The problem of low returns
Global equity markets have proved to be remarkably resilient in recent weeks in the face of higher inflation, increases in interest rates and the economic disruption caused by Russia’s invasion of Ukraine.
But investors still face a long-term problem, as explained by Antti Ilmanen of quant-based investment firm AQR Capital Management in his new book Investing Amid Low Expected Returns. Investors have enjoyed strong realised returns because of falling yields across asset classes that have translated into significant capital gains. But yields cannot fall forever (indeed, bond and cash yields have started to rise). From these starting yield levels, real returns are likely to be low.
In the case of US equities, Ilmanen says that a simple dividend discount model suggests expected annual real returns of 3.2 per cent. That translates into about 5.5 per cent in nominal terms. That is a big problem for US public sector pension plans, which are counting on 7 per cent nominal returns from their portfolios (that usually include low-yielding assets such as bonds as well) to fund retirement benefits.
The reaction of many investors to prospective low returns is to shift towards “alternative” assets such as private equity, which they hope can perform better. But Ilmanen is cautious. Some of these alternatives focus on illiquid assets. Because such assets are not marked-to-market, their returns look smoother, which may understate their risks.
Competition among private equity firms also means higher initial valuations when businesses are acquired and thus lower expected returns. Indeed, Ilmanen says that the private equity industry has been hard-pressed to deliver any net outperformance over public equities in fund vintages since 2006.
Instead, Ilmanen focuses on styles, or factors, which have been shown to deliver better risk-adjusted returns. Take for example, “low beta” stocks that are less correlated with the overall equity market. Under the widely-accepted capital asset pricing model, such stocks should deliver lower returns than the market average. In real life, low-beta shares offer higher returns than theory would suggest and by using leverage, or borrowed money, low-beta stocks can earn higher returns with less risk.
Better-known approaches include momentum trading, buying assets that have recently risen in price, and the carry trade, borrowing in a low-yielding currency and investing the proceeds in a higher-yielding asset. The same effect can be achieved by shorting the low-yielding asset, selling an asset with the hope of buying it back at a lower price.
These strategies can work in the long-run but are prone to sudden reversals, with sharp losses for investors. These losses are even more painful if the investors have used borrowed money.
The drawbacks are clear with one of the best-known strategies — value. This involves the belief that companies that look cheap on one or more valuation measure are set to rebound. Ilmanen looks at a specific version of this approach: buying stocks that are cheap, relative to their asset values, and shorting stocks that are dear. This worked terribly in the period between 2007 and 2020, with the cumulative loss at the worst point being 63 per cent.
Investors would have to be incredibly patient to continue with such strategies. Clearly, the use of leverage or shorting makes these approaches available only to the most sophisticated. Everyone else would have to rely on a professional fund manager to do it for them. But that depends on an investor being able to choose a manager who can select the right strategy, carry it out efficiently and charge a fee that does not eliminate all the gains from the approach. The book quotes Cliff Asness, AQR’s boss, as saying that “no investment product is so good that high enough fees cannot make it a bad investment”.
Doubtless, some of these anomalies will continue to be exploited by the sophisticated investors at whom Ilmanen’s book is aimed. But that still leaves the investment industry with a problem in aggregate. Assuming average real returns are low, if cheap stocks do well then expensive stocks will perform very poorly. Someone must own the latter. Even if alternatives such as private equity or commodities perform well, those sectors are not big enough to absorb the world’s pensions, insurance and endowment savings.
Low returns mean that investors, from the humble private saver to the mightiest pension fund, will have to put more money aside if they want to achieve their targets. Or they will have to accept that they won’t achieve their goals at all.