The transcript from this week’s, MiB: Antti Ilmanen, Co-Head, Portfolio Solutions, AQR, is below.
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ANNOUNCER: This is Masters in Business with Barry Ritholtz on Bloomberg Radio.
BARRY RITHOLTZ; HOST; MASTERS IN BUSINESS: This week on the podcast, I have an extra special guest, Antti Ilmanen is AQR’s Co-head of the Portfolio Solutions Group. He is the author of a new book, “Investing Amid Low Expected Returns: Making the Most When the Markets Offer the Least.”
He has an incredible CV full of all sorts of awards and has worked at all sorts of places like Salomon Brothers and Brevan Howard before ending up at AQR. If you’re at all interested in value investing, factor investing, understanding how your starting condition leads to future returns that might be better or worse than historical averages, you’re going to find this to absolutely be a master class in investing. I found it absolutely fascinating and I think you will as well.
With no further ado, my conversation with AQR’s Antti Ilmanen. Welcome to Bloomberg.
ANTTI ILMANEN. CO-HEAD, AQR’S PORTFOLIO SOLUTIONS GROUP: Thanks, Barry. I’m really looking forward to this.
RITHOLTZ: Same here. So, first, I found the book to be quite fascinating, very in depth and you managed to take some of the more technical arcana and make it very understandable. We’ll circle back with that.
Let’s start just by talking about your career. You began as a central bank portfolio manager in Finland.
ILMANEN: Yes. My really first stroke of luck, I think, was getting that job. Before that, I had been nerdy kid with interesting esoteric things like royal family trees or track and field statistic trading. And when I was studying in university economics, I did not really get the passion. The passion came when I went to invest the country’s foreign exchange reserves there and it was very much global government bond markets.
So, thinking about macro picture. And then nor later I had, I don’t know, much interest then on single stock picking. So, thinking about the big picture. And there were some lovely, lovely things like I was there in October ’87 crash. I saw two-year yields falling in one overnight from 9.5% to 7.5%. You don’t see those movements anymore.
RITHOLTZ: That’s a giant move. Yes. Absolutely.
ILMANEN: Yes. Anyway, so that was a great learning experience. And then my second related stroke of luck was that Professor Ken French came there.
RITHOLTZ: Really? Dartmouth,
ILMANEN: Yes. He came to educate us in 1989 and teach us what we were doing, what we should be doing and I was just an enthusiastic kid there. Well, by that time, I was already almost 28 then. And he — when I was expressing some interest about studying in the U.S., he was saying, you should do it soon. He said, you’re old enough to do that. And a few months later, I was in the U.S. and it was so lucky in my life because there I met then Cliff Asness and John Liew who later founded AQR. So, as my fellow students, I met my wife there. She was MBA student from Germany and would have left a few months later.
RITHOLTZ: University of Chicago?
ILMANEN: University of Chicago. So, all of these lucks sort of was related to my wonderful first jobs.
RITHOLTZ: Right. And Gene Fama teaches there and his research partner is Ken French.
ILMANEN: Yes. Yes. Both Cliff — actually, all three, Cliff, John and I’m, we had Fama and French as our dissertation chairman and that’s a small source of pride.
RITHOLTZ: Right. Little intimidating. So, you go from Chicago, is that how you ended up at Salomon Brothers?
ILMANEN: Yes. So, that relationship actually already started when I was a portfolio manager, right? Finally, in a faction (ph) like one of these. Michael Lewis’ Liar’s Poker’s good guys was one of my sales contacts there.
ILMANEN: Yes. Yes. He didn’t have many good guys with one of us. Anyway, so — and I got to know people like Marty Leibowitz before I went to Chicago and I think he helped — he may have again had a hand somewhere there. And so, when I finished my studies, it was pretty clear that I wasn’t sort of up academic enough. I wanted to go to either buy side or sell side. I even talked to GSAM somewhere, Cliff and John were, didn’t go there.
I sort of thought from my ’80s experience that buy side is dusty. Wrong choice. Anyway, I then went to Salomon Brothers, did laundry search for a couple of years and yield curve strategies then moved to Europe, that was always a deal with my wife, to be a bond strategist at Salomon for many years. Initially, very discretionary but gradually becoming more and more systematic and eventually returned from this customer-oriented role to prop trading for a while.
RITHOLTZ: And then how did you end up with Brevan Howard.
ILMANEN: Yes. So, I think that from these times when I was strategist, I was talking to my — to great people like earlier on some LTCM and then various other people, including Allan who came actually from Salomon. And so, somewhere, all three sort of invited me to try to be a mini-Cliff, a very systematic trader with a small team there at Brevan Howard which was in some sense great but it is sort of misfit because it’s a very discretionary place.
ILMANEN: And so, trying to do systematic in that environment was harder and I think none of us were doing extremely well, none of us were doing extremely badly. But it just didn’t become a great success.
RITHOLTZ: Just not a great fit.
ILMANEN: Yes. Yes. Yes. But it was — on the other hand, it was just a great place, well, first to try it but the second thing is when 2008 came along, it was one of the few places that we’re making money. So, it was very comfortable vantage point for that environment.
RITHOLTZ: How did you go from being a Mini-Cliff Asness to maxi-Cliff Asness?
ILMANEN: Yes. So, I had stopped that systematic trading. What I had been talking with those guys often of possibly joining. It was a matter also of them opening Europe office because that’s where I was physically. And so, that was approaching. It also helped that I was — I basically decided to write this book “Expected Returns” and when I wrote it, they asked Cliff to write the foreword for it.
And by the way, like if you check sometime the first word he has there, like it was — I was sweating when I read that and it’s that by telling that, first time I met Antti, I thought he was insane and I was right. So, that was a little stressful but it turns out very nice.
But anyway, so that experience reminded, I think, both of us how aligned our thinking is based on this common background and that somehow, I think, motivated them to offer and me to say yes to the idea of joining them. Really, what I would think is getting to my natural home and that happened in 2011.
! So, you’ve been there for more than a decade. You’re now cohead of portfolio solutions. What is that role like? What you — what’s your day-to-day work like at AQR Capital?
ILMANEN: Yes. So, the Portfolio Solutions Group advises mainly institutional clients on all kinds of challenges that they have and thinking about the expected returns, portfolio construction, risk management, et cetera. And then in addition, we write lots of papers. I speak in many conferences.
And then in addition to that, I’ve had a hand in designing and improving some of our strategies especially related Style Premia that was something I was quite passionate about when I joined. And by now, I’m co-head, the guy who has collaborated very closely with me, Dan Villalon, has taken more and more over the day-to-day running of the thing and I took time to write the second book recently and now I’m talking about it. And I think with my age, I’m happy to sort of move to part-time status, I think.
RITHOLTZ: So, in the book, Cliff Asness, again, does the introduction and he says, you overshare a great characteristic for someone in research but he sometimes says he’s afraid you’re going to reveal the secret sauce. What — explain oversharing of financial research.
ILMANEN: Yes. So, this is — this is related to all of us having this University of Chicago experience where we were really taught the value of being open and putting your research out there for public scrutiny to improve it then to educate.
But, of course, there are possible downsides to that and that has been always a question. So, I’m not and we are not writing about all the proprietary strategies that we have but we are talking quite openly about some things like, again, style factor investing, alternative risk premia, things that are relatively widely known and I have this — I don’t know, yes, I’m sort of leaning that was of being too transparent than the — and then somebody may have to control me a little.
RITHOLTZ: So, let’s just talk a little bit about two of the key themes in the book. The first is alpha, it’s the holy grail but also elusive and costly. Explain.
ILMANEN: Alpha is something we all aspire for but in reality, the evidence is very limited that most investors can deliver alpha. Moreover, there’s a lot of is good resource by others who send us showing that much what people think is alpha, can be explained by either hedge funds running —
ILMANEN: Lots of equity correlation.
ILMANEN: More than correlation to these various styles that are not quite market beta but it’s certainly not pure alpha either. So, somehow, this type of demystifying, I think, is helpful. But it’s clear that investors tend to be managers and investors tend to be overconfident in their ability to find that elusive alpha.
RITHOLTZ: So, I’m glad you brought that up because there’s another bullet points in the last chapter of the book which strikes me — let me read it, quote, “Discipline, humility and patience as a key to investing success.” That sounds more like behavioral finance than factor investing.
ILMANEN: Yes. Yes. So, one other founder, David Kabiller, he’s always had this very good point that good investment results require good investment strategies and good investors. And so, we wrote the paper together almost a decade ago on bad habits and good practice and really thinking about those.
Certainly, it does definitely get to behavioral advices. In general, I think behavioral finance literature focuses way too much on how you can exploit other people’s mistakes as opposed to looking into mirror and reducing your own mistakes.
RITHOLTZ: Really quite interesting. So, let’s talk a little bit about some of the concepts about expected returns. You mentioned in the beginning of the book lower asset yields and richer asset prices have pulled forward future returns.
In other words, a lot of the gains we’ve seen in the 2010s, and I would guess ’21 and ’22, weren’t so much based on that multiple end of earnings but future multiples that were pulled forward into that time period. Explain that.
ILMANEN: It’s always good to think of starting yields and valuation sort of two sides of the same coin. So, starting yields of all major assets were coming down in the last decade and last decade — actually, several decades. So, something that I try to make investors see that they naturally think of this way also of expected returns with bonus. But when they think of equities or housing, they sort of look at the rearview mirror and think historical various returns. That can be distorted by this returning (ph) or cheapening quite a lot.
So, I think it’s helpful to think that all of these long-owned investments are priced by thinking of expected cash flows discounted by a common discount rate, riskless part, and some various asset specific premia. And now, when this common discount rate has been at all-time lows and was coming down for decades.
So, that was making everything expensive at the same time whatever happened to the expected cash flows and other premia. And so, that situation has gotten us to this sort of everything bubble some say and I think it’s — bubble is a bit wrong word there in the sense that there is a fundamental story behind it. The low real years that were influencing all kinds of investments.
RITHOLTZ: It makes a lot of sense. You wrote this book in 2021 or at least finished it in 2021 and you described in the book what you see as an, quote, “investment winter ahead.” I have to say that seems pretty pressing considering since you handed the book in to be published last year. Markets have pretty much done nothing but roll over and head south in 2022. Was this just lucky timing or were you little pressing in?
ILMANEN: I’ll put it largely to lucky timing. So, the story I was always saying that we know that we got these low expected returns give those slow starting yields and by the way, related to what you’re saying, I really like another statement. We borrowed returns from the future —
ILMANEN: — when we were — when we are capitalizing everything at those expensive levels.
RITHOLTZ: Makes sense.
ILMANEN: And so, that’s locked in low future returns, we just didn’t know whether that’s going to materialize through slow pain staying in this slow expected return world or fast pain cheapening. And so, then in the book, I was saying that I don’t really have a strong view on this one. But in conclusions, I did put there that it just seems that stars are aligning for some fast pain and it wasn’t just high valuations but there was a catalyst.
There was this — basically, the inflation problem was seemingly getting as close to the day when Fed finally has to make some hard choices. And so, that I got right but I would say that I was really lucky because I could have written in six months earlier. And in general, I’ve had other market timing calls. I’m not famous for being good at marketing. I don’t know anybody who is. There are no old gold market timers for most billionaire list.
RITHOLTZ: Right. There’s old and there’s old but there’s not both. Let’s talk a little bit about the pushback to low expected returns. Following the financial crisis and the Fed cutting rates, economy and the market starts recovering in late 2009 and then 2010 and we kept hearing from a lot of different value corners, hey, everything is richly priced.
Bonds are the most expensive. They’ve been in 30 years. Stocks are pricey. Lower your return expectations. But yet, the 2010s, so, returns and equities and bonds close to double historical averages. How do we explain why that advice took so long before it started to work?
ILMANEN: So, I think there is a fair risk that we — anybody who was talking like that is thought that’s the boy who cried wolf and losing credibility then by this time. And I think that would be sad because I think sometimes, it’s going to really work and this year really looks like it can be — can be that sometime.
And I felt always somewhat good that we were — at least we were not pushing for — we were not predicting mean reverting valuations that would have made things worse.
ILMANEN: We were saying let’s be really humble about any market timing use of this stuff but low starting yields do anchor expected returns lower. But it’s true that — and what we saw then in that decade that rich things can get richer and that’s going to take quite a long time.
And so, actually, my favorite quote is to think about what happened to S&P 500, the Shiller PE that went from mildly above historical average 20 to double and widely above average 40 in 10 years’ time and that type of thing gives you, well, basically seven percent annual returns prorated then. And so, that’s the key reason.
And something similar happened, real yields and bonds were already low. There were even lower rental yields on equities, credit spreads, anything you look at had basically tailwinds from these falling years and that re-pricing then gave high returns and that — there’s a danger that people then look at the rearview mirror and become complacent just at the wrong time.
RITHOLTZ: Right. So, let’s talk a little bit about that. How significant was the ultralow rates of the Federal Reserve to making all of these different asset classes richly valued and continuing to generate strong returns right up until the Fed started raising rates?
ILMANEN: So, I think — so short term, what happened this year was really there was a catalyst of inflation and Fed tightening but the long-term story was always about valuations. And the important thing, as I said, is related to this common part low real yields.
And should we blame Fed for that or should we blame somehow greedy investors? I’d buy more the stories that there was this fundamental effects, most important probably savings but excess savings coming from pension savers, also another story that when the wealthy were getting a bigger share of the pie, their savings rates are higher.
There are research on both transmits which explained why we’ve gotten this exceptional savings glut which was then pushing all assets yields lower and creating this. And Fed and investors were basically then responding to that situation rather than driving it.
RITHOLTZ: Now, we heard a lot about the savings plot from then Chairman Ben Bernanke in the early 2000s. Is this savings glut qualitatively different than what we saw two decades ago?
ILMANEN: Yes. It’s the same idea. So, always when you think of real yields, you think of, okay, there’s some — there’s either an issue with investments or savings and it’s a balance between those two. And he was highlighting that there probably is more coming from the saving side and then he was emphasizing that this is China and often emerging market foreign reserves.
Those types of excess savings were sort of the culprit for the conundrum in 2005 or whatever it was. And I think that story still has some legs but sort of the key culprit then became demographics and retirement savers and the latest story now is in the sort of the one percent.
RITHOLTZ: So, the flipside of that, if there’s a savings glut, meaning big uptick in demand for that paper, does that also suggest we have a dearth of high-quality sovereign paper of bonds issued by countries like the U.S. or the UK or is it just whatever the existing supply of paper is what it is and it’s the demand that has spiked?
ILMANEN: Yes. I think that demand has been driving things and, well, the supply has been there. Like there’s been plenty of supply as well to cater for it and really given the need for that to cover the public deficits that’s owned. But again, I think if one thinks of what sort of started this among fundamental forces, I choose to go with that savings glut. That’s my best reading of the literature.
RITHOLTZ: Makes some sense. So, you wrote the prior book a decade ago, 2011 the “Expected Returns.” In the decade between that book and this book, what have we all learned, what has the markets taught us, and how did you work that into the new book?
ILMANEN: Well, I like the — I like the basic framework still in the book but I think certainly, it was a terrible decade for all kinds of contrarian strategies and I have become even more humble. It’s sort of funny that I wrote my dissertation 40 years ago on duration timing and I talked about all kinds of market.
I mean, every decade, I become more humbled about the endeavor and yet, even as I told like in the — at the end of this latest book, I’m still mentioning stars are aligning and it might be. So, the temptation is there but I think we — the main point I want to say is I think what we should really try to think of investing as a strategic effort, good diversification as opposed to some great technical timing course (ph) that doesn’t do well.
So, I think that would be — and partly relearned through the difficulty of contrarian timing strategies. Then another thing which was very important in this decade was there was a growing interest in these diversifying return sources. But I think by now, the most popular one is related to illiquid investments whereas my favorites were then and are still now more liquid strategies, barrier style premia value investing trend following and so on and so.
RITHOLTZ: So, one of the interesting things you talked about in the book is that we continue to find more data not just the decade of data that went by but historical data or old data going back to the 1800s. I have to ask, where is this — do we call it ancient? Where is this 19th century data coming from and how can you apply it to investing in the 21st century?
ILMANEN: Yes. So, the first point is that we accrue out of sample new experience so slowly that it’s sort of painful to do that waiting and therefore, it is helpful supplementary source to get some old data source. Most early studies were done with data since 1960s to ’90s and then it was extended to beginning of CRSP data, 1926.
And now, we’ve had people going further back and I am — so I haven’t been one of those in the archives but I’m one of those looking at that data and studying it critically and seeing what we can learn from there mainly whether you get similar patterns. I do love it when I find that some strategies have worked persistently over different centuries pervasively across different countries and asset classes and robust with different specification.
So, that makes me more confident. But I do — I have recognized and that’s something I say in the book as well that when people see my 100 and 200 years of data there, some would just roll their eyes and —
RITHOLTZ: Why is that?
ILMANEN: Why do — why do I care about 200 years of data? I really cared about last three years with my old portfolio.
RITHOLTZ: Well, obviously, that’s a very specific samples that you want to go way beyond that but it raises — people rolling their eyes, raise the question, how reliable is that data, how accurate is it, can we have confidence that it’s been cleanly assembled? Because the technology of the 1800s little more manual than today.
ILMANEN: All fair. So, I would just — I’ll just say, well, first, I’ll say you just do the best you can.
ILMANEN: And I think — so, there’s some value in that data but the — there are data problems, there are investability questions even if the data we’re finding maybe liquid and do foreign diversification or something like that. Actually, before first — well, maybe you could, that was pretty international era.
And then there’s whole criticism that the world has structurally changed and that criticism has more bite the further back you go. So, I think for all these reasons, we should be skeptical but I still like it as a supplementary evidence not as main motivation for anything.
RITHOLTZ: So, you mentioned diversification earlier. In the last section of the book, you write an ode to diversification. Tell us about that.
ILMANEN: Sure. I do think — it’s a cliché but diversification is pretty close to a free lunch and it is a wonderful, wonderful aid to improving portfolios. I think it’s much easier to improve your risk-adjusted returns through good risk diversification than by getting somehow greater insights in one particular strategy.
And so, I write about it both — I do know, the simple maths about it how you can double shop ratios for uncorrelated strategies and then remind that it’s really difficult to find for uncorrelated strategies in long-only world. You may have to get to long-short world to take advantage of those types of opportunities.
And then the flipside of that, I am saying that diversification has got some critics of the diversification order or that diversification phase when most needed. And so, when I think — I can counter those to some extent. But I think there are challenges. Good risk diversification often then requires you to use some shorting and leverage and there are limits to how much people want to do that.
There’s unconventionality issues and then there’s this what we’ve highlighted in recent years that you sort of inherent, you lack stories. And so, it’s very sort of, I don’t know, math oriented or algebra-oriented type of thing as opposed to great stories which drive most investment passions.
RITHOLTZ: Right. Right. That makes a lot of sense. You mentioned free lunch. You talked about rebalancing arguably another free lunch. Tell us your thoughts on rebalancing.
ILMANEN: Yes. So, rebalancing, I think, is a way of ensuring that you can retain your risk targets and you can retain your diversification. So, I think of it primary years that there’s a follow-up question whether you can get better returns and then how you do it and so on and I talk a little. I think I wouldn’t be too strict on rebalancing. I think like one good idea is to be somewhat lazy with rebalancing strategy.
RITHOLTZ: So, that means one year?
ILMANEN: Yes. Something like that or maybe four times a year but part of the portfolio.
ILMANEN: So, you’re sort of averaging. You don’t get so dependent on when you did it during the year.
ILMANEN: So, that type of thing. But basically, if you are a little lazy or patient with rebalancing, let the near-term momentum play out then you might get closer to the time when there’s mean reversion advantages. So, you’re trying to play a little bit disadvantages that tend to be in the financial markets with momentum and mean reversion.
RITHOLTZ: So, let’s talk a little bit about low expected returns. We already talked about the impacts on Fed rates. What else goes into driving valuation factors that can lower future expected returns?
ILMANEN: It really depends on what horizon we talk about. So, monetary policy macro conditions are very important for short term but I think I’d like to focus and I do focus in the book mainly on long-term expected returns. And then it is —
RITHOLTZ: Long term being three, five, seven years?
ILMANEN: Five to 10 years, something like that. And, yes, it’s interesting, if you go even further then sort of valuations even don’t matter. So, everything gets diluted.
ILMANEN: And then you have to think about what some theoretical long-term return. But sort of for 10 years ahead then starting yields and valuations are essential and again — so, I think those are very helpful anchor for thinking about those returns even though you can get these very ugly forecasters like what happened in the last decade.
But when such a thing happens, then it pretty much stores problem for the future. So, last decade, as its reach on its adjustment, you’re going to have even more problems in those future returns. And I think the only way you can sort of solve the low-expected return problem here is — at least for risky assets is that they would be this much faster growth, this techno optimism that you hear in some quarters.
And there, I’d say, could be but we’ve had wonderful technological advances last hundred years and two percent real growth is pretty much as good as it gets.
RITHOLTZ: And that’s interesting thing because you talked in the book about very often mom-and-pop investors, individual investors, tend to confuse GDP growth with expected returns. Academically, we know there’s almost no correlation between the two, is there?
ILMANEN: It’s surprising that whether you look at over time in one country or you look at across countries, the relation is very modest and my favorite poster boy in that one is China, which had this 30 years of very fast GDP growth.
RITHOLTZ: Massive. Massive growth.
ILMANEN: And for equity investors, it was really sorry story.
RITHOLTZ: Yes. No. It’s a lost opportunity. If you piled into China in 1990, you missed a lot of opportunity elsewhere in the world.
RITHOLTZ: It’s quite amazing.
ILMANEN: Yes. And there are some stories why that’s — why that’s the case, Like basically, one logic is a GDP growth doesn’t capture how the IE shared between corporates and so on and there’s different sector compositions, there’s public versus unlisted sectors.
All kinds of questions like this that can then mechanically explain why this happens. But it is — it’s a weird result and it’s understandable and I think it commonly motivates people to look for those fast-growing countries and taking it for granted that that’s a good equity investment.
RITHOLTZ: So, when we’re thinking about various asset classes, how does cash work into that allocation strategy, is that a legitimate asset class or is it just a drag on future returns except for years like 2022.
ILMANEN: Well, even in 2022, again, the relative sense, cash, is, of course, doing fine but the real returning cash is whatever minus five percent. It just happens to be better than even more —
ILMANEN: — various results. And so, I think one interesting thing is you sort of — you need to have some market timing ability, I think, to make cash useful and use it almost as an option. And then it matters whether you have got some interesting yield levels. Twenty years ago, you had that three, four percent real return on cash.
ILMANEN: Not around in this situation. So, I do think that the main story with cash like you said that there’s something about the drag and it dilutes. It’s not to diversify or it dilutes the performance. It would be good if you have got some great market timing skills. But let’s be humble about it.
Often, I’d even say that cash may be best used as basically on the other side like you want to use for leverage for some long-short strategies. And so, that maybe helpful answer on what you do with that.
RITHOLTZ: In the book, I like the way you described certain investor type based on their future liabilities. So, pensions, endowments, defined benefit plans, you point out that they’re particularly sensitive to low-expected returns. Tell us what makes them so susceptible. Is it the future liabilities they have? Why is merely the concept of lower expected return so problematic for them?
ILMANEN: Yes. Well, I think it is — it is for any investor, but if you have made some commitments for the future, then it is maybe more legally binding and — and that — that makes it better than for somebody who can — who can basically adjust expectations or try to just leave through these things without — without sort of recognizing the low expected return until — until somewhere far into the future.
RITHOLTZ: So, let’s talk about far into the future. How long should we expect lower returns for? Is this a question quarters or years and decades ? Is this cyclical? Does it eventually turn on? Tell us a little bit about the duration of expected returns?
ILMANEN: Sure. So, the main story of the book is about low — those low starting years and therefore, we are talking of long-run story. Then I’m — I’ll sort of turn in to more speculative punditry by thinking about the current situation where I do think that we are now in this fast pain situation where we will probably get more, where we will surely get more monetary policy tightening and I suspect that the latest — latest market positive is on yield so it’s maybe way too optimistic. I think — I think you will need — you will need more tightening to control inflation.
And again, this is — this is a speculative talk here. So, I think fast pain will be with us for various risky assets but I — I think there will be a limit to it because of the structural forces. I refer to the savings glut.
I think that’s not going away anytime soon, and therefore, there’s going to be a lead on how far yields can rise and that — and basically, those bond yields, they have been underwriting high valuations and all other on stocks and real estate and so on and those rising years have been very important in cheapening those other asset classes.
And so, I think there’s gong to be more pain on that front but not too much. I don’t think we will get so much higher yields and cheaper asset valuations that we would sort of solve all of the long run problem of low expected returns. We will — we will still get some pain, but we’ll — I think the slow pain will be with us quite a long time.
RITHOLTZ: So, let me see if I can explain that. If I — if I understand that. We’ve had a savings glut that has put a cap on interest rates which means that the cost of capital has been very low and therefore that allowed us to speculate in real estate, in inequity, and that allowed valuations to go high and what’s going to determine how much those multiples compress is how high rates end up going up? Am I oversimplifying that?
ILMANEN: No, no, that is — that is right. And again, we have gotten now the cyclical situation where — where basically their inflation problem forced finally central banks to act quite aggressively then on, well, Fed, anyway, on the interest rate front and then how much more they have to do is going to be important in the near-term, but I just don’t see a scenario where they would raise rate so much that we will get back to the kind of four, five percent expected real return, so 60-40 portfolios which used to be there, we are about half of that nowadays.
We’ve come from the lows but we are still like, let’s say, 60 to 40, two percent real yield is roughly the number as opposed to the four plus long run.
RITHOLTZ: So, we’re recording this the first week of July. The Fed has already raised 75 basis points on top of their previous 50 basis points. For a while, the consensus is that the end of July, I think it’s the 27th, that meeting seem to be 75 basis points. It sounds like fears of recession might drive that down to 50 basis points, but clearly, there’s no consensus there yet.
How far do you think the Fed’s going to go in tightening and do we run the risk that we’re behind the curve in 2021? Are we running the risk that they’re getting ahead of themselves in 2022?
ILMANEN: Yes. First, as a qualifier here that …
RITHOLTZ: Nobody knows.
ILMANEN: Nobody knows and we don’t trade on my views, we don’t, like, this is — this is — that’s important. Then it is — it’ s incredibly difficult. But, yes, we certainly do think about those — those issues will attend and my — I’m pretty much in, let’s say, Larry Summers camp there thinking that it’s very hard to get the immaculate disinflation here and you will need — Fed needs to do more to get that information into control.
And if it does, either if it acts more or financial markets drop enough, then there’s going to be some pretty bad outcomes to risky assets without that I think we are — we are going to continue to have that inflation problem.
And this — there’s a narrow path how it could go in a more benign way and market seems to be clutching that straw right now.
RITHOLTZ: So, what would make you change your mind? What would lead you to say, oh, I’ve been too cautious about future expected returns and because A, B, and C happen, I think we could get a little more confident.
ILMANEN: Yes. So, I — I think the long horizon estimates are very difficult to change. The starting yields are heavy anchor. So, I think it would be — it would really require the growth environment to change. Again, I mentioned earlier a technological progress, those types of things.
So, short term, anything can happen. But somehow, you have to have this type of idea with a greater Internet usage globally and all kinds of technological progress moving us from the two percent to three, four percent real growth …
RITHOLTZ: Which is hard to do.
ILMANEN: Hard to do. Has not happened.
RITHOLTZ: Right. And then you mentioned earlier the cheapening, if stocks got much cheaper, that could potentially change it, the starting valuation, but do — do we really think that’s a likely probability?
ILMANEN: Yes. I would be surprised that we would get that much cheaper. And again, the economic logic I have is the savings glut somehow that basically real yields are not going to allow that — we have too, I don’t know fragile economy, too fragile financial markets to — allow that much cheapening.
And we usually would — we might be talking of 40-50 percent further — further force that …
RITHOLTZ: Right. And that — that seems pretty unlikely from, at least with the state of the world today, obviously that can change any — anytime. That — that’s really, that’s really quite interesting.
So, lets’ talk about some things that seem relatively cheap. Cliff Asness, in the foreword of the book wrote, quote, “Value premia seems record cheap today.” That was the end of 2021. Is value premia still cheap today value premium is still very cheap and it’s been a lovely year in the sense that we have had positive returns and yet the value spread this forward-looking measure of how cheap value stocks versus growth stocks has remained wide.
And partly, it is that you get some pullbacks like we have recently — recently gotten, but also, you — we are basically rotating into new value stocks and growth stocks and — and the fundamentals have actually further had sort of favorable developments favoring value stocks versus growth stocks.
So, for all these reasons, we see that value stocks, the way we tend to trade them, are as cheap or even cheaper than they were at the worst times during the dot-com bubble. And it is important to just distinguish. I’ve wrote about this in a blog recently that that dot-com bubble was very much about tech versus others and across sectors, we haven’t gotten to the new highs.
But we tend to focus on within industry stock selection in our value strategies and with that, the key story of this recent bubble was really the markets favoring these disruptive profitless growth companies within every sector and that opportunity remain still very wide and we would love seeing like pretty good performance behind ascendant, very good runway because those values spreads remain quite wide.
RITHOLTZ: And in the U.S., I’ve noticed that small-cap value is done much better than the large-cap companies and then emerging markets, small-cap value, last I looked, it might have even been green for the year, might’ve been positive returns for the year, why are small cap doing so well in the value spaces here?
ILMANEN: When it often happens, like you just — you just get bigger movements in good and bad on the small caps than large caps.
RITHOLTZ: So, I mentioned the quote from Cliff, he’s a big character. What’s it like working with him?
ILMANEN: It’s mainly, it’s great. Though, if you had him with us here on this studio, I think you wouldn’t hear much of me and that’s just as well because he is — he is faster on his feet than his — he’s wittier, so that’s in everybody’s benefit.
But it — so seriously, it does help that our investment thinking investment beliefs are so similar. So, I really rarely have got any — any, any ways to second-guess anything he says or does. So, that’s great.
And then, most importantly, I do love his ethical antenna and his kind of truth-telling obsession that he has. I mean, sometimes there’s — there are overshoots that, but it’s really — it’s a reason for me why I love to work in AQR more than any other place in financial …
RITHOLTZ: Because of Cliff? Usually, you get a guy who’s quantitatively oriented, you tend not to get that sort of articulateness and you also tend not to get that sort of sense of humor which is very, very specific to him. He’s a very funny guy.
ILMANEN: He is. Yes. And I — a bit mixed feelings because there’s no way to beat him on those things. But that’s OK.
RITHOLTZ: That’s very funny. So, let’s talk a little bit about the things that have changed since you wrote this book. What’s going on in the current market? Is it just confirming what you’re expectations were for — for future returns? Tell us a little bit about how 2022 has, now that is half over, how has this impacted the general premise of the book?
ILMANEN: Yes. I think overall, I feel totally blessed that we got — the book came out at the time when markets where roughly acting the way the title was saying, talking about low expected returns. We’ve got low realized returns so that sounds — sounds great. And it also turns out that some of our strategies, value strategy trend following these types of strategies are doing very well, so — so I’m getting like great, great response.
But of course, things have some — some things have happened as expected related to inflation central tightening, but then I had no idea of what, the geopolitics Russia, Russia-Ukraine or the greater split we have between U.S. sphere and China and so and so. And I don’t have — I don’t have great insights to this.
For us, when I think of the long run expected returns, the key story is that as it’s have cheapened, as one would — one would have expected in this situation and — and the question is whether there’s going to be more, I think it’s — it is interesting that we’ve had — we’ve seen the biggest moves in bonds, smaller moves. When I think of yield, yield space, not price space, but in yield space, equity yields have risen more and then illiquidity yields have risen, so far, very little. And of course, there is a smoothing effect.
And so, that’s a — but I do expect that there’s going to be an an issue. I saw in March when — when equities didn’t instantly respond to rising yields, it reminded me of Wiley Coyote running over that cliff and sort of waiting for gravity to hit and I think something like maybe still happening with the private assets, that they are sort of waiting, waiting to price things.
RITHOLTZ: So let’s talk a little about that. There’s been a lot of discussion about private markets and the illiquidity premium. They get — what are your thoughts on this? Should nontraded assets get an illiquidity premium?
ILMANEN: Yes. So, I’ve written a lot about it. Cliff, of course, also and more wittily on this. And I think it is — it’s dangerous that people think too automatically. That if I invest in illiquid investments, I’m going to earn an illiquidity premium.
I think after equity premium, that’s probably the second most confident statement people would have on longer expected returns.
And data doesn’t really support it. So we’ve done lots of empirical evidence on this. And so, the logic why the data is then, so maybe disappointing is, I think, that — that people somehow confuse — they — they think that the illiquidity is the only important feature.
So, yes, I think it is fair to require illiquidity premium for locking your money for 10 years, but then there’s these other characteristics, like — characteristic, lack of mark-to-market, the smoothing service — services, I call it. And that may totally offset the amount of excess return that you get. So, if there’s a two, three percent required illiquidity premium for forward-looking money, we might accept the same return for public and private equities because with the private equities, you don’t get the great volatility.
RITHOLTZ: Now, you also show a chart in the book that shows how the bottom third of illiquid markets have, you know, by definition, they’re underperforming the top third but that gap has just been widening and it seems like in addition to whatever illiquidity premium are in private markets, there also seems to be a pretty substantial, I don’t know if I want to call this quality factor, but the best of the illiquid investments seem to really dramatically outperform the bottom. That spread is much bigger than we might have anticipated, otherwise.
ILMANEN: So, apart from thinking about illiquid’s overall, one of these great sailing points there is the wide dispersion between outperformers and underperformers and to me, that’s such a lovely example of investor over confidence that when people see this, this person, they think, the upside is for me, the downside is for someone else.
And so, clearly, this opportunity involves some risk as well and it is -it’s somehow that that industry doesn’t seem to have anybody getting that downside. So, sorry. I do think that some investors have got a decent claim to expect to get those top quartile right, let’s say to half managers but for others, I think it’s a somehow, it’s better to just think, OK, if we get the industry level returns, that’s reasonable.
RITHOLTZ: So, Will Rogers used to always advise people only buy stocks that go up. If they don’t go up, don’t buy them. Does the same thing apply to private markets? Only invest in private markets that outperform. If they don’t outperform, stay away from them.
ILMANEN: Yes. Yes.
RITHOLTZ: If only it was that simple.
ILMANEN: Hindsight, it’s great. But it is — and so, I would say, just positively, there that historically, in particular, if we look at private equity, it has a great 35-year history of outperforming S&P 500 by a three percent or something like that every year and that’s after five, six percent fees. That gross alpha is just mindboggling in some sense.
But looking ahead, we should be much more: cautious because the gap has already been much narrower the last 15 years and it seems to be narrower because the money was flowing in because of the popularization of the Yale model. Since then, the forward-looking opportunity has been much narrower and realized opportunity has been much more — much more modest and the fees, are the good old fees. So, I think next decade will be one disappointing than we’re from.
RITHOLTZ: Right. And when we look back to the early days of that outperformance, there were a tiny fraction of the number of funds then. What is it? Like 10,000 private equity funds that used to be — that used to be numbered in hundreds, not thousands.
ILMANEN: Yes. Yes.
RITHOLTZ: Same as the hedge fund and the venture capital world, success has attracted a lot of capital which leads to underperformance.
ILMANEN: Yes and one further thing is these questions were already relevant a few years ago, but private equity did very well the last few years and I saw Dan Rasmussen wrote quite nicely, so recognize — I mean, that’s rare and lovely one somebody does. It’s postmortem on my mistake, that’s what he did there and he said that he got it so wrong because they — private equity like hedge funds and especially venture capital, were pushing a lot into the growth sector and that worked very well for a few years and I think to the extent that we are right about the value versus growth, that benefit will turn into advantage, I think, in the coming years and so.
RITHOLTZ: Really, really interesting. We haven’t talked about a couple of other alternatives. Credit spreads, commodities, what else are you thinking about in the alt space?
ILMANEN: Yes. I think commodities is the most interesting case. And so, I’ve got a double positive story on that one. The first one is the obvious one when we look for inflation hedging investments, they are pretty much the best there is.
And so, most portfolios that invest — most constituents of anybody’s portfolio, stocks, bonds, and so on, they have what this disinflationary tilt that was helpful for a long time recently. And so, if you want to have a pretty neutral portfolio, you should have some allocation to commodities.
Then the second point is that many investors think that you don’t earn a positive long-run reward on commodities but the data says otherwise. Basically …
ILMANEN: Yes. Diversified combination of commodity futures has earned something like three, four percent long run reward and that’s a — it’s a weird thing and I — and I focus on it in the commodity sector telling that it’s part of it is related commodity, role maybe, but important part is related to diversification return. So, basically, this is getting very geeky, but let me just try. Commodities, on a single — single commodity base have a 30-40 percent volatility which means that that that type of volatility hurts compound returns a lot and — and when you combine lowly correlated commodities together, you can reduce that volatility roughly half and you can get this volatility drag much smaller.
And so, for — if as the evidence suggests, that a single commodity has pretty much not outperformed cash in the long run, portfolio of them has done it because of this saving on this volatility drag, thanks to diversification.
RITHOLTZ: So, it’s a basket of energy and industrial metals and precious metals and foodstuffs and not just …
ILMANEN: And lots of — lots of, yes. And lots of single one of them. And so, again, you get — commodities, these types of effects happen in any investment. On your equities, on your bonds and so on, it just doesn’t matter so much with them because the correlations tend to be higher or volatilities, lower commodities have got this glorious combination of high volatility and low correlation that makes this really matter.
RITHOLTZ: Very, very interesting. Let’s talk about ESG. There have been some estimates that it’s now over $20 trillion. You talk a little bit about ESG investing. Tell us about your thoughts.
ILMANEN: Yes. So, it clearly growing force and I would argue also, largely a force for good, but the expected return impact is debatable. And so, Cliff wrote already a blog a few years ago highlighting this simple logic that, one logic is constraints always should have a cause. But another logic is that if you want to be virtuous and you want to raise the discount rates for sinful companies, well, you do that by maybe investing less, less in the more even — in some cases, you could, you could short them.
And so, if you do that and you raise their discount rate, you also raise that discount rate, this flipside of expected return.
RITHOLTZ: Makes them more attractive.
ILMANEN: Yes. Yes. So, somebody else is willing to basically buy those sinful companies than we’ll earn higher returns.
So, that is pretty much long-run story that should happen when investors really like something for nonmonetary reasons and that includes ESG.
Then the, I think, the reasonable counterargument is that we may be in a transition phase here where we are getting the repricing. How do we get to those higher discount rates? Well, we get it basically by making those — those companies cheaper and then we can debate now whether we are in early innings or late innings on — on that question. So, in the long run, I think there will be some cost and I think most investors who are ESG oriented should be willing to take some, of course, as a flipside of their virtuous investing. But in between, they might get sort of the win-win outcome that they so like.
RITHOLTZ: Now, you weren’t getting the win-win outcome the past six months, especially if you were low carb and low oil, any of the energy stocks have just done spectacularly the past year, is that going to be the long-run trade-off? Is that — if you’re staying away from some of these, you take a chance that there’s a big move up in a sector that you’ve reduced your exposure to?
ILMANEN: Yes. I — that possibility always exists. And now, we — now that we had it, I think it is going to raise more discussions in some organizations than how to deal with any financial trade. I must say that in Europe, I think that investors will largely stay with their ESG beliefs and there’s not going to be questioned if they — if they think they — there’s some financial cost that’s okay.
In the U.S., there’s more doubts and it has become such a political issue …
ILMANEN: … that it’s going to be , I think, harder. Just, I — everything or anything I can say on this one, I think is that — is that there was a sort of easy travel towards more ESG for the last few years. And now, I think we are — we are in a world where it’s going to be harder. I think the trend is still the same but it’s going to be more jagged going ahead and maybe especially so in U.S.
RITHOLTZ: And before I get to my favorite questions, I got to throw a curveball at you, Cliff Asness mentioned you like to go in a 120-degree sauna and jump out and roll around in the snow? Is this Finland — Finnish sort of thing? Tell us about your heat and cold habits?
ILMANEN: That is — that is exactly what we do for cheap fun. And sadly, there are fewer opportunities with the global warming. But yes.
RITHOLTZ: So, how hot does the sauna get?
ILMANEN: I was thinking whether you are talking Fahrenheit or centigrade.
ILMANEN: But, yes, I knows we are talking, so say..
RITHOLTZ: Not boiling water?
ILMANEN: You want to know, in centigrade, now we do go close to …
RITHOLTZ: Forty degrees? Thirty-five degrees?
ILMANEN: I don’t know. We go to 80-100 degrees. Definitely so.
RITHOLTZ: In centigrade?
ILMANEN: Yes. Yes, yes, yes.
RITHOLTZ: So, that’s like 160-180 …
ILMANEN: You’ll do the translation there.
ILMANEN: But I — I think of, you know, the I do my Fahrenheit and Celsius not in that area.
RITHOLTZ: But still, 80 degrees is very — you’re just — that’s very warm.
ILMANEN: Yes, it’s nice to sweat.
RITHOLTZ: And then when you jump into the snow, isn’t that a little bit of a shock to the system?
ILMANEN: Yes. Well, or you go to a polar, icy — well, you go into icy water.
ILMANEN: That’s even better but that’s hard. But, yes, it’s great fun when you can rarely do that. Yes.
RITHOLTZ: Quite interesting. All right. So let’s jump to our favorite questions that we ask all of our guests starting with what have you been streaming these days? Tell us about your favorite — whatever kept you entertained during the pandemic or whatever podcast you listen to.
ILMANEN: Sure. Sure. Yes, I thought about this in recent months when I have had you asked these questions. And by the way, I’ve gotten some good tips. I got “Le Bureau” and “Call My Agent,” the French ones, and some Israeli shows in from here. So, thanks for those.
RITHOLTZ: “Fauda.” Yes. “Fauda” was …
ILMANEN: Yes, yes, yes. Yes.
RITHOLTZ: That’s why I ask it because I get to speak to people who have interesting sensibilities. I want to hear what they’re seeing and hearing.
ILMANEN: Yes. Well, so, as a first none albeit or none interesting answer, I think recently, “Better Call Saul,” looking forward to the last few episodes. But — so that’s been great. But I thought that I’d rather highlight then less well-known older series.
So, my favorites, I think, in last 10 years were sort of slow burn, “The Americans,” the Russian spies. That one or “Rectify.” It was a story of from the southern U.S. and just, I think — I think lovely stories. Got to take time for those.
And likewise, then in podcasts, I listen a lot to history. And so, beyond investing. And I’ll just — well, on near investing, I would say Tim Harford’s “Cautionary Tales” is fun and Zingales and Bethany McLean “Capitalisn’t” has got very thoughtful topics. So, I think they are — they are good but I love — in history area, I love Dan Carlin, Mike Duncan, Patrick Wyman. And there’s a British show called “Rest is History” which just always makes me laugh.
RITHOLTZ: That’s a good — that’s a very interesting list. Let’s talk about some of the mentors who helped to shape your career.
ILMANEN: Sure. So, obviously, I told the dissertation chairman, Fama and French, so they’ve been very influential in many ways. But I would especially then highlight Marty Leibowitz, so all — before, during, and after Solomon years. So, and he’s such a mentor that it is — it’s wonderful to have known him for decades.
RITHOLTZ: What about books? What are some of your favorites and what are you reading right now?
ILMANEN: Yes. So, I am a voracious reader. Lots of investing fiction, nonfiction, all kinds of things. I thought I — I will highlight from fiction really big one. Hillary Mantel’s trilogy on Thomas Cromwell, “Wolf Hall.” I was thinking, I think maybe I heard in your show also “The Three Body Problem,” very different, sci-fi, the Chinese one. So, I think that was great.
And then on nonfiction, I — I think the most impressive book I read in last couple of years was Joe Henrich’s, “The WEIRDest People in the World.” So, this is — WEIRD is Western Educated rich democratic. And it’s basically telling how different the people who are most often studied in various psychological studies, they invest in university students, how different they are from most cultures and then it’s explaining why things went that way.
And it’s — it’s most parts of the story are very interesting. But again, a very long book.
RITHOLTZ: Really, really intriguing.
ILMANEN: Yes. And currently, Zach Carter, I think, is the author. The book on price — “Price of Peace.” Yes.
RITHOLTZ: Good. That’s a good, that’s pretty good list. What sort of advice would you give to a recent college graduate who is interested in a career in either investing finance, value, quantitative, investing, how would you advise them?
ILMANEN: I’ll go with the old-fashioned saying. Don’t sacrifice your ethics, that integrity matters.
RITHOLTZ: Good — that’s really good advice. And our final question, what do you know about the world of investing today that you wish you knew 30 or so years ago when you were first getting started?
ILMANEN: Yes. I thought — I’ll say this lightly that bond yields can go negative, you know. Didn’t expect that to happen but the funny thing is that I thought that, really, I would have then expected that do coincide with bearish equity markets. But in 2010s, it actually happened with — with a big bull market.
So, it wasn’t that — that equities pushed equity weakness, pushed bond yields down, but it was that low bond yields pushed equities up. So, so causality went that way and that’s a pricing.
So, I think that’s — that’s one. And then, another serious, serious is, is how important and how hard patience is. So, with all of these ideas, I talked about this long-run strategies and you just — it doesn’t matter too much if you don’t have the stickiness.
So, I think one has to really calibrate one’s investment to the amount of patience one can reasonably expect to have.
RITHOLTZ: Really, really intriguing. We have been speaking with Antti Ilmanen, cohead of portfolio solutions at AQR.
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