The Ilmanen cube

Reading the work of Antti Ilmanen on expected returns, (Expected Returns: An Investor's Guide to Harvesting), leads to a focus on his useful cube structure for looking at expected return differences. The cube is based on three different methods for looking at or classifying expected returns: asset classes, strategies or styles, and underlying factors. 

Asset classes - The world can be divided into four major asset classes: equities, sovereign bonds, credit, and alternatives. This covers the key alternatives available to any portfolio manager.

Strategy styles - Value, trend, carry, and volatility. The expected returns of any asset class will be based on rich/cheapness, momentum, the yield or cash flows received and the sensitivity to volatility.

Risk factors - growth, illiquidity, inflation, and tail risk. The macro factors include growth which drives sales and earnings, inflation which effects both input and output prices, tail risk which could be considered sensitivity to risk and crises, and illiquidity which is associated with the premium for holding assets that may not trade at key times.

For each asset class there is a different risk premium based on its underlying characteristics. Equities will have a higher excess return than bonds because they represent the residual value of the firm. Bonds over carry but no  upside beyond the principal of the bond. Credit will have a premium above government bonds, and alternatives such as commodities or real estate will have a premium that is unique given its sensitivity to different macro factors like the business cycle and inflation. A fist level of diversification should include a mix of all of the asset classes since they are not perfectly correlated and have risk premiums that will have different sensitivities to macro risk factors. Bonds will be negatively affected by inflation while equities should not be as sensitive if earnings increase with inflation. 

Strategy styles have unique risk and return potentials relative to the market. Value will change through time because to represents the price paid by investors for earnings. The trend or momentum style has shown to be unique from market risk and persistent through time. Carry represents the cash flows that are received by investors whether through coupon or dividends and will also vary through time. Different asset classes will have different sensitivity to volatility given the underlying optionality of each asset class. In the most obvious case, bonds such as mortgages that have embedded options will have a prices that move with volatility changes. Risk premiums will vary with volatility as investors demand lower prices for taking on more risk. 

Risk factors will also have significant impact on returns. Illiquid assets will need to have higher returns to pay for the factor that it may be difficult to sell these assets during times of stress. Inflation is a factor that can have a significant impact on nominal assets. Growth will push up earnings and will have an effect on real interest rates. Hence, there is a premium price for those assets which perform better in recessions and there is a higher return demanded for asset that will do poorly during times of financial stress. Tail risk represents the fact that many assets all do poorly in times of recession and during financial crisis. 

True diversification tries to spread exposure across all asset classes, strategies and risk factors. Thinking about one factor, strategy, or asset class will limit the set of opportunities as well as expose a portfolio to the only one set of risks.