In the Financial Times, Philip Coggan examines the failure of markets to produce expected returns, and the need to save more for retirement than before. He writes:
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.
Read more here.