AQR’s latest edition of Alternative Thinking offers the firm’s multi-year projections for global stocks and government bonds. In addition to updating estimates from the previous year’s edition, the new whitepaper also reviews AQR’s framework and methodology, and goes beyond the major asset classes to include an examination of smart beta indexes and long/short strategies.
AQR’s current estimate of U.S. stocks’ long-term real (above inflation) returns is just 3.8%. European, Australian, Canadian, and emerging market stocks are all projected to outperform the U.S., with respective long-term real returns of 5.5%, 6.1%, 4.6%, and 6.6%. U.K. stocks are expected to generate long-term real returns of 6.2%, also besting the U.S.; while only Japanese stocks are expected to underperform American equities, with returns of 3.5% above inflation.
AQR arrived at these projections by considering earnings yields and combining the Shiller E/P (earnings to price) ratio with the DDM (dividend discount model) to form a synthesis. Normally, a projected “reversion to the mean” is also included in these calculations, but AQR is unconvinced that “mean reversion” component enhances the accuracy of projections – just consider how wrong investors were in 2014 when they generally expected a reversion to mean bond yields.
With U.S. stock returns expected to average less than 4% in real terms, bonds will need to pick up the slack for “60/40” stock/bond portfolios. Unfortunately in AQR’s view, this is unlikely to happen – they project U.S. 10-year government bonds’ long-run real returns at 0.6%, among the lowest on record. Japanese, German, and British government bond returns are projected to be even lower, in real terms, at -0.6%, 0.2%, and 0.3%, respectively. Only Australia and Canada are expected to produce more “robust” real returns – if they can be called that at 0.9% and 0.8% apiece.
Over the past few years, many investors have held strong views that (1) bond yields will rise soon, and (2) this outcome will be very bad news for bond investors. So far the first view has not worked, and we will argue that it is not so clear that either view will be correct for the future.
AQR describes smart beta portfolios as “tilted long-only portfolios” that disregard market cap in their weighting methodologies and instead emphasize other factors. These are systematic, rules-based portfolios that are frequently recalibrated to take advantage of market developments.
AQR looks at two types of smart beta strategies: value and multi-style. The former is described as “value-tilted but still diversified,” and AQR anticipates long-term real returns of 4.8% for such portfolios – a full percentage point higher than the 3.8% projected for U.S. large-cap, cap-weighted stock portfolios. AQR predicts even better performance from multi-style smart beta strategies, which are projected to return 5.7% a year above inflation.
Long/short strategies aren’t the main topic of AQR’s report, but the whitepaper’s authors do provide some general comments: Because long/short strategies can be invested in at any volatility level, the authors say it makes more sense to focus on Sharpe ratios, and that multiple long/short styles applied across multiple asset classes can result in Sharpe ratios of 0.7 to 1.0. By contrast, long-only portfolios rarely reach Sharpe ratios of even 0.6, which indicates long/short strategies generally produce superior risk-adjusted returns. AQR concludes its whitepaper by conceding that while real returns from traditional asset classes are projected to be low, “this concern may not apply to long/short strategies.”
For more information, download a pdf copy of the whitepaper.