At the Research Foundation of CFA Institute, we are honored to publish Expected Returns of Major Asset Classes by Antti Ilmanen. Below is sample content taken from the author's summary.
We hope you enjoy reading this and other books published by the Research Foundation...
Bud Haslett, CFA
Research Foundation of CFA Institute
Expected returns are arguably the most important input into investment decisions. Many investors determine their expectations for returns on investments on the basis of subjective views. More objective predictions are anchored on historical experience, financial theories, and prevailing market conditions.
In my book Expected Returns: An Investor's Guide to Harvesting Market Rewards (Chichester, U.K.: John Wiley & Sons, 2011), I tackle this broad topic in a comprehensive manner; this shorter book, in contrast, adapts four of my central chapters on asset class returns (stocks, government bonds, corporate bonds, and alternatives). Both books stress that the traditional paradigm of expected return estimation should be broadened in two ways: (1) moving beyond the narrow perspective of asset class investing to focus additionally on expected returns for active strategy styles and for underlying factors and (2) reducing the focus on historical performance and widening the set of inputs used. Following these principles results in two key benefits: better-diversified portfolios and more forward-looking analysis.
Broadening Away from Equity Concentration and Asset Class Perspective.
Even though many investors have improved portfolio diversification by shifting from home-biased holdings to truly global investments and by expanding their asset class opportunity set, they still largely rely on the equity premium for long-term returns. Both 60%/40% stock/bond portfolios and "endowment model" portfolios (which make significant investments in alternatives) have high stock market betas, and equity risk often accounts for 90% of the portfolio risk budgets in either type of portfolio.
This book drills into the building blocks of asset class diversification: the equity premium, term and credit premia in fixed income, and the performance of the main alternative assets (real estate, commodities, hedge funds, and private equity). My 2011 book argues further that by looking beyond asset class allocation, investors can achieve more effective portfolio diversification. The book uses a three-dimensional cube to help readers visualize adding to the asset class perspective by including the complementary viewpoints of strategy styles and risk factors.
* Strategy styles. The strategy style perspective is important for understanding the profit potential of popular active trading styles. Empirical research shows that the characteristics of cheap valuations, high starting yields, and recent success (momentum) have provided long-run performance tailwinds in almost any investment context studied, often comparable in magnitude to the equity premium. The relation between volatility and future returns is tenuous and is often negative within an asset class.
* Underlying factors. Sophisticated investors are increasingly trying to look beyond asset classes and strategies in order to identify the underlying factors driving their portfolio returns. Each asset can be viewed as a bundle of characteristics or systematic factor exposures that largely determine its expected returns. For example, a corporate bond portfolio is subject to interest rate and default risks. Even more fundamentally, it is exposed to fluctuations in inflation and real rates, to gyrations in global and firm-specific growth, and to liquidity and volatility developments.
In summary, it is helpful to view investment returns from many angles--which asset classes earn them, what active strategy types deliver them, what underlying factors explain them. The broadened perspective helps investors harvest market rewards from multiple sources to achieve more effective portfolio diversification and superior risk-adjusted returns.