenses, which is 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. - And give me your views on REITs. - Sure. Lots of thinking about illiquidity premium, because like I sometimes say, illiquidity premium 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 the 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 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 leverage 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 are great illiquidity premium in private assets. - That's very interesting. And the other two, which I don't really want to spend that much time on is private equity and private credit. Most individual investors really don't have access to good private equity.

- They are recently, they are 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. So 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. - 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, alpha decay, should investors be seeking alpha? - Yeah, I mean, that's 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 clear, there is some evidence, 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 that whether 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 own active investing or traditional active managers and pay decent fees. And that is somehow telling of the both marketing success and overconfidence that we have. - 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? - 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 the flip side of that can be chasing last three 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 very good or very bad performance, it is more likely to be random luck than really 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. 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. - Opportunity cost? - Yeah, yeah, yeah. So that's opportunity cost indeed. And then there's the actual cost of 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 the 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 give better long run results, what kind of strategies you can use to make yourself more patient, cultivate personal or organizational patience. - 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 Boglehead site to remind yourself. Move slowly into new ideas. Avoid complexity. And a few others as well. - 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 premia are helpful. And I think just the 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 makes challenging from patient's perspective.

- You talked about just doing simple rebalancing versus doing tactical market timing. Could you just touch on that? - 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 wanna buy more than normally.

Whereas with rebalancing, you are sort of defensively contrarian. You just wanna get back to your target weights. So I think the key idea with rebalancing is that you've got some idea of what's a good long run portfolio for you, asset class weights or risk targets, and you wanna 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 there 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.

- 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 just too much complexity. I 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. Good habits is a discipline 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.

Do you have any more you'd like to add to the good and bad habits? - That is the key list. And again, the first one I said is related is 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. So then I say that, at some point I say that, actually, it could be that stories are really bad but they cater to some biases that we have.

Like they cater certainly to our hindsight bias. They make future seem more predictable than it is. And another concept is so-called base rate neglect. So 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. - Let's hold on. I mean, 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, Andi.

- Yeah, but the stories tend to be, let's say that they, well, by the way, 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. - Well, Cliff Asness wrote the foreword 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 premium, 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, write 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.

- Yeah, yeah, no, it's a good summary. And I would say that most investors have apparently taken a take more risk approach, and it can be more equity. So then they go private equity with a smoothing advantage and so on. So that I think is, and that somehow I found from historical data that it is so common when expected returns fall, investors are used to earning what they, they wanna 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 I also, I do like the last story, this Jack Bogle idea. Just humbly accept that markets are now offering less and let's just do the best we can in that situation.

- Antti, thank you so much for coming on "Bogleheads Uninvested," and we greatly appreciate your insight. Really love the work that you're doing. And keep on writing, it's very interesting stuff. - Thanks Rick, very enjoyable conversation. - This concludes this edition of "Bogleheads Uninvesting." Join us each month as we interview a new guest.

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