AQR Long-Short Equity/AQR Equity Market Neutral: A Review

This analysis originally appeared in the April 2016 Mutual Fund Observer, but I'm republishing it here for completeness's sake. I've made some minor edits and updates. As always, comments welcome.

Objective and strategy

AQR offers its absolute return equity strategy in two mutual fund flavors: AQR Equity Market Neutral and AQR Long-Short Equity. Equity Market Neutral, or EMN, goes long global stocks that score well on proprietary composite measures and shorts global stocks that score poorly. AQR groups these measures into six broad “themes”:

Value is the strategy of buying stocks that are cheap on fundamental measures such as book value, earnings, dividends and cash flow.

Momentum is the strategy of buying stocks with strong recent relative performance according to measures such as price returns, abnormal returns after earnings announcements (earnings surprises), abnormal risk-adjusted returns (residual momentum), and returns of economically linked firms (indirect momentum).

Earnings quality is the strategy of buying stocks with reported earnings that are more reliable indicators of future earnings, according to measures such as accruals.

Stability is the strategy of buying stocks with defensive characteristics, such as low volatility, low beta, and low leverage.

Investor sentiment is the strategy of buying stocks with wide agreement by “smart money”, according to measures such as low short interest as a percentage of market capitalization and high commonality of holdings by elite hedge funds.

Management signaling is the strategy of buying stocks where management engages in actions that indicate financial strength or cheapness, such as debt retirement and share repurchases.

Stocks are ranked by these measures within each industry. The stocks with the highest composite scores are bought and the stocks with the lowest composite scores are shorted. Industry neutrality improves risk-adjusted returns on a wide variety of stock selection signals, perhaps because it removes persistent industry bets.

In addition, the strategy engages in country-industry pairs selection using the same six sets of signals and industry selection using only value and momentum. Because AQR dislikes concentrated bets, the country-industry pairs and industry selection strategies are allotted a smaller portion of the strategy’s overall risk than the stock-selection strategy.

The balance of the long and short sleeves is managed to produce returns uncorrelated with the MSCI World Index, a market-weighted benchmark of developed market stocks. This does not mean each sleeve has the same notional size. The long sleeve tends to exhibit lower volatility for each unit of notional exposure than the short sleeve. In order to balance them, the strategy must own more dollars of the long sleeve, creating the impression that it has net long equity exposure. The gross exposure for each sleeve has a floor of 100% NAV and a cap of 250% NAV, meaning the strategy’s gross exposure can range from 2x to 5x the net asset value of the fund. As of February end, AQR Equity Market Neutral had 190% notional long exposure and 173% notional short exposure, for a total gross notional exposure of 363%.

AQR takes steps to mitigate the risks of leverage. First, the strategy is well diversified, with over 1700 stock positions, most of them under 0.5% notional exposure and the biggest at a little under 1.7%. Single-stock concentration goes against every bone in AQR. Like most quant investors, AQR goes for seconds and thirds when it comes to the “free lunch” of diversification.

Second, AQR has a 6% annualized volatility target for the strategy, which means AQR will likely reduce gross leverage if its positions behave erratically. This is a trend-following strategy as periods of high volatility usually coincide with bad returns. For reference, the volatility target is about a third of the historical volatility of the U.S. stock market and roughly the same as the historical volatility of the Barclays Aggregate Bond Index (though in recent years the bond index’s volatility has dropped to about 3%).

Finally, the strategy applies what AQR calls a “drawdown control system”, a methodology for cutting risk when the strategy loses money and adding it back as it recoups its losses (or enough time lapses since a drawdown). The drawdown control system can cut the fund’s target volatility by up to half in the worst circumstances. AQR’s use of volatility targeting and drawdown control are common practices among quantitative investors. As a group these investors tend to cut and add risks at the same time. It is unclear whether they are influential enough to alter the nature of markets and perhaps render these methods obsolete or even harmful (think of portfolio insurance and its contribution to Black Monday in 1987, when the Dow Jones Industrial Average fell 22.6%). My guess is quantitative investors aren’t yet big enough because many more investors are counter-cyclical rebalancers over the short-run, particularly institutions. This is speculation, of course. The market is a big and wild herd that will sometimes stampede in a direction it had never gone before—a lesson AQR itself learned at least twice: during the madness of the dot-com bubble and during the great quant meltdown of 2007.

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Long-Short Equity, or LSE, takes the EMN strategy (though they’re not exact clones if we’re to judge by their holdings and position sizes) and overlays a tactical equity strategy that targets an average 50% exposure to the MSCI World Index, with the ability to adjust its exposure by +/- 20% based largely on valuation and momentum. The equity exposure is obtained through futures.

In a back-test of a simplified version of the strategy, the market-timing component did not add much to the strategy’s performance while it worsened the drawdown during the financial crisis.

Adviser

AQR Capital Management, LLC, was founded in 1998 by a team of ex-Goldman Sachs quant investors led by Clifford S. Asness, David G. Kabiller, Robert J. Krail, and John M. Liew. (Krail is no longer with the firm.) AQR stands for Applied Quantitative Research. Asness, Krail and Liew met each other at the University of Chicago’s finance PhD program. The firm’s bread and butter has long been trading value and momentum together, an idea Asness studied in his dissertation under Eugene Fama, father of modern finance and one of the co-formulators of the efficient market hypothesis.

AQR is mostly owned by AQR Group LP, which in turn is owned by employees of the firm. AMG, a publicly traded asset manager, has owned a stake in AQR since 2004 and in 2014 it increased it, but remains a minority shareholder (terms of both transactions have not been disclosed). AMG largely leaves its investees to run themselves, so I am not concerned about the firm pushing AQR to do stupid things to meet or beat a quarterly target. Though the implosion of Third Avenue, an investee, may spur AMG to more actively monitor its portfolio companies, I doubt Asness and his partners gave AMG much power to meddle in AQR’s affairs.

AQR’s mutual fund business has grown rapidly in size and sophistication since 2009, when it launched arbitrage and equity momentum funds. It competes with DFA for the mantle of academic “thought leadership” among advisors, its main clients. This has put Asness in the awkward position of competing with his former mentor Fama, who is a significant shareholder in DFA and the chief intellectual architect of its approach. Like DFA, AQR emphasizes the primacy of factors in managing portfolios.

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When AQR started up, it was hot. It had one of the biggest launches of any hedge-fund up to that point. Then the dot-com bubble inflated. The widening gap in valuations between value and growth stocks almost sunk AQR. According to Asness, had the bubble lasted six more months, he would have been out of business. When the bubble burst, the firm’s returns soared and so did its assets. The good times rolled on and the firm was on the verge of an IPO by late 2007. According to the New York Post, AQR had to shelve it as the subprime crisis began roiling the markets. The financial crisis shredded its returns, with its flagship Absolute Return fund falling more than 50 percent from the start of 2007 to the end of 2008. Firm-wide assets from peak-to-trough went from $39.1 billion to $17.2 billion. The good times are back: As of December-end, AQR had $142.2 billion in net assets under management.

The two near-death experiences have instilled in AQR a fear of concentrated business risks. In 2009, AQR began to diversify away from its flighty institutional clientele by launching mutual funds to entice stickier retail investors. The firm has also launched new strategies at a steady clip, including managed futures, risk parity, and global macro.

AQR has a strong academic bent. Its leadership is sprinkled with economics and finance PhDs from top universities, particularly the University of Chicago. The firm has poached academics with strong publishing records, including Andrea Frazzini, Lasse Pedersen, and Tobias Moskowitz. Its researchers and leaders are still active in publishing papers.

The firm’s principals are critical of hedge funds that charge high fees on strategies that are largely replicable. AQR’s business model is to offer up simplified quant versions of these strategies and charge relatively low fees.

Managers

Both the Equity Market Neutral and Long-Short Equity strategies are run by Jacques A. Friedman, Andrea Frazzini, and Michele L. Aghassi. Ronen Israel helps manage EMN. Hoon Kim helps manage LSE. All five are principals, or partners, in the firm.

Friedman heads AQR’s Global Stock Selection team. Prior to joining AQR at its inception in 1998, he developed quantitative stock selection strategies at Goldman Sachs. He is the principal portfolio manager and supervises Frazzini, Aghassi and Kim.

Israel heads AQR’s Global Alternative Premia Group. Prior to joining AQR in 1999, he was a senior analyst at Quantitative Financial Strategies, Inc.

Frazzini researches global stock-selection strategies. Prior to joining AQR in 2008 he was a star finance professor at the University of Chicago.

Aghassi is co-head of research of AQR’s Global Stock Selection team. Prior to joining AQR in 2005, she obtained her PhD in operations research at MIT.

Kim is the head of equity portfolio management in AQR’s Global Stock Selection team. Prior to joining AQR in 2005, he was head of quantitative equity research at Mellon Capital Management.

Israel and Friedman have master’s degrees in mathematics. Frazzini, Aghassi and Kim have PhDs.

Strategy capacity and closure

The EMN and LSE funds together have over $1.6 billion in assets. However, AQR runs hedge funds, institutional separate accounts, and foreign funds, and re-uses the same signals in different formats, such as long-only funds. The effective dollars dedicated to the signals use by the funds are almost certainly much higher than reported by the aggregate net asset values of the mutual funds.

Fortunately, AQR has a history of closing funds and ensuring its assets don’t overwhelm the capacity of its strategies. When the firm launched in 1998, it could have started with $2 billion but chose to manage only half that, according to founding partner David Kabiller. Of its mutual funds, AQR has already closed its Multi-Strategy Alternative, Diversified Arbitrage and Risk Parity mutual funds. Soon after I wrote about AQR Style Premia Alternative QSPIX and AQR Style Premia LV QSLIX in the September 2015 edition of MFO, AQR announced a soft close of the funds. It went into effect on March 31, 2016. AQR will meet additional demand by launching funds that are tweaked to have more capacity. 

Management’s stake in the funds

As of December 31, 2014, the funds’ managers had relatively low investments in the mutual funds.

Friedman had $50,001 to $100,000 in the EMN fund and $100,001 to $500,000 in the LSE fund.

Israel had no investment in the EMN fund.

Frazzini had $10,001 to $50,000 in both funds.

Aghassi had no investments in either fund.

Kim had no investment in the LSE fund.

The low levels of investment should not be held against the managers. It is cheaper and more tax efficient for them to invest in the strategies through AQR’s hedge funds. They also have a direct interest in the success of the firm. Unlike many other hedge funds, AQR does not compensate partners and employees largely based on the profits attributable to them. The team-based nature of AQR’s quantitative process means profits cannot be cleanly attributable to a given employee. Moreover, there is a huge element of luck in the performance of a given strategy and AQR rightly does not want to overwhelmingly tie compensation to it. All the portfolio managers of the funds are partners and so earn a payout based on the firm’s earnings and their relative ownership stakes. AQR grants ownership stakes based on “cumulative research, leadership and other contributions.”

I expect that over time the managers’ stakes will rise as a matter of window-dressing for consultants who take a check-the-box approach to due diligence (most of them). There is evidence that window-dressing has occurred: Some of AQR’s principals own both the low- and high-volatility versions of the same strategy, which is strange because it is costlier to own the low-volatility version per unit of exposure.

Comments

Since its October 2014 inception, AQR Equity Market Neutral Fund I QMNIX has returned 18.6% annualized with a standard deviation of 7.0%, for a Sharpe ratio of 2.66. Since its July 2013 inception, AQR Long-Short Equity Fund I QLEIX has returned 14.4% above its benchmark (a 50-50 blend of the MSCI World Index and cash) with a standard deviation of 5.8%, for a Sharpe ratio of 2.46. Almost all of the abnormal returns were driven by the market-neutral equity stock selection sleeve; AQR’s tactical market timing in the LSE strategy contributed zilch to the fund’s returns from inception to the end of 2015.

These are not sustainable numbers. A more reasonable, conservative long-run Sharpe ratio is 0.5. Translated to a raw return, that’s 3% above cash for a market-neutral strategy that runs at a 6% volatility.

While AQR’s absolute return global stock selection strategy has done well, its long-only funds have not. Since the LSE fund launched in 2013, its active returns (that is, returns above its benchmark) have far outstripped the active returns of the AQR Multi-Style funds. In the chart below I plotted the cumulative active returns of AQR Long-Short Equity (which has a longer live track record than AQR Equity Market Neutral) against a sum of the active returns of AQR Large Cap Multi-Style I QCELX and AQR International Multi-Style I QICLX. The long-only funds have stagnated, while the long-short fund has consistently made lots of money. While I doubt this divergence will remain big and persistent, I’m confident that it’s well worth paying up for AQR’s long-short strategy.

View fullsize

While past performance by itself is usually not predictive, there are logical reasons to believe AQR's long-short stock selection strategy will maintain its edge over AQR's multi-style long-only stock selection strategies. First, AQR's long-short strategy is much more diversified than its long-only strategies. AQR uses many more signals, owns many more stocks, and turns over its portfolio much more aggressively (AQR Large Cap Multi-Style's turnover is 60%; AQR Equity Market Neutral's is 383%). The superior diversification and breadth of the portfolio should result in a superior risk-adjusted return. Second, AQR cannot justify a higher fee on its long-short strategies without offering higher expected returns. More cynically, it makes economic sense for AQR to put its better, limited-capacity signals in its smaller, higher-fee mandates.

I have almost a third of my net worth in AQR Long-Short Equity and none in AQR's Multi-Style funds. I'm putting my money where my mouth is.

Bottom line

AQR’s long-short global stock-selection strategy is well worth the money and a better deal than its long-only stock funds.

The Misuse of Aggregate Active v. Passive Comparisons

Every six months Standard & Poor’s releases its SPIVA Scorecard, a report on the percentage of active funds that underperformed selected S&P benchmarks. Almost every report says the same thing: If you had randomly selected an actively managed mutual fund, you probably would have underperformed a closely matched benchmark. Is this fact by itself a persuasive argument for passive investing? Not really.

We already know that before costs the typical actively managed dollar and the typical passively managed dollar earn the same return,  but that after costs the typical actively managed dollar underperforms on account of higher costs. This is a mathematical truism commonly known as the arithmetic of active management or the cost matters hypothesis. The SPIVA is simply a noisy repeat measurement of this mathematical fact.

I say noisy because it is possible for most active managers to beat their SPIVA-assigned benchmarks. The typical manager tends to underweight larger-cap stocks relative to their SPIVA-assigned benchmarks. All it takes is a collapse in larger-cap stocks for managers as a whole to look brilliant. This happened in 2000, when 63% of large-cap stock funds beat the S&P 500 as the dot-com bubble burst. Many investors mistook this to mean that active managers are better to own during bear markets.

Even the arithmetic of active investing by itself can’t tell you whether indexing is a good idea for a specific investor or even most investors. You can imagine a world in which a handful of large entities like central banks predictably underperform the rest of the market in pursuit of non-economic goals. This would allow many smaller investors to outperform. You can also imagine a world in which a handful of elite investors predictably outperform the rest of the market because of superior information. This would require many smaller investors to underperform. The decision to go active or passive should depend on a sober assessment of one’s “edges”, or inherent advantages over other market participants, and the composition of other players in the market.

Once these factors are taken into account, active investing may be preferable for some investors and not others. For what it’s worth, I happen to believe that index funds are the best options for most investors, most of the time—just not for all investors, all of the time.

Why Investors Are so Bad at Picking Alternatives

This post first appeared in the February Mutual Fund Observer.

Gateway (GATEX) is the $8 billion behemoth of the long-short equity mutual fund category, and one of the biggest alternative mutual funds. I’ve long marveled at this fund’s size given its demonstrable lack of merit as a portfolio diversifier. Over the past 10 years the fund has behaved like an overpriced, underperforming 40% stock, 60% cash portfolio. Its R-squared over this period to the U.S. stock market index is 0.85.

Not only is its past performance damning, but little in the substance of the strategy suggests performance will radically change. Gateway owns a basket of stocks designed to track the S&P 500, with a slight dividend tilt. On this portfolio the managers sell calls on the S&P 500, capping the potential upside of the fund in exchange for a premium up front, and simultaneously buy puts, capping the potential downside of the fund at the cost of a premium up front. By implementing this “collar” strategy, the managers protect the portfolio from extreme ups and downs.

There is another way to soften volatility: Own less equities and more cash—which is pretty much what this fund achieves in a roundabout manner.

Portfolio theory says that an investment is only attractive to the extent that it improves the risk-adjusted return of a portfolio. That means three things matter for each asset: expected return, expected volatility, and expected correlation with other assets in the portfolio. The first two are intuitive, but many investors neglect the correlation piece. A low return, high volatility asset can be an excellent investment if it has a low enough correlation with the rest of the portfolio.

Consider an asset that’s expected to return 0% with stock-like volatility and a perfectly negative correlation to the stock market (meaning it moves in the opposite direction of the market without fail). Many investors, looking at the asset’s standalone returns and volatility, would be turned off. Someone fluent in portfolio theory would salivate. Assume the expected excess return of the stock market is 5%. If you own the stock market and the negatively correlated asset in equal measure, the portfolio’s expected excess return halves to 2.5% and its expected volatility drops to 0%. Apply some leverage to double the portfolio’s return and you end up with a 5% expected excess return with no volatility.

In practice, many investors do not assess assets from the portfolio perspective. They fixate on standalone return and volatility. Much of the time this is a harmless simplification. But it can go wrong when assessing alternatives, such as with Gateway. Judged by its Sharpe ratio and other risk-adjusted measures, Gateway looks like a reasonable investment. Judged by its ability to enhance a portfolio’s risk-adjusted return, it falls flat.

I don’t believe individual investors are responsible for Gateway’s size. If anything, institutional investors (particularly RIAs) are to blame. You would think that supposedly sophisticated investors would not fall into this trap. But they do. A large part of the blame belongs to committee-driven investment processes, which dominate institutional money management. When a committee is responsible for a portfolio, they often hire consultants. These consultants in turn promise to help members of the committee avoid getting fired or sued.

In this context, the consultants like to create model portfolios that have predefined allocations to investment types—X% in large growth, Y% in small-cap value, Z% in long-short equity, and so on—and then find suitable managers within those categories. When picking those managers, they tend to focus on return and volatility as well as performance relative to peers. If not done carefully, a fund like Gateway gets chosen, despite its utter lack of diversifying power.

Why Vanguard Will Take Over the World

As with the last post, this was originally published in the Mutual Fund Observer.

Vanguard is eating everything. It is the biggest fund company in the U.S., with over $3 trillion in assets under management as of June-end, and the second biggest asset manager in the world, after BlackRock. Size hasn’t hampered Vanguard’s growth. According to Morningstar, Vanguard took in an estimated $166 billion in U.S. ETF and mutual fund assets in the year-to-date ending in August, over three times the next closest company, BlackRock/iShares. Not only do I think Vanguard will eventually overtake BlackRock, it will eventually extend its lead to become by far the most dominant asset manager in the world.

With index funds, investors mostly care about having their desired exposure at the lowest all-in cost, the most visible component of which is the expense ratio. In other words, index funds are commodities. In a commodity industry with economies of scale, the lowest-cost producer crushes the competition. Vanguard is the lowest-cost producer. Not only that, it enjoys a first-mover advantage and possesses arguably the most trusted brand in asset management. These advantages all feed on each other in virtuous cycles.

It’s commonly known Vanguard is owned by its mutual funds, so everything is run “at cost.” (This is a bit of a fiction; some Vanguard funds subsidize others or outside ventures.) “Profits” flow back to the funds as lower expense ratios. There are no external shareholders to please, no quarterly earnings targets to hit. Many cite this as the main reason why Vanguard has been so successful. However, the mutual ownership structure has not always led to lower all-in costs or dominance in other industries, such as insurance, or even in asset management. Mutual ownership is a necessary but not a sufficient condition for Vanguard’s success.

What separates Vanguard from other mutually owned firms is that it operates in a business that benefits from strong first-mover advantages. By being the first company to offer index funds widely, it achieved a critical mass of assets and name recognition before anyone else. Assets begot lower fees which begot even more assets, a cycle that still operates today.

While Vanguard locked up the index mutual fund market, it almost lost its leadership by being slow to launch exchange-traded funds. By the time Vanguard launched its first in 2001, State Street and Barclays already had big, widely traded ETFs covering most of the major asset classes. While CEO and later chairman of the board, founder Jack Bogle was opposed to launching ETFs. He thought the intraday trading ETFs allowed would be the rope by which investors hung themselves. From a pure growth perspective, this was a major unforced error. The mistake was reversed by his successor, Jack Brennan, after Bogle was effectively forced into retirement in 1999.

In ETFs, the first-movers not only enjoy economies of scale but also liquidity advantages that allows them to remain dominant even when their fees aren’t the lowest. When given the choice between a slightly cheaper ETF with low trading volume and a more expensive ETF with high trading volume, most investors go with the more traded fund. This makes it very difficult for new ETFs to gain traction when an established fund has ample trading volume. The first U.S. ETF, SPDR S&P 500 ETF SPY, remains the biggest and most widely traded. In general, the biggest ETFs were also the first to come out in their respective categories. The notable exceptions are where Vanguard ETFs managed to muscle their way to the top. Despite this late start, Vanguard has clawed its way up to become the second largest ETF sponsor in the U.S.

This feat deserves closer examination. If Vanguard’s success in this area was due to one-off factors such as the tactical cleverness of its managers or missteps by competitors, then we can’t be confident that Vanguard will overtake entrenched players in other parts of the money business. But if it was due to widely applicable advantages, then we can be more confident that Vanguard can make headway against entrenched businesses.

A one-off factor that allowed Vanguard to take on its competitors was its patented hub and spoke ETF structure, where the ETF is simply a share class of a mutual fund. By allowing fund investors to convert mutual fund shares into lower-cost ETF shares (but not the other way around), Vanguard created its own critical mass of assets and trading volume.

But even without the patent, Vanguard still would have clawed its way to the top, because Vanguard has one of the most powerful brands in investing. Whenever someone extols the virtues of index funds, they are also extoling Vanguard’s. The tight link was established by Vanguard’s early dominance of the industry and a culture that places the wellbeing of the investor at the apex. Sometimes this devotion to the investor manifests as a stifling paternalism, where hot funds are closed off and “needless” trading is discouraged by a system of fees and restrictions. But, overall, Vanguard’s culture of stewardship has created intense feelings of goodwill and loyalty to the brand. No other fund company has as many devotees, some of whom have gone as far as to create an Internet subculture named after Bogle.

Over time, Vanguard’s brand will grow even stronger. Among novice investors, Vanguard is slowly becoming the default option. Go to any random forum where investing novices ask how they should invest their savings.  Chances are good at least someone will say invest in passive funds, specifically ones from Vanguard.

Vanguard is putting its powerful brand to good use by establishing new lines of business in recent years. Among the most promising in the U.S. is Vanguard Personal Advisor Services, a hybrid robo-advisor that combines largely automated online advice with some human contact and intervention. VPAS is a bigger deal than Vanguard’s understated advertising would have you believe. VPAS effectively acts like an “index” for the financial advice business. Why go with some random Edward Jones or Raymond James schmuck who charges 1% or more when you can go with Vanguard and get advice that will almost guarantee a superior result over the long run?

VPAS’s growth has been explosive. After two years in beta, VPAS had over $10 billion by the end of 2014. By June-end it had around $22 billion, with about $10 billion of that  growth from the transfer of assets from Vanguard’s traditional financial advisory unit. This already makes Vanguard one of the biggest and fastest growing registered investment advisors in the nation. It dwarfs start-up robo-advisors Betterment and Wealthfront, which have around $2.5 billion and $2.6 billion in assets, respectively.

Abroad, Vanguard’s growth opportunities look even better. Passive management’s market share is still in the single digits in many markets and the margins from asset management are even fatter. Vanguard has established subsidiaries in Australia, Canada, Europe and Hong Kong. They are among the fastest-growing asset managers in their markets.

The arithmetic of active management means over time Vanguard’s passive funds will outperform active investors as a whole. Vanguard’s cost advantages are so big in some markets its funds are among the top performers.

Critics like James Grant, editor of Grant’s Interest Rate Observer, think passive investing is too popular. Grant argues investing theories operate in cycles, where a good idea transforms into a fad that inevitably collapses under its own weight. But passive investing is special. Its capacity is practically unlimited. The theoretical limit is the point at which markets become so inefficient that price discovery is impaired and it becomes feasible for a large subset of skilled retail investors to outperform (the less skilled investors would lose even more money more quickly in such an environment—the arithmetic of active management demands it). However, passive investing can make markets more efficient if investors opting for index funds are largely novices rather than highly trained professionals. A poker game with fewer patsies means the pros have to compete with each other.

There are some problems with passive investing. Regularities in assets flows due to index-based buying and selling has created profit opportunities for clever traders. Stocks added to and deleted from the S&P 500 and Russell 2000 indexes experience huge volumes of price-insensitive trading driven by dumb, blind index funds. But these problems can be solved by smart fund management, better index construction (for example, total market indexes) or greater diversity in commonly followed indexes.

Why Vanguard Might Fail

I’m not imaginative or smart enough to think of all the reasons why Vanguard will fail in its global conquest, but a few risks pop out.

First is Vanguard’s relative weakness in institutional money management (I may be wrong on this point). BlackRock is still top dog thanks to its fantastic institutional business. Vanguard hasn’t ground BlackRock into dust because expense ratios for institutional passively managed portfolios approach zero. Successful asset gatherers offer ancillary services and are better at communicating with and servicing the key decision makers. BlackRock pays more and presumably has better salespeople. Vanguard is tight with money and so may not be willing or able to hire the best salespeople.

Second, Vanguard may make a series of strategic blunders under a bad CEO enabled by an incompetent and servile board. I have the greatest respect for Bill McNabb and Vanguard’s current board, but it’s possible his successors and future boards could be terrible.

Third, Vanguard may be corrupted by insiders. There is a long and sad history of well-meaning organizations that are transformed into personal piggybanks for the chief executive officer and his cronies. Signs of corruption include massive payouts to insiders and directors, a reversal of Vanguard’s long-standing pattern of lowering fees, expensive acquisitions or projects that fuel growth but do little to lower fees for current investors (for example, a huge ramp up in marketing expenditures), and actions that boost growth in the short-run at the expense of Vanguard’s brand.

Fourth, Vanguard may experience a severe operational failure, such as a cybersecurity hack, that damages its reputation or financial capacity.

Individually and in total, these risks seem manageable and remote to me. But I could be wrong.

In short:

• Vanguard’s rapid growth will continue for years as it benefits from three mutually reinforcing advantages: mutual ownership structure where profits flow back to fund investors in the form of lower expenses, first-mover advantage in index funds, and a powerful brand cultivated by a culture that places the investor first.

• Future growth markets are huge: Vanguard has subsidiaries in Australia, Canada, Hong Kong and Europe. In these markets passive investing has low market share and correspondingly high fees. Arithmetic of active investing virtually guarantees Vanguard funds will have a superior performance record over time.

• Vanguard Personal Advisor Services VPAS stands a good chance of becoming the “index” for financial advice. Due to fee advantages and brand, VPAS may be able to replicate the runaway growth Vanguard is experiencing in ETFs.

• Limits to passive investing are overblown; Vanguard still has lots of runway.

• Vanguard may wreck its campaign of global domination through several ways, including lagging in institutional money management, incompetence, corruption, or operational failure.

AQR Style Premia Alternative: A Review

This analysis originally appeared in the September 2015 Mutual Fund Observer, but I'm republishing it here for completeness's sake. As always, comments welcome.

Objective and strategy

AQR’s Style Premia Alternative, or SPA, strategy offers leveraged, market-neutral exposure to the four major investing “styles” AQR has identified:

Value, the tendency for fundamentally cheap assets to beat expensive assets.

Momentum, the tendency for relative performance in assets to persist over the short run (about one to twelve months).

Carry, the tendency for high-yield assets to beat low-yield assets.

Defensive, the tendency for low-volatility assets to offer higher volatility-adjusted returns than high-volatility assets.

To make the cut as a bona fide style, a strategy has to be persistent, pervasive, dynamic, liquid, transparent and systematic.

SPA offers pure exposure to these styles across virtually all major markets, including stocks, bonds, currencies, and commodities. It removes big, intentional directional bets by going long and short and hedging residual market exposure. As with all alternative investments, the goal is to create returns uncorrelated with conventional portfolio returns.

SPA sizes its positions by volatility, not nominal dollars. In quant-speak, risk is often used as short-hand for volatility, a convention I will adopt. Of course, volatility is not risk (though they are awfully correlated in many situations).

SPA’s strategic risk allocations to each style are as follows: 34% each to value and momentum, 18% to defensive, and 14% to carry. Its strategic risk allocations to each asset class are as follows: 30% to global stock selection, 20% each to equity markets and fixed income, and 15% each to currencies and commodities. There is a bias to the value and momentum styles, perhaps reflecting AQR’s greater confidence in and longer history with them.

Risk allocations drift based on momentum and “style agreement,” where high-conviction positions are leveraged up relative to low-conviction positions. The strategy’s overall risk target falls in steps in the event of a drawdown and rises as losses are recouped. These overlays embody some of the hard-knock knowledge speculators have acquired over the decades: bet on your best ideas, cut losers and ride winners, and cut capital at risk when one is trading poorly.

SPA targets a Sharpe ratio of 0.7 over a market cycle. AQR offers two flavors to the public: the 10% volatility-targeted QSPIX and the 5%-vol QSLIX.

Adviser

AQR Capital Management, LLC, was founded in 1998 by a team of ex-Goldman Sachs quant investors led by Clifford S. Asness, David G. Kabiller, Robert J. Krail, and John M. Liew. AQR stands for Applied Quantitative Research. The firm’s bread and butter has long been trading value and momentum together, an idea Asness studied in his PhD dissertation at the University of Chicago. (Asness’s PhD advisor was none other than Eugene Fama, father of modern finance and one of the co-formulators of the efficient market hypothesis.)

When the firm started up, it was hot. It had one of the biggest launches of any hedge-fund up to that point. Then the dot-com bubble inflated. The widening gap in valuations between value and growth stocks almost sunk AQR. According to Asness, the firm was six months away from going out of business. When the bubble burst, the firm’s returns soared and so did its assets. The good times rolled until thefinancial crisis shredded its returns. Firm-wide assets from peak-to-trough went from $39.1 billion to $17.2 billion. The good times are back: As of June-end, AQR has $136.2 billion under management.

The two near-death experiences have instilled in AQR a fear of concentrated business risks. In 2009, AQR began to diversify away from its flighty institutional clientele by launching mutual funds to entice stickier retail investors. The firm has also launched new strategies at a steady clip, including managed futures, risk parity, and global macro.

AQR has a strong academic bent. Its leadership is sprinkled with economics and finance PhDs from top universities, particularly the University of Chicago. The firm has poached academics with strong publishing records, including Andrea Frazzini, Lasse Pedersen, and Tobias Moskowitz. Its researchers and leaders are still active in publishing papers.

The firm’s principals are critical of hedge funds that charge high fees on strategies that are largely replicable. AQR’s business model is to offer up simplified quant versions of these strategies and charge relatively low fees.

Managers

Andrea Frazzini, Jacques A. Friedman, Ronen Israel, and Michael Katz. Frazzini was a finance professor at University of Chicago and rising star before he joined AQR. He is now a principal on AQR’s Global Stock Selection team. Friedman is head of the Global Stock Selection team and worked at Goldman Sachs with the original founders prior to joining AQR. Israel is head of Global Alternative Premia and prior to AQR was a senior analyst at Quantitative Financial Strategies Inc. Katz leads AQR’s macro and fixed-income team.

Frazzini is the most recognizable, as he has the fortune of having a last name that’s first in alphabetical order and publishing several influential studies in top finance journals, including “Betting Against Beta” with his colleague Lasse Pedersen.

Unlisted is the intellectual godfather of SPA, Antti Ilmanen, a University of Chicago finance PhD who authored Expected Returns, an imposing but plainly-written tome that synthesizes the academic literature as it relates to money management. Though written years before SPA was conceived, Expected Returns can be read as an extended argument for an SPA-like strategy.

Strategy capacity and closure

AQR has a history of closing funds and ensuring its assets don’t overwhelm the capacity of its strategies. When the firm launched in 1998, it could have started with $2 billion but chose to manage only half that, according to founding partner David Kabiller.

Of its mutual funds, AQR has already closed its Multi-Strategy Alternative, Diversified Arbitrage and Risk Parity mutual funds. However, AQR will meet additional demand by launching additional funds that are tweaked to have more capacity. As of the end of 2014, AQR reported a little over $3 billion in its SPA composite return record. Given the strategy’s strong recent returns, assets have almost certainly grown through capital appreciation and inflows.

Because AQR uses many of the same models or signals in different formats and even in different strategies, the effective amount of capital dedicated to at least some components of SPA’s strategy is higher than the amount reported by AQR.

Management’s stake in the fund

As of Dec. 31, 2014, the strategy’s managers had no assets in the low-volatility SPA fund and little in the standard-volatility SPA fund. One trustee had less than $50,000 in QSPIX. Collectively, the managers had $170,004 to $700,000 in the SPA mutual funds.

Although these are piddling amounts compared to the millions the managers make every year, the SPA strategy is tax-inefficient. If the managers wanted significant exposure to the strategies, they would probably do so through the partnerships AQR offers to high-net-worth investors. But would they do that? AQR, like most quant shops, attempts to scarf down as much as possible the “free lunch” of diversification. The managers are well aware that their human capital is tied to AQR’s success and so they would probably not want to concentrate too heavily in its potent leveraged strategies.

Opening date

QSPIX opened on October 30, 2013. QSLIX opened on September 17, 2014. The live performance composite began on September 1, 2012.

Minimum investment

The minimum investment varies depending share class, broker-dealer and channel. For individual investors, a Fidelity IRA offers the lowest hurdle: a mere $2,500 for the I share class of the normal and low-volatility flavors of SPA. Or you can get access through an advisor. Otherwise, the hurdles are steep: $5 million for the I class, $1 million for the N class, and $50 million for the R6 class.

Expense ratio

The I class for the normal and low-volatility versions cost 1.50% and 0.85%, respectively. The N classes costs 0.25% more and the R6 classes costs 0.10% less.

The per-unit price of exposure to SPA is lower the higher the volatility of the strategy. QSPIX targets 10% vol and costs 1.5%. QSLIX targets 5% vol and costs 0.85%. Anyone can replicate a position in QSLIX by simply halving the amount invested in QSPIX and putting the rest in cash. The effective expense ratio of a half QSPIX, half cash clone strategy is 0.75%.

Comments

Among right-thinking passive investors who count fees by the basis point, AQR’s SPA strategy elicits revulsion. It’s expensive, leveraged, complicated, hard to understand, and did I mention expensive?

To make the strategy easier to swallow, some passive-investing advocates argue SPA is “passive” because it’s a transparent, systematic, and involves no discretionary stock-selection or market forecasting. This definition is not universally accepted by academics, or even by AQR. The purer, technical definition of passive investing is a strategy that replicates market weightings, and indeed this definition is used by the venerable William Sharpe in his famous essay, “The Arithmetic of Active Management.”

I do not think SPA is passive in any widely understood sense of the word. In fact, I think it’s about as active as you can get within a mutual fund. And I also happen to think SPA is a great fund. Regardless of my warm feelings for the strategy, I consider SPA suitable only for a rare kind of nerd, not the investing public.

Though SPA is aggressively active, its intellectual roots dig deep into the foundations of financial theory that underpin what are commonly thought to be “passive” strategies, particularly value- and size-tilted stock portfolios (DFA has made a big business selling them).

The nerds among you will have quickly caught on that what AQR calls a style is nothing more than a factor, a decades-old idea that sprung from academic finance.

For the non-nerds: A factor, loosely speaking, is a fundamental building block that explains asset returns. Most stocks move together, as if their crescendos and diminuendos were orchestrated by the hand of some invisible conductor. This co-movement is attributed to the equity market factor. According to factor theory, a factor generates a positive excess return called a premium as reward for the distinct risk it represents.

It is now widely agreed that two factors pervade virtually all markets: value and momentum (size has long been criticized as weak). AQR’s researchers—including some of the leading lights in finance—argue there are two more: carry and defensive. They’ve marshalled data and theoretical arguments that share an uncanny family resemblance with the data and arguments marshalled to justify the size and value factors.

The SPA strategy is a potent distillation of the factor-theoretical approach to investing. If you believe the methods that produced the research demonstrating the value and size effects are sound, then you have to admit that those same tools applied to different data sets may yield more factors that can be harvested.

OK, I’ve blasted you with theory. On to more practical matters.

Who should invest in this fund?

Investors who believe active management can produce market-beating results and are willing to run some unusual but controllable risks.

How much capital should one dedicate to it?

Depends on how much you trust the strategy, the managers, and so on. I personally would invest up to 30% of my personal money in the fund (and may do so soon!), but that’s only because I have a high taste for unconventionality, decades of earnings ahead of me, high conviction in the strategy and people, and a pessimistic view of competing options (other alternatives as well as conventional stocks and bonds). Swedroe, on the other hand, says he has 3% of his portfolio in it.

How should it be assessed?

At a minimum, an alternative has to produce positive excess returns that are uncorrelated to the returns of conventional portfolios to be worthwhile.

However, AQR is making a rather bold claim: It has identified four distinct strategies that produce decent returns on a standalone basis and are both largely uncorrelated with each other and conventional portfolios. When combined and leveraged, the resulting portfolio is expected to produce a much steadier stream of positive returns, also uncorrelated with conventional portfolios.

So far, the strategy is working as advertised. Returns have been good and uncorrelated. In back-tests, the strategy only really suffered during the dot-com bubble and the financial crisis. Even then, returns weren’t horrendous.

Is AQR’s 0.7 Sharpe ratio target reasonable?

I think so, but I would be ecstatic with 0.5.

What are its major risks?

Aside from leverage, counterparty, operational, credit, etc., I worry about a repeat of the quant meltdown of August 2007. It’s thought that a long-short hedge fund suddenly liquidated its positions then. Because many hedge funds dynamically adjust their positions based on recent volatility and returns, the sudden price movements induced by the liquidation set off a self-reinforcing cycle where more and more hedge funds cut the same positions. The stampede to the exits resulted in huge and sudden losses. However, the terror was short-lived. The funds that sold out lost a lot of money; the funds that held onto their positions looked fine by month-end.

AQR is cognizant of this risk and so keeps its holdings liquid and doesn’t go overboard with the leverage. However, it is hard for outsiders to assess whether AQR is doing enough to mitigate this risk. I think they are, because I trust AQR’s people, but I’m well aware that I could be wrong.

Bottom line

One of the best alternative funds available to mutual-fund investors.