AgPa #53: Investing in Interesting Times

Investing in Interesting Times (2023)
Annti Ilmanen
The Journal of Portfolio Management Multi-Asset Special Issue 2023, URL/AQR

Almost exactly one year ago, Antti Ilmanen (Partner at AQR Capital Management) released his outstanding book Investing Amid Low Expected Returns: Making the Most When Markets Offer the Least. The book is (in my opinion) a must-read and the timing couldn’t have been better. Many of the key themes began to materialize in 2022. Given how much markets have changed since then, Antti released a few updates for six of his major ideas in this week’s AGNOSTIC Paper.

Everything that follows is only my summary of the original paper. So unless indicated otherwise, all tables and charts belong to the authors of the paper and I am just quoting them. The authors deserve full credit for creating this material, so please always cite the original source.

Setup and Idea

The main takeaway of the book is quite simple. Because of ultra-low or even negative interest rates at the end of 2021, virtually all assets were expensive. This is not surprising because the theoretical value of any asset is the sum of the discounted cash flows over its lifetime. Naturally, risk-free interest rates are a component of discount rates and therefore affect asset values. All else equal, lower risk-free rates lead to lower discount rates and the same future cash flow becomes more valuable today.

Unfortunately, present value mathematics work in both directions. You can invest in the world’s best stocks, but when the risk-free rate rises by 236bp (as it did in 2022) their value will fall.1Once again, this is of course an “all else equal” statement… In his book, Antti therefore made the case of a low expected return challenge. In English, investors that started in late 2021 were quite unlucky because they bought expensive assets. In fashion of good research, Antti also provides solutions for this challenge and advices investors to step outside their comfort zone, increase diversification, and add alternative components like long-short strategies to their portfolios.2The commercial interests of AQR of course also play a role here. But the book is entirely evidence-based (as are the strategies of AQR).

Data and Methodology

The paper is a collection of broader investment themes and there is no particular Data and Methodology to discuss at this point.

Important Results and Takeaways

To his credit, many of the key ideas in Antti’s book began to materialize in 2022 and in this week’s paper he explains where we stand one year later. Specifically he groups the most important points into six major themes. Note that I skipped the section on the Value factor because I have already written about it in quite some detail.

  • The low expected return challenge
  • Investors’ response to low expected returns – private markets
  • What happened in 2022 and where we stand now
  • Long-only versus long-short strategies
  • Downside protection via trend following

The low expected return challenge

The more you pay for an asset, the lower your expected return going forward. Buying a house that generates $20,000 rent per year is more attractive at a price of $300,000 than at $400,000. This simple relation applies to all cashflow-producing assets. By the end of 2021, ultra-low interest rates made virtually all assets very expensive and forced investors to pay a lot for future cash flows. The result, as the chart below shows, were expected returns as low as never before in 120 years of history.

Exhibit 1 of Ilmanen (2023).

The chart also shows that the situation was much more severe for bonds than for equities. By the end of 2021, AQR still expected equities to earn about 4% over inflation. This is lower than the historic average but still okay. Bonds, in contrast, were so expensive that the long-term expected return over inflation was actually negative. Think about that for a moment. You buy a bond and expect to destroy purchasing-power over your investment horizon. That’s pretty crazy… Unsurprisingly, the popular 60/40 portfolio of equities and bonds therefore also had its lowest expected return in more than 120 years of history by the end of 2021.

The key takeaway from this chart is that the last two decades and in particular the years since the financial crisis 2008/09 were quite special. Rock-bottom interest rates fueled asset prices and expected returns became lower and lower. While continuous richening of asset valuations lead to very strong realized returns in this period, the pattern finally reversed in 2022.

Investors’ response to low expected returns – private markets

What can we do if all assets offer low expected returns? The first option is to accept it and simply save more. Not very appealing. The second and more common approach among institutional investors was therefore to take more risk. Higher equity allocations, more credit risk within fixed income, alternative risk premiums, hedge funds, and most importantly, private markets. Especially over the last 3-5 years, illiquid private assets experienced tremendous inflows.

For institutional investors, there are two key arguments for investing in private markets. First, the idea of an illiquidity premium. Second, potential advantages from a lack of mark-to-market pricing. According to the author, both are currently poised for disappointment. The theoretical idea of an illiquidity premium is of course plausible, but the other desirable features of private assets could eventually turn this premium into a discount. And while a lack of mark-to-market accounting indeed helps institutional investor to bring their portfolio allocations better through time and may even prevent some psychological biases, it is still a denial of reality.3Cliff Asness coined the term “volatility laundering” for that…

While the debate often gets polarized, the author calls for sanity. Private assets are useful for investors and play an important role in the economy. Even more importantly, allocations to private markets worked out very well for many institutions. Going forward, however, the author stresses that investors shouldn’t expect the same outstanding results as over the last years.

What happened in 2022 and where we stand now

Due to accelerating inflation and turbo-charged by the global shock of the Ukraine war, interest rates increased strongly in 2022. In fact, the magnitude was truly striking and in most developed countries long-term risk-free rates increased by more than 200 basis points.

As we have all experienced, that lead to severe losses in virtually all asset classes except energy stocks and commodities.4And private markets funds which have decided to not yet report the lower prices of their holdings… From all its particularities, this was the most differentiating feature of 2022. Multi-asset diversification simply didn’t work because the common element of all assets’ discount rates, long-term risk-free rates, increased sharply.

I don’t want to engage in forecasts about what happens next and whether the current (I am writing this in March 2023) positive perception of the market is appropriate. Instead, let me highlight a few plausible consequences from the paper.

First and most importantly, bear markets are a great time to invest for young savers. In fact, the chart above shows that the long-term expected real return of the 60/40 portfolio doubled from 1.3% at the end of 2021 to 2.6% after last year’s pain. Second, although 2022 was painful, some asset classes are still not cheap given the new interest environment. As I mentioned above, I don’t want to engage in forecasts and I am not willing to bet against the stock market right now. However, I think the author is right when he urges us to lower our expectations and rather let us surprise on the upside than the downside. Fortunately, he also explains that a mean reversion to the higher interests before the 1980s seems unlikely. The main reasons for that are the lasting savings glut of pension savers and the very rich.

Long-only versus long-short strategies

Given that Antti works at AQR Capital Management, we need to discount the following results a little bit but many of them are simply empirical evidence. If risk-free interest rates increase, there are no places to hide for long-only investors.5Except you correctly betted on energy stocks and/or commodities. Even if you picked the best stocks, you can lose money because of an increasing discount rate. This is not the case for well-constructed long-short strategies.

For example, the Value factor should make money from the fact that cheap stocks tend to outperform expensive ones. As long as this pattern holds, the market risk cancels out and those strategies can still make money. Of course, this comes at the cost of more complexity and unconventionality. In addition to that, diversifying into well-constructed and affordable long-short strategies is also not possible for most non-institutional investors. But the general idea to look for other sources of long-term returns than just the long-only equity risk premium is a good one.

Downside protection via trend-following

Another defining feature of markets during the post-GFC period was, until recently, relatively low volatility. With the exception of COVID in March 2020, there were few crashes and drawdowns usually recovered very fast. In an environment of higher interest rates and (maybe) without the support from central banks, this may change. The relevance of downside protection thus increases.

The author compares several risk-mitigating strategies (trend-following, put options, treasuries, gold, and long-short quality stocks), but particularly highlights trend-following because of its “dual mandate”. Many risk-mitigating strategies, especially put options, work like insurance contracts. As we all know, we usually don’t get paid for buying insurance. Put strategies, gold, and treasuries therefore tend to have low or even negative expected return over the long-term. This is fine because, just like an insurance, they (usually) pay-off in really bad crashes.

Trend-following is different. By construction, trend strategies won’t help in short crashes like March 2020. There is simply no trend to follow when the market suddenly crashes within a few days. However, trend-following does help in prolonged bear markets like 2022. If prices fall for a longer period (and continue to do so), trend-followers eventually go short and make money. The second attractive feature is that at least historically, trend-strategies earned a modest positive return over the long-term. So you get insurance in prolonged bear markets (but not crashes!) and probably make a small return over the long-term. That‘s the dual mandate.

The author explains that investors must decide which type of pain is more relevant for them and choose the appropriate protection. For short-term crashes, you need put options, treasuries, or gold. For longer bear markets, trend-following is probably better. In particular, trend-strategies should be a very good hedge for private assets because due to their lack of mark-to-market accounting, the latter usually don’t crash but decline gradually over time.

Conclusions and Further Ideas

The paper delivers on its name. Those are indeed Interesting Times to invest and (as always) there are several challenged remaining. In my opinion, this paper and Antti‘s book from last year provide a helpful and solely evidence-based framework to better navigate through these interesting times. I don’t say we need to do everything Antti says, but I think it is at least worth listening to him. And some of his empirical facts are of course hard to deny…

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1 Once again, this is of course an “all else equal” statement…
2 The commercial interests of AQR of course also play a role here. But the book is entirely evidence-based (as are the strategies of AQR).
3 Cliff Asness coined the term “volatility laundering” for that…
4 And private markets funds which have decided to not yet report the lower prices of their holdings…
5 Except you correctly betted on energy stocks and/or commodities.