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Slow pain or fast pain? The implications of low investment yields

IN 1988 STEVE GUTTENBERG, a comic actor, appeared on a British talk show. At one point he was asked why he had not appeared in “Police Academy 5”, having starred in the earlier films. He replied that, in his view, all the important philosophical questions had been addressed in the first four movies. This brings us to the more serious business of investing, and a sequel of a very different kind. Ten years ago Antti Ilmanen, a finance whizz, published “Expected Returns”, a brilliant distillation of investment theory, practice and wisdom. His latest book, “Investing Amid Low Expected Returns”, is an update, taking in a decade’s worth of additional research and data. Mr Ilmanen has read all the books and papers, sorting the good stuff from the junk. He has a gift for explaining clearly and concisely the lessons of this research for investors. The new book is as invaluable a resource as the old one. If it has a fault, it is that it does not quite address all the important philosophical questions. A sequel may be necessary. Start, though, with a recap of the expected-returns framework. There are two sources of return on an investment: income and capital gain. The income on, for instance, a government bond is the interest (or “coupon”) paid once or twice a year. Bond prices and yields move inversely. So when interest rates fall, as they did for much of the past four decades, bond investors enjoy a capital gain. In essence a capital gain of this kind brings forward future returns. You get the income now you were going to get later. But as yields fall ever lower the scope for further capital gains becomes more limited. So low yields imply low expected returns. This bond-like logic holds for other assets—equities, property, private equity and so on. Dividend and rental yields have fallen in response to the secular fall in interest rates. Owners of all kinds of assets have experienced windfall gains. But today’s low yields imply low expected returns in the future. What now? As Mr Ilmanen sees it, low expected returns can materialise through either “slow” or “fast” pain. In the slow-pain scenario, assets remain expensive and investors receive desultory bond coupons, equity dividends and rental receipts for years on end. In the fast-pain scenario yields revert to their higher historical averages. This implies a spell of brutal capital losses followed by fairer returns thereafter. The choice is between well-heeled stagnation and a crash. Mr Ilmanen is too much of an epistemological sceptic to put all his chips on one scenario. He is also too careful an analyst to miss that low inflation made the high-asset-price, low-yield 2010s what they were. Many of the factors that kept a lid on inflation in that decade—globalisation, efficient supply-chain management, tight fiscal policy, an expanding global workforce—are now attenuating or unwinding. Mr Ilmanen’s hunch is that the 2020s will see something of a reversal of the investment trends of the preceding decade. But he generally eschews investing on hunches. Faced with lower expected returns, investors have three courses of action: they can take more risk to reach for higher returns; they can save more; or they can accept reality and play the hand they have been dealt as well as they can. The first approach may increase returns but also makes them more uncertain. Saving more means sacrificing today for the sake of tomorrow, a highly personal choice. Understandably, Mr Ilmanen’s focus is on the third approach. He sets out a chapter-by-chapter analysis of various investment assets and styles. He advises how to put them together in a truly diversified portfolio. Along the way, he explains why market timing is a snare (you end up taking too little risk); what the true appeal of private equity is (not superior returns); and why portfolio insurance will not save you (it is too expensive in the long run). There are shortcomings. A quarter of the 500+ references are from authors affiliated with AQR Capital Management, Mr Ilmanen’s employer. This weighting gives the book a less independent air than “Expected Returns”. Readers would have benefited greatly from a chapter on the implications of low expected returns for different sorts of savers. The fast-pain scenario, for instance, is surely preferable for young savers, to whom the book is dedicated. Perhaps this and other gaps will be filled in “Expected Returns III”. Even Mr Guttenberg has been teasing fans with the prospect of “Police Aca demy 8”. The big philosophical questions are never truly settled.

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