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Antti Ilmanen - Expected Returns: An Investors Guide to Harvesting Market Rewards

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Book:
Expected Returns: An Investors Guide to Harvesting Market Rewards
Author:
Antti Ilmanen
Publisher:
Wiley
Genre:
Science / Business
Year:
2011
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Expected Returns is a one-stop reference that gives investors a comprehensive toolkit for harvesting market rewards from a wide range of investments. Written by an experienced portfolio manager, scholar, strategist, investment advisor and hedge fund trader, this book challenges investors to broaden their minds from a too-narrow asset class perspective and excessive focus on historical performance. Coverage includes major asset classes (stocks, bonds, alternatives), investment strategies (value, carry, momentum, volatility) and the effects of underlying risk factors (growth, inflation, illiquidity, tail risks). Judging expected returns requires balancing historical returns with both theoretical considerations and current market conditions. Expected Returns summarizes the state of knowledge on all of these topics, providing extensive empirical evidence, surveys of risk-based and behavioral theories, and practical insights.

This is the best book on active management ever written - and it achieves that status without mentioning a single stock or bond by name. Anyone who performs the rigorous analysis Ilmanen describes - admittedly a neat trick, since the worlds most sophisticated investors struggle to do it successfully - will beat the market.
Laurence B. Siegel, Former Director of Research, The Ford Foundation

Antti Ilmanen shows the way forward for the investment management profession in this remarkable book. In a comprehensive and impressive way, he combines financial theory, historical performance data and forward-looking indicators, into a consistent framework for assessing expected returns and risk. His approach is both scientific and practical, based on decades of studies and his own trading experience. With a touch of personal wisdom and humility, Ilmanens book is a fascinating and educational journey into the future of investment management.
Knut N. Kjaer, Founding CEO of the Norwegian Government Pension Fund/NBIM and former president of RiskMetrics Group

Ilmanens wonderful book manages to be exquisitely readable while covering just about every aspect of the investment process. Filled with many, many fresh and useful insights. This volume deserves to be read and then kept close at hand - because it is sure to be needed again and again.
Martin L. Leibowitz, Managing Director, Morgan Stanley, and former CIO, TIAA-CREF

Job one for any investor is to estimate asset class returns. For the first time, Antti Ilmanen has assembled into one volume all of the tools necessary for this task: for the working money manager, a unique treasure trove of analytical techniques and empirical evidence; for the academic, a comprehensive guide to the relevant academic literature; and for the consultant, a blinding light with which to illuminate performance. Expected Returns is destined to occupy the front shelves of investment professionals around the world.
William J. Bernstein, author of The Intelligent Asset Allocator, The Birth of Plenty, and A Splendid Exchange, and co-principal of Efficient Frontier Advisors

Anttis synthesis of experience and theory has given us a book which fills a major gap in the literature on investing. Amazing, but true, this is the first book dedicated to the critical and challenging task of estimating how much we should expect to earn on our investments. This illuminating book, teaming with valuable insights that have never before been gathered under one roof, cannot fail to make the reader a more successful and discerning investor.
Victor Haghani, Associate Lecturer, London School of Economics, and former founding partner of LTCM

Ilmanen has written a thorough and detailed analysis of one of the central issues in investing.
Ken French, Heidt Professor of Finance, Dartmouth College

Investors decisions should be evidence based. Antti Ilmanen assembles a global body of evidence, and interprets it with insight. Read this book and you will improve your understanding of the future.
Elroy Dimson, Emeritus Professor of Finance, London Business School

If I could choose only one book on active management, I would choose Expected Returns. This book is extremely thorough and well researched, yet direct and to the point.
Roger G. Ibbotson, Professor in the Practice of Finance, Yale School of Management, and Chairman and CIO of Zebra Capital Management

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Table of Contents

For other titles in the Wiley Finance Series please see www.wiley.com/finance

This edition first published 2011

2011 Antti Ilmanen

Registered office

John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex, PO19 8SQ, United Kingdom

For details of our global editorial offices, for customer services and for information about how to apply for permission to reuse the copyright material in this book please see our website at www.wiley.com

The right of the author to be identified as the author of this work has been asserted in accordance with the Copyright, Designs and Patents Act 1988.

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, except as permitted by the UK Copyright, Designs and Patents Act 1988, without the prior permission of the publisher.

Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books.

Designations used by companies to distinguish their products are often claimed as trademarks. All brand names and product names used in this book are trade names, service marks, trademarks or registered trademarks of their respective owners. The publisher is not associated with any product or vendor mentioned in this book. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold on the understanding that the publisher is not engaged in rendering professional services. If professional advice or other expert assistance is required, the services of a competent professional should be sought.

ISBN 978-1-119-99072-7

A catalogue record for this book is available from the British Library.

Project management by OPS Ltd, Gt Yarmouth, Norfolk

Typeset in 10/12pt Times

Foreword

The first time I met Antti Ilmanen I thought he was insane. I was right. But, I was to discover quickly he was insane in a good way. The incident in question was at a new Ph.D. student mixer, about as exciting as it sounds, where seconds after being introduced to Antti he asked me who do you rate in the top-five academics in finance and why? He had his own answers on a set of Post-it notes. By the way, Antti has become famous for these Post-it notes. Suffice it to say if he consults the Post-its, and says you said something 17 years ago that turned out to be disproved in the latest Journal of Finance paper, just assume hes right and move on.

Getting back to my story, he couldnt understand how I couldnt name five. Truth be told I probably could have named maybe three academics in total, and as to justifying my choices with why?, I was stuck at zero. I had not chosen finance because, like Antti, I was already obsessed with it. I chose it as my dad, a lawyer, forbade me to go to law school, I had some mild ability at mathematics, I recognized that finance might be both intellectually interesting and provide a good living, and finally I chose a Ph.D. as being a professor seemed like a nice life (little did I know the Sirens of Wall Street would soon call me away...) Antti looked at me with a what the heck are you doing in the Ph.D. program confused stare, and I politely ran away from the very intense, very finance-obsessed young Finn. Now, 20+ years later, and after countless similar incidents, I no longer run away (he finds me anyway), but hes still intense and obsessed with finance. Over the years, and specifically through this book, those traits of his have made us all better off.

One more aside before my foreword begins in earnest. I briefly considered not writing this foreword in protest or as a rearguard action. Antti gives away a lot in this book. Perhaps few true secrets (though there are some!), as this is more a textbook than original research. But he makes much of what has become called quantitative finance easily (OK, 300+ dense pages, in original format, of easily) accessible in one place. Long term, that cant be good for people like me who make their livings from this stuff being at least a bit secret. But being skilled at game theory I quickly determined that if I didnt write the foreword somebody else would, so refusal would not accomplish much. With that strategy shot down, I very fleetingly considered having him killed, but this seemed to entail too much tail risk (see Chapters 15 and 19) and, anyway, is at least somewhat morally ambiguous. Besides, Anttis just the type to have stashed a Post-it at his lawyer with a note in the event of my untimely... So in the end I decided to smile and write the foreword, and just resolve to work harder (along with many others at my firm and others throughout the field) to give Antti material for a sequel 20+ years from now!

Now lets talk about the title subject.

Expected returns are how much you make on average over time on an investment or strategy. Risk is the possibility that, over any time horizon, you never get your expectation, as once again the world interferes with a perfectly good plan. Risk can make you fail to reach your expectations because of the simple uncertainty around expectations it brings, or because, as in 2008 for many, bad realizations call into question long-term survival or at least the ability to stick with a plan. Still, expected returns are incredibly important. If you survive and stick to a good plan, they add up nicely.

Antti has chosen to write a book on expected return in the Age of Risk. Risk, and particularly risk in the sense of survival, is all the rage in these days following a major financial crisis. This wide-ranging discussion of risk is right and proper. If some investors took too much risk and that caused or exacerbated the financial crisis, thats a pretty important event to learn from. If some investors thought risk was simple and all figured out, and got a black swan dropped on their heads, it is important to learn from that too. However, its not the whole story.

While perhaps differing from the vast majority of risk-focused researchers and authors these days, Id argue that the study of expected returns deserves more of our attention, even just after one of the biggest left tails in history. For one thing, as scary as the world got, some of our much maligned simple normal models actually did OK for all assets other than highly structured and/or levered ones, or over the very short term (see http://www.dimensional.com/famafrench/2009/05/how-unusual-was-the-stock-market-of-2008.html) . For another thing, in a theme Antti returns to again and again in his book, expected returns dont have to stay the same throughout time. Part of what we see as risk materializing during events like the 2008 financial crisis, and the 19992000 tech bubble, are more accurately seen as investors misunderstanding or misestimating expected returns. In both those cases the extreme dnouement that followed occurred, at least according to many (and me), because before the disaster, investors were willing to accept far too low an expected return, first on stocks and specifically on technology stocks, and then a decade later on credit and real estate. In both the theory and the reality of these globe-shaking events, the discussions of risk and expected return are intimately linked.

So why so much more discussion of risk than expected return these days? Well, obviously the magnitude of recent events makes all of us greatly value the chance we could have avoided that pain. But again, a careful study of expected return might have easily, perhaps even more easily, led to the same protection by avoiding certain investments on the ground that their expected returns were too low. Frankly, I think a lot of the answer is that discussing risk is inherently sexier than discussing expected returns. Good forecasts of expected return add up over the long term, but dont matter for squat next week. Risk can kill you, or make you a hero, in the time it takes you to say flash crash. Would you rather write about a tsunami or erosion? More specifically, from a safe perch, say the hindsight of authoring a book, which event would be more dramatic to narrate? The analogy, forced though it may be, continues to work as erosion, or expected return, might be mind-numbingly boring at any one moment, but it has a heck of a lot to say about how the future will be shaped.

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