Practical analysis for investment professionals
05 November 2019

Just a Little Higher? Antti Ilmanen on the Low-Return Challenge

In a low-for-long interest rate environment, “How long is long?”

That’s the question Lars Rohde, chair of the Board of Governors of Danmarks Nationalbank, posed to the attendees of the 1st Nordic Investment Conference in Copenhagen, Denmark.

His answer? “We do not know. What we do know is that it will be prudent for the financial sector and investors to prepare for a long period of very low interest rates. This is — so to speak — the new normal. It creates new challenges for the financial sector. The only thing you can do is to adapt.”

So how can investors adapt to a low for long rate environment? Antti Ilmanen of AQR Capital Management doesn’t claim to have the answer, but he did propose several potential strategies from the toolkit of the so-called Nordic model. In combination, he believes these could help address the low-interest-rate, low-return challenge that today is not restricted to bonds, but seems to pervade all asset classes.

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And that’s important. This may not be the first time in history when rates have been historically low. For Rohde, the question is “whether unconventional monetary policy instruments, such as asset purchases and targeted lending, will become conventional during the next downturn.”

Past this point, a brave new world awaits, one in which previously reliable central bank policies whose outcomes were largely predictable will cease to be effective.

So what are investors to do while rates remain low, or fall even lower? The Nordic model does not offer straightforward results, although the Danish pension fund’s recent shift of focus from bonds to equities has been successful.

Of course, for Ilmanen, there is no one unified Nordic model. Rather there are commonalities across the region that have worked well, among them, environmental, social, and governance (ESG) integration, increasing fee consciousness, growing allocations to alternatives but with a still-limited focus on hedge funds, and factor investing.

All these characteristics of the Nordic approach reflect, to varying degrees, major trends among global institutional investors since 2000.

But are they the ingredients to successful investment strategies?

Past performance is never indicative of future results and while the real return of the traditional 60/40 stock/bond portfolio was 5.4% over the last 65 years, current expected returns for the next decade sit at only 2%, according to AQR.

It’s not clear how these expected low returns will be generated. Will it be a “slow pain” process with years of persistently low yields and few windfall gains, or a “fast pain” process where all yields rise and fall more dramatically?

Ilmanen offered his perspective on the possible pathways and their drawbacks amid a continuing low-returns scenario.

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1. More Equities

Equities have a good track record over the last half century, he noted. But might they carry too much risk presently? Figuring out market maturity is tricky, especially in the current prolonged bull market, and Ilmanen believes the increased equity strategy is probably overused. “Hopefully, [it’s] not the only answer,” he said.

2. More Illiquid/Private Assets

The Yale endowment, among other asset owners with super long-term investment horizons, has focused on private and alternative assets. But unlike the reams of data on equities, there is very little on illiquidity premia. Among the few sectors where a robust sample is available, US real estate data since the 1970s stands out. “[It’s] not a great story,” Ilmanen said. Direct real estate investments offer a no illiquidity premium compared to more liquid real estate investment trusts (REITs).

Additionally, private equity investors tend to overpay to reduce volatility and that can offset fair illiquidity premia.

“Investors prefer smooth sailing to a bumpy ride,” Ilmanen said. “There is something very useful in illiquid assets, but not as useful as it is currently thought.”

3. Add Factor Tilts and Alternative Risk Premia

Factor investing has grown increasingly popular over the last 20 years for good reason. But which factors are actually well-rewarded?

New, historical research by AQR on nearly a century of hypothetical gross Sharpe ratios points to evidence of style premia, and not necessarily just for long-only equity portfolios. In fact, long-short multi-asset portfolios show the most potential for diversification benefits.

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Accept, Prepare, Adapt

The truth is there is no single solution that will turn a low expected return environment into a high-return one. But fusing these three solutions in a wide-harvesting approach that combines diversification across premia is a good start.

The more difficult question is what not to do. Ilmanen recommends against seeking classic alpha or trying to time the market.

Very low rates for a very long time could lead to a returns dystopia, in which previously successful investment strategies, like traditional monetary policies, no longer function.

But even in this grim scenario, Ilmanen sees a glimmer of hope. He recommends a three-step program: accept the situation, prepare, and adapt to the new normal.

For more from Antti Ilmanen, don’t miss Expected Returns on Major Assets from the CFA Institute Research Foundation.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image courtesy of CFA Society Denmark


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About the Author(s)
Anastasia Diakaki

Anastasia Diakaki is director of continuing professional development content for the EMEA region at CFA Institute.

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