When the equity risk premium fades, alpha shines

For the past century, US equities have delivered an average annual return of 10%. The equity risk premium (ERP), in other words, the extra return investors get for investing in stocks over other asset classes, has long been a cornerstone of investing. Historically the ERP has provided a 5% excess return over bonds and 6% over cash. In this framework, alpha – the additional return from fundamental or quantitative active management – was often considered a secondary benefit, contributing only a modest share of total returns even for the best investors.

However, the conditions that fueled this historical ERP are changing. Expanding valuation multiples, strong earnings growth, favorable demographics, and US market dominance in the last decades were the key tailwinds supporting those high equity returns. And today, many of these forces are weakening.

Many investors active today have in fact never experienced negative equity returns, and have grown accustomed to strong performance. However, history tells a different story, with prolonged periods of weak or even negative returns in the 1930s, 1970s, and early 2000s. So, what does a strong 10-year return tell us about the decade to come?

A simple way to assess future equity returns is to examine past equity return patterns. To explore this, we categorized historical 10-year realized equity premiums into three groups – low, medium, and high – and analyzed the returns that followed. Indeed, the data supports the principle of mean reversion: strong equity market returns are often followed by weaker returns, and vice versa.

While mean reversion provides a useful framework, it oversimplifies the drivers of future returns. A deeper analysis of historical return decomposition reveals what fueled past performance. Our recent research shows that the recent US equity rally was not only driven by earnings growth but also by a significant expansion in valuation multiples – particularly in large-cap growth stocks. Less recognized is that small caps and low volatility stocks delivered strong fundamentals but remained undervalued.

This raises concerns about the sustainability of future returns, especially as valuations remain historically elevated and the US market now comprises 74% of the total global market capitalization. A more comprehensive approach, rooted in economic first principles, considers the fundamental components of the equity risk premium – dividends, valuation changes, and expected earnings growth – over a 10-year horizon. Robeco’s five-year outlook 2025-2029, which integrates multiple valuation metrics along with growth estimates, projects the US equity premium will be close to zero. However, the global outlook is more favorable – driven by more attractive valuations in Europe and emerging markets, where the global ERP stands at approximately 2%.

Interestingly, periods of strong equity performance often coincide with lower factor premiums, and vice versa. To explore this relationship, we use the US value and momentum factors as a rough proxy for active quantitative investing, splitting the sample into three segments based on realized 10-year equity premiums.

We see that factor premiums remain stable – and even rise slightly – when equity returns are low. Most strikingly, when viewed as a share of total returns, alpha shifts from being a complement to being the dominant source of performance.

Our research on factor investing further supports this asymmetry in alpha. Blitz (2023), for example, finds that factor alphas tend to rise when equity market returns are lower, reinforcing the importance of factors in a low-equity-premium environment. Even if factor alphas remain constant across regimes, their relative contribution to total returns increases when market beta weakens. In such periods, factors like value, low volatility, quality, and momentum offer an alternative, uncorrelated source of alpha.