Expected Returns

Antti Ilmanen is a Principal at AQR Capital Management, a leading global investment-management firm. Since starting as a central bank portfolio manager in Finland in 1986, Antti has worn many hats to bridge academic finance and practitioner investing. Having earned a finance PhD in 1994 from the University of Chicago Graduate School of Business, he spent a decade at Salomon Brothers/Citigroup as a bond researcher, strategist, managing director and a trader. Before joining Brevan Howard in 2004, Antti had published extensively in finance and investment journals and had received a Graham & Dodd scroll and the Bernstein Fabozzi/Jacobs Levy award for his articles. Over the years, Antti has advised many institutional investors, most regularly Norway's Government Pension Fund Global on its long-run investment strategy.

"Every investor will find something of value in this book" (Professional Investor, October 2015)

• Foreword by Clifford Asness xiAcknowledgments xviiAbbreviations and acronyms xixPart I Overview, Historical Returns, and Academic Theories 11 Introduction 31.1 Historical performance 71.2 Financial and behavioral theories: A brief history of ideas 91.3 Forward-looking indicators 131.4 View-based expected returns 151.5 General comments about the book 161.6 Notes 202 Whetting the appetite: Historical averages and forward-looking returns 232.1 Historical performance since 1990 242.2 Sample-specific results: Dealing with the pitfalls 272.3 Forward-looking return indicators 322.4 Notes 353 The historical record: The past 20 years in a longer perspective 373.1 Stocks 393.2 Bonds 433.3 Real asset investing and active investing 473.4 FX and money markets 503.5 Real return histories 523.6 Notes 524 Road map to terminology 574.1 Constant or time-varying expected returns? 574.2 Rational or irrational expectations formation? 584.3 Return measurement issues 594.4 Returns in what currency? 604.5 Risk-adjusted returns 614.6 Biased returns 634.7 Notes 635 Rational theories on expected return determination 655.1 The old world 665.2 The new world 685.3 Detour: a brief survey of the efficient markets hypothesis 815.4 Notes 836 Behavioral finance 876.1 Limits to arbitrage 876.2 Psychology 896.3 Applications 986.4 Conclusion 1066.5 Notes 1077 Alternative interpretations for return predictability 1117.1 Risk premia or market inefficiency 1117.2 Data mining and other “mirage'' explanations 1127.3 Notes 115Part II A Dozen Case Studies 1178 Equity risk premium 1198.1 Introduction and terminology 1198.2 Theories and the equity premium puzzle 1208.3 Historical equity premium 1228.4 Forward-looking (ex ante objective) long-term expected return measures 1288.5 Survey-based subjective expectations 1418.6 Tactical forecasting for market timing 1448.7 Notes 1499 Bond risk premium 1539.1 Introduction, terminology, and theories 1539.2 Historical average returns 1579.3 Alternative ex ante measures of the BRP 1609.4 Yield curve steepness: important predictive relations 1619.5 Explaining BRP behavior: first targets, then four drivers 1649.6 Tactical forecasting—duration timing 1749.7 Notes 17710 Credit risk premium 17910.1 Introduction, terminology, and theory 17910.2 Historical average excess returns 18310.3 Focus on front-end trading—a pocket of attractive reward to risk 18810.4 Understanding credit spreads and their drivers 19110.5 Tactical forecasting of corporate bond outperformance 19810.6 Assessing other non-government debt 19910.7 Concluding remarks 20410.8 Notes 20511 Alternative asset premia 20711.1 Introduction to alternatives 20711.2 Real estate 21011.3 Commodities 21911.4 Hedge funds 22611.5 Private equity funds 24111.6 Notes 24512 Value-oriented equity selection 24912.1 Introduction to dynamic strategies 24912.2 Equity value: introduction and historical performance 25112.3 Tweaks including style timing 25812.4 The reasons value works 26112.5 Does the value strategy work in equities beyond individual stock selection or in market or sector selection in other asset classes? 26512.6 Relations between value and other indicators for equity selection 26712.7 Notes 26813 Currency carry 27113.1 Introduction 27113.2 Historical average returns 27213.3 Improvements/refinements to the baseline carry strategy 27613.4 Why do carry strategies work? 28213.5 Carry here, carry there, carry everywhere 28813.6 Notes 29014 Commodity momentum and trend following 29314.1 Introduction 29314.2 Performance of simple commodity momentum strategies 29414.3 Tweaks 29814.4 Why does momentum—such a naive strategy—work? 29914.5 Momentum in other asset classes 30114.6 Notes 30515 Volatility selling (on equity indices) 30715.1 Introduction 30715.2 Historical performance of volatility-trading strategies 31115.3 Tweaks/Refinements 31415.4 The reasons volatility selling is profitable 31515.5 Other assets 31915.6 Notes 31916 Growth factor and growth premium 32116.1 Introduction to underlying factors in Chapters 16–19 32116.2 Introduction to the growth factor 32716.3 Theory and evidence on growth 32816.4 Asset market relations 33116.5 Time-varying growth premium 33816.6 Notes 33817 Inflation factor and inflation premium 34117.1 Introduction 34117.2 Inflation process—history, determinants, expectations 34517.3 Inflation sensitivity of major asset classes and the inflation premium 35017.4 Time-varying inflation premium 35617.5 Notes 35618 Liquidity factor and illiquidity premium 35918.1 Introduction 35918.2 Factor history: how does liquidity itself vary over time? 36218.3 Historical evidence on average liquidity-related premia 36518.4 Time-varying illiquidity premia 37018.5 Note 37419 Tail risks (volatility, correlation, skewness) 37519.1 Introduction 37519.2 Factor history 37819.3 Historical evidence on average asset returns vs. volatility and correlation 38019.4 Theory and evidence on the skewness premium 38919.5 Verdict on why high-volatility assets fare so poorly 39219.6 Time-varying premia for tail risk exposures 39519.7 Notes 396Part III Back to Broader Themes 39920 Endogenous return and risk: Feedback effects on expected returns 40120.1 Feedback loops on the direction of risky assets 40120.2 Feedback loops on less directional positions 40320.3 Agenda for market timers and researchers 40520.4 Notes 40721 Forward-looking measures of asset returns 40921.1 Popular value and carry indicators and their pitfalls 41021.2 Building blocks of expected returns 41321.3 Notes 41622 Interpreting carry or non-zero yield spreads 41922.1 Introduction 41922.2 Future excess returns or market expectations? 42022.3 Empirical horse races for various assets 42422.4 Conclusions 42822.5 Notes 42923 Survey-based subjective expected returns 43123.1 Notes 43524 Tactical return forecasting models 43724.1 Introduction 43724.2 What type of model? 43824.3 Which assets/trades? 44124.4 Which indicator types? 44224.5 Enhancements and pitfalls 44324.6 Notes 44425 Seasonal regularities 44525.1 Seasonal, cyclical, and secular patterns in asset returns 44525.2 Monthly seasonals and the January effect 44625.3 Other seasonals 45326 Cyclical variation in asset returns 45726.1 Typical behavior of realized returns and ex ante indicators through the business cycle 45826.2 Typical behavior of realized returns and ex ante indicators across different economic regimes 46126.3 Notes 46527 Secular trends and the next 20 years 46727.1 Contrasting 1988–2007 with 1968–1987 46727.2 Reversible and sustainable secular trends 46827.3 The next 20 years 47427.4 Notes 47828 Enhancing returns through managing risks, horizon, skill, and costs 47928.1 Introduction: how can investors enhance returns? 47928.2 Risk 48228.3 Investment horizon 49228.4 Skill 49628.5 Costs 49928.6 Notes 50129 Takeaways for long-horizon investors 50329.1 Key takeaways from theory 50429.2 Empirical return sources 50429.3 My take on key debates 50629.4 Know thyself: large long-horizon investors’ natural edges 51229.5 Institutional practices 51329.6 Notes 514Appendices 515A World wealth 515A.1 Global total 516A.2 Asset class detail 516A.3 Notes 518B Data sources and data series construction 519B.1 Asset class and sector returns 519B.2 Strategy style returns 521B.3 Factor proxies 522B.4 Forward-looking yields and spreads 523B.5 Survey data and expected inflation 523B.6 Miscellaneous other 524Bibliography 527Index 551