Book] Investing | Expected Returns - Antti Ilmanen (2011)

🐵 I. Quick Summary:

"Expected Returns" provides a comprehensive framework for understanding and evaluating different asset classes and constructing well-diversified portfolios. By considering a range of factors, such as valuation ratios, macroeconomic variables, and risk management strategies, investors can increase their chances of achieving their investment goals.

Introduction

Antti Ilmanen’s Expected Returns sets out a comprehensive framework for thinking about returns across asset classes and strategies. He begins by distinguishing between the ex‑ante risk premium – the compensation investors expect for bearing risk – and ex‑post realised returns. Expected returns combine expected cash flows (for example, coupon payments or dividends) and expected capital gains, and are shaped by fundamental drivers (economic growth, inflation, interest rates) as well as investor sentiment and behavioural factors. Ilmanen stresses that simply extrapolating past performance is dangerous because expected returns vary through time, and human biases like overconfidence, extrapolation and herd behaviour can distort asset prices. Contemporary finance theory therefore views expected returns as driven by multiple risk factors – some rational (risk and liquidity premia), others behavioural – rather than by a single‐factor CAPM.

Historical asset‑class returns

Ilmanen reviews long‑run returns for equities, bonds, commodities and alternative assets. Equities have historically delivered an excess return of ~4–5 percentage points over Treasury bills, but this premium has been volatile and has varied across decades. He decomposes equity returns into dividend yield, real earnings growth and multiple expansion; historically the latter component can be pro‑cyclical and is unlikely to persist indefinitely Government bonds earn a term premium above cash; the excess return comes from inflation compensation, expected short‑rate changes and a bond risk premium driven by inflation uncertainty, safe‑haven demand and supply–demand imbalances. Corporate bonds offer slightly higher yields, but much of the ex‑ante yield spread compensates for default risk and illiquidity; ex‑post returns have been only ~30 basis points above Treasuries because investors forced to sell downgraded bonds forego the recovery premium.

Ilmanen is sceptical about alternative assets. Returns on real estate, hedge funds and private equity have been broadly comparable to public equities once fees, illiquidity and reporting biases are accounted for. Private equity returns vary widely; only top‑quartile funds have consistently beaten the stock market. Consequently, diversification across traditional asset classes remains the core of most portfolios, but investors should not expect extraordinary rewards from alternatives without taking on material illiquidity and selection risk.

Table 1 – Selected long‑run excess returns and style premia

*Long‑run geometric mean excess returns reported by Ilmanen; returns are before trading costs and exclude cash income.

Limits of mean‑variance optimisation and the case for multi‑factor models

Mean‑variance optimisation assumes normally distributed returns and perfect liquidity. Ilmanen notes that real markets exhibit fat tails, skewness and illiquidity, making simple mean‑variance approaches fragile. He recommends incorporating transaction costs, liquidity constraints and non‑normal return distributions into portfolio construction. To improve return estimates, he advocates multi‑factor models: instead of relying on a single market factor, investors should model expected returns as a sum of exposures to multiple macroeconomic and market factors. Each asset’s expected return is its sensitivity (beta) to each factor multiplied by that factor’s risk premium. The AQR summary emphasises that rational determinants (risk and liquidity premia) and behavioural influences (extrapolation, overconfidence) both drive returns, and that expected premia can vary through time.

Time‑varying expected returns and market timing

A key theme in the book is that expected returns are not constant. Valuations, macro conditions and investor risk appetite change, and these shifts affect future returns. Ilmanen notes that valuation indicators (such as yields on bonds or earnings yields on equities) show positive correlations with subsequent performance: cheap assets tend to deliver higher future returns. He recommends modest contrarian timing – shifting allocations when valuations are extreme – while warning that market timing involves concentration and career risk. Trend‑following and momentum strategies exploit the persistence of asset price movements over one‑year horizons but eventually give way to mean reversion; investors often chase multi‑year winners, which is when reversals dominate.

Estimating equity and bond risk premiums

For equities, Ilmanen suggests combining historical averages with forward‑looking indicators. Dividend yields and earnings yields provide a baseline, while expected earnings growth and changes in valuation multiples add or subtract from the expected return. High valuations imply lower future returns; merely projecting historical returns (for example, the 10 % U.S. equity return from 1926–1990) would have been misleading when valuations were high in 1999. Surveys and models that discount expected cash flows (such as the Gordon growth model) offer alternative estimates.

For bonds, expected returns equal the starting yield plus any term premium. Ilmanen decomposes bond yields into an inflation component, expected short‑term rate path and a bond risk premium. The bond risk premium compensates for inflation uncertainty, recession hedging (safe‑haven demand) and supply‑demand dynamics. Corporate bond spreads contain compensation for default risk, downgrade risk and illiquidity; investors often realise less than the yield spread because bonds are sold when they are downgraded.

Credit risk and illiquidity premia

Credit risk premiums arise because investors demand extra return for bearing the possibility of default. The size of the premium depends on credit ratings, default probabilities and recovery rates. Liquidity also matters: bonds and other assets that are expensive to trade or have limited markets should offer higher expected returns. Ilmanen’s research shows a positive relationship between illiquidity and long‑run returns – investors are compensated for holding less liquid investments – though the premium can shrink when too many investors seek illiquidity. The 2008 crisis highlighted that illiquidity premiums can disappear abruptly; investors should be wary of overpaying for illiquid alternatives.

Alternative asset classes

Ilmanen examines real estate, hedge funds and private equity. Real estate returns in 1978–2008 were around 10 % for commercial property and 5.7 % for residential property, but these figures exclude transaction costs and taxes. Hedge fund returns, after adjusting for survivorship and reporting biases, consist of market‑related (beta) components and a smaller “alpha” of around 3 %. Private equity as an asset class delivers returns roughly comparable to the stock market; only top‑quartile funds consistently outperform. Illiquidity and high fees further erode net returns. Consequently, alternative assets can play a role in diversification but are not a panacea.

Active management and evaluation of strategies

Active management involves attempting to beat benchmarks through security selection or market timing. Ilmanen notes that persistent outperformance is rare and often attributable to exposure to hidden risk factors rather than manager skill. He recommends evaluating strategies using robustness, stress testing and scenario analysis to ensure that historical excess returns are not artefacts of data mining. In assessing popular strategies, he highlights that value, carry, momentum/trend, volatility selling and defensive (low‑beta/quality) styles have delivered positive long‑run risk‑adjusted returns. However, each style experiences prolonged drawdowns, so diversifying across several styles reduces timing risk. Long/short implementation can improve diversification and reduce transaction costs.

Behavioural finance and investor biases

Ilmanen integrates insights from behavioural finance to explain persistent anomalies. Value premiums may arise because investors overprice optimistic growth stories and extrapolate high earnings growth, leading to disappointment later. Momentum strategies work because price trends persist for up to a year, yet investors tend to chase past winners over multi‑year horizons – exactly when reversal effects dominate. Low‑volatility and defensive strategies offer better risk‑adjusted returns because investors overpay for both “lottery” high‑volatility assets and insurance‐like assets. Illiquidity premiums reflect behavioural preferences for the illusion of stability: investors accept lower liquidity in exchange for return smoothing.

Portfolio construction and risk budgeting

The book emphasises diversification across both asset classes and style factors. Combining multiple style premia with low correlations can significantly improve Sharpe ratios: Ilmanen shows that diversifying across value, carry, momentum/trend, volatility and defensive strategies can reduce portfolio volatility by half and double the Sharpe ratio compared with a traditional market‑cap weighted portfolio. He suggests risk budgeting, allocating risk (not capital) across different factors and strategies, and considering approaches like risk parity and Bayesian optimisation to balance exposures. Because many institutions cannot use leverage, their portfolios are dominated by equity market risk; to achieve balanced risk allocation, some leverage may be required. Investors should also incorporate liability-driven investing for pension funds and endowments, matching asset duration to liabilities and considering regulatory and governance constraints.

Managing institutional portfolios

Institutional investors face additional constraints: liability obligations, regulatory requirements and governance structures. Ilmanen advocates liability‑driven investing that aligns portfolio duration with the timing of liabilities, and asset‑liability management to ensure that funding ratios remain stable. Regulation can constrain leverage and shorting, limiting the ability to harvest certain premia; governance challenges can lead to pro‑cyclical decisions. Institutions should diversify across asset classes and styles, manage illiquidity carefully and adopt risk budgeting frameworks to allocate risk where it is most rewarded.

Key takeaways for investors

• Diversify beyond asset classes. Combine traditional assets (stocks, bonds, commodities) with style premia such as value, carry, momentum/trend, volatility and defensive strategies to balance risk exposures. Avoid concentrating on a single risk factor.
• Use multiple inputs to estimate returns. Base expected return estimates on a blend of historical averages, economic theory and forward‑looking indicators like yields and valuation ratios. Do not rely solely on past returns.
• Recognise time‑varying premia. Expected returns fluctuate with valuations, macro conditions and investor sentiment. Modest contrarian timing based on valuations can improve outcomes.
• Beware high‑volatility “lottery” assets. The most volatile securities often deliver low risk‑adjusted returns. When seeking higher expected returns, consider leveraging low‑volatility assets rather than buying high‑volatility assets.
• Understand risk and liquidity trade‑offs. Bond yields and spreads contain compensation for inflation, duration, default and liquidity risks. Illiquid assets may offer higher expected returns, but premiums can evaporate during crises.
• Be realistic about alternatives and active management. Alternative assets and active managers rarely deliver superior net returns unless you can access top‑tier funds; evaluate strategies using robustness and diversify across multiple styles.
• Address behavioural biases. Recognise how overconfidence, extrapolation and herd behaviour can impair investment decisions. Systematic strategies and disciplined rebalancing help mitigate these biases.
• Implement risk budgeting. Allocate risk rather than capital across different factors; consider risk parity and factor portfolios to achieve balanced exposures.
• For institutions, align with liabilities. Use liability‑driven investing and asset‑liability management to meet future obligations, and be mindful of regulatory and governance constraints.

Conclusion

Expected Returns is a dense but invaluable guide for investors seeking to understand the drivers of returns across asset classes and strategies. Ilmanen combines empirical evidence, economic theory and behavioural insights to argue that harvesting multiple risk premia is the most reliable way to build robust portfolios. The book cautions against complacency: high valuations and low bond yields suggest that future returns may be muted, so investors must diversify broadly, manage risk judiciously and temper expectations. By embracing a multi‑factor, risk‑balanced approach and remaining alert to time‑varying opportunities, investors can improve their chances of achieving long‑term goals in an uncertain and evolving market landscape.

Resources and References

Here are several useful resources for investors who want to dive deeper into Antti Ilmanen’s Expected Returns framework and related ideas:

1. “Expected Returns: An Investor’s Guide to Harvesting Market Rewards” (O’Reilly/Wiley, 2011) – The official book page on O’Reilly describes Ilmanen’s work as a comprehensive reference that offers a toolkit for forecasting and harvesting market rewards across a wide range of investments. It emphasizes balancing historical data with theory and current market conditions, explaining how expected returns differ by asset class and strategy. This is the primary source for the full framework and is essential reading for practitioners and advanced investors.
2. CAIA & CFA Institute conference proceedings: “Understanding Expected Returns” (2012) – In this paper, Ilmanen argues that investors should look beyond historical averages, incorporating economic theories and forward‑looking indicators when setting expectations. He stresses diversifying across styles (value, carry, momentum, volatility and liquidity) rather than just asset classes, since style premia have historically offered returns comparable to the equity premium. The piece also advocates modest contrarian timing and explains that diversification remains the best way to reduce risk in a low‑return environment.
3. AQR Perspective: “Antti Is (Still) Trying to Understand Return Expectations” (Cliff Asness, 2025) – This article discusses how investors form expectations and highlights a disconnect between “objective” expected returns (anchored to yields and valuations) and investors’ subjective expectations, which often extrapolate past returns. It notes that subjective expectations can be dangerously optimistic at extreme valuations (e.g., 2000, 2021 or 2024). The piece argues that many practitioners focus on expected cash flows and ignore prices, leading to over‑confidence in high‑growth periods.
4. Rothman Investment Management – Book Review: Investing Amid Low Expected Returns (2025) – This review summarises Ilmanen’s follow‑up book and reinforces several themes: current yields (dividend yield for stocks, effective interest rate for bonds) are the best predictors of long‑term returns; in a low‑return environment investors often respond by increasing risk or savings; illiquid assets and alternatives may not offer much extra return once fees and reduced transparency are considered; and diversifying across style premia (value, momentum, carry, defensive) can improve risk‑adjusted returns.
5. Atlas Capital Advisors – “Insights from Antti Ilmanen: Investing Amid Low Expected Returns” (2025) – This article condenses three key insights from Ilmanen’s low‑returns book: U.S. stocks and related assets are priced for relatively low future returns; illiquid private assets may no longer carry an illiquidity premium; and there could be a valuation‑driven opportunity for value‑tilted equity strategies. It also discusses his methodology for estimating future real returns and cautions that recent above‑normal earnings growth cannot persist indefinitely.

Note) 'Resources and References' has been put together by AI and reviewed by a human, me.