Investing Amid Low Expected Returns

Investing Amid Low Expected Returns Plot Summary

Introduction

Today's investors face an unprecedented challenge: historically low expected returns across virtually all traditional asset classes. This fundamental shift in the investment landscape forces a critical reassessment of conventional portfolio construction approaches that have served investors well for decades. The low return reality stems from a confluence of factors including sustained low interest rates, elevated asset valuations, demographic headwinds, and slower economic growth trajectories in developed markets. This environment demands more sophisticated approaches to portfolio construction and risk management. Investors must look beyond traditional asset allocation models to identify alternative return sources, manage risk more dynamically, and implement strategies with greater cost efficiency. The theoretical framework presented here offers a comprehensive approach to navigating this challenging landscape, exploring how investors can combine traditional asset class premia with alternative return sources like style and illiquidity premia. By understanding the full spectrum of available investment tools and their appropriate application, investors can construct more resilient portfolios capable of meeting their objectives even when markets offer historically meager returns.

Chapter 1: The Reality of Low Expected Returns

The investment landscape has fundamentally changed. For decades, investors benefited from secular tailwinds that boosted returns across major asset classes: declining interest rates, expanding valuation multiples, favorable demographics, and accelerating globalization. These tailwinds created an environment where even relatively simple investment approaches could generate satisfactory results. However, these favorable conditions have largely run their course, leaving investors facing a much more challenging return outlook. This new reality is reflected in historically low bond yields, elevated equity valuations, and compressed risk premia across virtually all traditional asset classes. Government bonds in many developed markets offer yields near or below inflation rates, providing minimal or even negative real returns. Meanwhile, equity markets trade at valuation multiples well above historical averages, suggesting future returns significantly below historical norms. These conditions are not merely cyclical fluctuations but reflect structural changes in the global economy that may persist for an extended period. The mathematics of these low starting yields and high valuations is unforgiving. Bond returns are heavily influenced by their starting yields, while equity returns are similarly constrained by initial valuation levels. Empirical research consistently demonstrates the strong relationship between starting valuations and subsequent long-term returns. This creates a sobering outlook for traditional portfolios, with projected returns for balanced allocations often falling several percentage points below historical averages and well below the return targets of many institutional and individual investors. The implications of this low return environment extend beyond simply reduced wealth accumulation. Pension funds face widening funding gaps as their assumed return rates increasingly diverge from market realities. Endowments and foundations may struggle to maintain spending rates while preserving capital. Individual investors may find their retirement savings insufficient despite following conventional planning advice. These challenges force difficult choices: accept lower returns and adjust spending expectations accordingly, increase savings rates to compensate for lower investment growth, or seek additional sources of return beyond traditional asset classes. The psychological impact of this environment should not be underestimated. Investors accustomed to the generous returns of previous decades may be tempted to "reach for yield" by taking inappropriate risks or abandoning diversification principles. Alternatively, they might swing to excessive conservatism, holding cash despite its negative real returns. Neither extreme represents an optimal response to the challenge. Instead, investors need a framework for thoughtfully navigating this new landscape, one that acknowledges the reality of lower returns while identifying the most promising paths forward.

Chapter 2: Traditional Asset Class Premia and Their Limitations

Asset class premia represent the excess returns investors can expect to earn by bearing systematic risks associated with broad market exposures. These traditional premia include the equity risk premium, term premium in government bonds, credit premium in corporate bonds, and various risk premia in commodity markets. Historically, these premia have formed the foundation of most investment portfolios, providing reliable sources of return over long time horizons. The equity risk premium—the additional return stocks provide over risk-free assets—has historically been the largest and most reliable premium available to investors. This premium compensates for the uncertainty of corporate cash flows and the psychological discomfort of market volatility. While the long-term historical equity premium has averaged around 5% annually in developed markets, current elevated valuations suggest future returns may be considerably lower. Research consistently shows that starting valuation metrics like cyclically-adjusted price-to-earnings ratios or dividend yields have strong predictive power for subsequent long-term returns, pointing to reduced equity premia in the coming decade. Fixed income premia have similarly compressed in the current environment. The term premium—the additional yield investors receive for holding longer-duration bonds—has declined significantly and even turned negative in some markets. Credit premia, which compensate investors for default risk in corporate bonds, have also narrowed as investors have bid up prices in search of yield. These compressed premia reflect both structural factors like demographic shifts and policy interventions including central bank asset purchases, suggesting they may remain subdued for an extended period. The limitations of traditional asset class premia become particularly apparent during market stress periods. Correlations between stocks and corporate bonds often increase precisely when diversification benefits are most needed, undermining their effectiveness as portfolio diversifiers. Even government bonds, which have historically provided reliable protection during equity market downturns, may offer reduced hedging benefits in a low yield environment where their income cushion is minimal and their potential for price appreciation is limited by the zero lower bound on interest rates. Another significant limitation is the concentration of risk in traditional portfolios. Despite the appearance of diversification, conventional allocations like the 60/40 stock-bond portfolio typically derive 80-90% of their risk from equity exposure. This risk concentration becomes particularly problematic in a low return environment where the compensation for bearing this risk has diminished. The fundamental challenge for investors is that simply increasing allocations to traditional risk assets to maintain historical return levels leads to risk concentrations that may exceed their true tolerance, especially during market drawdowns.

Chapter 3: Alternative Return Sources: Style and Illiquidity Premia

As traditional asset class premia have compressed, investors have increasingly turned to alternative return sources to enhance portfolio outcomes. Two particularly important categories are style premia and illiquidity premia, each offering distinct characteristics and potential diversification benefits when thoughtfully incorporated into investment portfolios. Style premia represent systematic return sources available across multiple asset classes based on persistent patterns in security pricing. The most robust style premia include value (buying relatively cheap assets), momentum (following price trends), carry (harvesting yield differentials), and defensive (focusing on lower-risk assets). These premia have been extensively documented in academic literature across decades of market history and multiple geographies, suggesting they reflect fundamental economic or behavioral forces rather than mere statistical artifacts. The power of style premia comes not just from their individual return potential but from their diversification benefits. Correlations between different styles are typically low or even negative (particularly between value and momentum), while correlations across asset classes for the same style are also modest. This creates opportunities for diversified style portfolios with attractive risk-adjusted returns. Unlike traditional asset class premia, style premia can often be accessed in market-neutral formats that have minimal exposure to broad market movements, potentially providing more reliable diversification during stress periods. Illiquidity premia represent the additional returns investors potentially earn for accepting limitations on their ability to quickly convert investments to cash. These premia exist because many investors have strong preferences for liquidity and are willing to accept lower expected returns on liquid assets. Private equity, real estate, infrastructure, and private credit all offer potential illiquidity premia, though their magnitude varies considerably across market environments and specific strategies. The theoretical case for illiquidity premia is compelling, but their empirical measurement presents challenges. Reported returns for illiquid assets typically show artificially low volatility due to infrequent and subjective valuations, making risk-adjusted return comparisons problematic. When adjustments are made for this "smoothing" effect and for the additional leverage often employed in private investments, the apparent risk-adjusted advantage of illiquid investments often diminishes substantially. Nevertheless, certain illiquid strategies continue to offer meaningful return premiums, particularly in less efficient market segments or where specialized operational expertise creates genuine value. Accessing these alternative return sources effectively requires overcoming several implementation challenges. Style premia strategies often involve higher turnover and potentially greater complexity than traditional investments, requiring careful attention to transaction costs and operational capabilities. Illiquid investments demand specialized due diligence skills, longer time horizons, and governance structures capable of maintaining commitment through market cycles. Both categories typically involve higher fees than passive exposure to traditional asset classes, making fee negotiations and alignment of interests particularly important in a low return environment.

Chapter 4: Portfolio Construction Beyond the 60/40 Model

The traditional 60/40 portfolio—comprising 60% equities and 40% bonds—has served investors well for decades, delivering strong risk-adjusted returns with relatively simple implementation. However, in a low expected return environment, this conventional approach may no longer generate sufficient returns to meet investor objectives. More sophisticated portfolio construction approaches are needed, incorporating a broader range of return sources while maintaining robust risk management. Modern portfolio construction begins with a clear articulation of investment objectives, constraints, and risk tolerance. These parameters will differ significantly across investor types—pension funds with defined liabilities face different challenges than endowments with perpetual time horizons or individuals saving for retirement. The low-return environment may require revisiting these fundamental parameters, potentially adjusting spending rates, contribution levels, or time horizons to align with realistic return expectations. Risk factor allocation represents an evolution beyond traditional asset allocation. This approach recognizes that seemingly different investments often share common underlying risk exposures. For example, corporate bonds, dividend-paying stocks, and real estate all contain elements of both equity risk and interest rate risk. By focusing on these fundamental risk factors rather than asset class labels, investors can build more truly diversified portfolios that better withstand various economic scenarios. This approach helps address the risk concentration problem in traditional portfolios, where equity risk typically dominates despite apparent diversification across asset classes. Alternative risk premia can play a crucial role in enhancing portfolio efficiency. By incorporating style premia strategies across multiple asset classes, investors can access return sources with low correlation to traditional market risks. These strategies can be implemented in various forms, from simple factor tilts within traditional allocations to dedicated alternative risk premia portfolios using long-short approaches. The appropriate implementation depends on investor-specific considerations including size, governance capacity, and liquidity requirements. Private market investments typically play larger roles in sophisticated portfolios, though their implementation requires careful consideration of fees, complexity, governance requirements, and potential crowding effects. The capacity of these strategies varies widely, and their expected returns may diminish as more capital flows into them. Successful implementation often requires specialized expertise, either developed internally or accessed through external managers with demonstrated skill in specific market segments. The role of dynamic allocation deserves consideration in a low-return world. While tactical asset allocation requires exceptional skill to execute successfully, more systematic approaches to dynamic risk management may enhance outcomes. These include volatility targeting (adjusting exposures to maintain consistent risk levels), trend following (reducing exposure during sustained market declines), and valuation-based allocation (gradually shifting capital toward undervalued assets and away from overvalued ones). These approaches can help manage drawdown risk without requiring precise market timing abilities.

Chapter 5: Risk Management in Challenging Market Conditions

Risk management takes on heightened importance in a low expected return environment, where the margin for error shrinks and recovery from significant drawdowns becomes more difficult. Effective risk management extends far beyond simple diversification to encompass a comprehensive framework for identifying, measuring, and mitigating various threats to investment objectives. The first step in robust risk management is proper risk identification—recognizing the full spectrum of risks beyond just market volatility. These include inflation risk (the erosion of purchasing power), liquidity risk (the inability to convert investments to cash when needed), shortfall risk (failing to meet long-term objectives), and various operational and counterparty risks. Each investor faces a unique risk profile based on their specific circumstances, making personalized risk assessment essential rather than relying on standardized approaches. Scenario analysis and stress testing form critical components of forward-looking risk management. Rather than relying solely on statistical measures based on historical data, these approaches ask "what if" questions about potential future environments. How would the portfolio perform during prolonged inflation, deflation, stagflation, or geopolitical crises? These assessments help identify vulnerabilities that might not be apparent from backward-looking metrics alone. Particularly valuable are analyses that consider regime shifts where historical correlations break down, as these often represent the greatest threats to portfolio stability. Tail risk management addresses the challenge of protecting portfolios against extreme negative outcomes that occur rarely but with devastating impact. Traditional diversification often fails during these tail events as correlations spike. Dedicated tail hedging strategies—using options, managed futures, or other approaches that can provide positive returns during market crises—may offer protection, though their ongoing cost must be carefully weighed against the potential benefits. The most cost-effective approaches often combine multiple protection strategies rather than relying on a single method. Dynamic risk management approaches adjust portfolio exposures based on changing market conditions rather than maintaining static allocations. Volatility targeting, for example, reduces positions when market volatility increases and expands them when volatility declines. This can help maintain more consistent risk levels through different market environments, potentially improving long-term risk-adjusted returns while avoiding the worst drawdowns that might trigger emotional responses. Similarly, drawdown control mechanisms can automatically reduce risk exposures when losses reach predetermined thresholds. Behavioral risk management acknowledges that investor psychology often poses the greatest threat to long-term success. Fear, greed, recency bias, and loss aversion can drive poor decisions at precisely the wrong moments. Systematic processes, clear decision frameworks, and explicit consideration of potential behavioral pitfalls can help mitigate these risks. For institutional investors, governance structures that maintain discipline during market stress are particularly important. Individual investors may benefit from working with advisors who provide behavioral coaching alongside portfolio management.

Chapter 6: Implementation Considerations and Cost Efficiency

In a low expected return environment, implementation efficiency becomes critically important as costs consume a larger proportion of gross returns. The compounding impact of seemingly small cost differences can dramatically affect wealth accumulation over long time horizons. Successful implementation requires attention to multiple dimensions of efficiency: direct costs, indirect costs, tax considerations, and operational effectiveness. Investment management fees represent the most visible cost component, but their evaluation requires nuance beyond simply seeking the lowest headline rates. The appropriate fee level depends on the complexity of the strategy, the skill required for implementation, and the capacity constraints of the approach. Passive market exposure should command minimal fees given its commoditized nature, while genuine alpha or access to capacity-constrained opportunities may justify higher compensation. Fee structures should align manager incentives with investor outcomes, potentially incorporating performance-based components with appropriate benchmarks and hurdle rates. Trading costs often receive less attention than management fees but can significantly impact returns, particularly for higher-turnover strategies. These costs include explicit components like commissions and taxes, but also implicit costs like bid-ask spreads and market impact. Sophisticated implementation approaches incorporate pre-trade cost estimation and optimization to minimize these expenses without sacrificing investment objectives. Trading efficiency can be enhanced through careful order sizing, optimal execution timing, and thoughtful use of different order types and venues. Tax efficiency represents another critical dimension for taxable investors. This includes strategic asset location (placing tax-inefficient investments in tax-advantaged accounts), thoughtful realization of gains and losses, and consideration of tax implications in rebalancing decisions. In some cases, tax considerations may justify deviations from what would otherwise be optimal portfolio allocations, particularly for high-net-worth individuals in high-tax jurisdictions. The after-tax return ultimately determines an investor's wealth accumulation, making tax planning an integral part of the investment process rather than a separate consideration. Operational efficiency encompasses the infrastructure and processes supporting investment implementation. This includes custody arrangements, cash management procedures, rebalancing protocols, and reporting systems. Inefficiencies in these areas can create significant drag on returns through implementation delays, cash drag, and various operational frictions. Technology increasingly offers opportunities to enhance operational efficiency while reducing costs, though technology investments must be evaluated based on their expected return enhancement or risk reduction relative to their cost. Scale considerations affect implementation across multiple dimensions. Larger investors can often negotiate more favorable fee arrangements and spread fixed operational costs across a larger asset base. However, they may face capacity constraints in certain strategies and greater market impact costs when trading. Smaller investors have greater flexibility to access capacity-constrained opportunities but may face higher percentage fees and limited access to certain investment vehicles. Understanding these scale dynamics helps investors identify their comparative advantages and disadvantages in different market segments.

Summary

Investing in a low expected return environment demands a fundamental recalibration of both strategy and expectations. The theoretical framework presented here offers a comprehensive approach to navigating this challenging landscape, combining traditional asset class premia with alternative return sources while maintaining disciplined risk management and implementation efficiency. The key insight is that while investors cannot control market-offered returns, they can control their approach to harvesting available premia, managing risks, and minimizing implementation costs. Success in this environment requires both analytical rigor and psychological resilience. Investors must avoid both the complacency of assuming historical returns will eventually return and the desperation of reaching for yield without understanding the associated risks. Instead, they must adapt their approach to current realities while maintaining the long-term perspective necessary for investment success. By diversifying across multiple return sources, managing risk dynamically, and implementing with relentless efficiency, investors can construct portfolios capable of meeting their objectives even when markets offer historically meager returns. Though the journey may be challenging, those who adapt thoughtfully will be best positioned to thrive in the new investment reality.

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Antti Ilmanen

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