Alternative Thinking The Role of Alternative Beta Premia While risk parity strategies are our highest-capacity answer for investing in long-only, core asset classes, alternative beta premia dynamic long-short strategies, are another highly effective way to further seek diversified sources of return. Alternative beta premiums can be classified in many ways by asset class, liquidity, long/short volatility, convergent/divergent, etc. To us, the most useful classifications are hedge fund strategy premia and style premia two complementary perspectives. Third Quarter 2012 AQR Capital Management, LLC Two Greenwich Plaza Greenwich, CT 06830 p: +1.203.742.3600 f: +1.203.742.3100 w: aqr.com
Alternative Thinking The Role of Alternative Beta Premia 1 The Role of Alternative Beta Premia Executive Summary Alternative Beta Premia are long-short sources of returns that are economically-intuitive, systematic and persistent due to behavioral biases, structural inefficiencies or compensation for bearing risk. We believe the two most useful classifications of Alternative Beta Premia are 1) hedge fund strategy premia and 2) style premia. We believe liquid portfolios should contain a combination of alternative beta premia with market risk premia, which we believe offer investors a more reliable way to reach CPI+5% targets. Two Complementary Perspectives While our risk parity strategies are our highestcapacity answer for investing in long-only, core asset classes, alternative beta premia are another highly effective way to further seek diversified sources of return. Importantly, risk parity and alternative beta premia are best viewed as complements in well-constructed portfolios. they require some use of derivatives, leverage and/or short-selling. Alternative beta premia can be classified in many ways by asset class, liquidity, long/short volatility, convergent/divergent, etc. To us, the most useful classifications are hedge fund strategy premia and style premia two complementary perspectives. Hedge Fund Premia Hedge fund strategy premia are returns of longshort strategies traditionally employed by hedge funds. AQR s takes a bottom-up approach in building a collection of these premia, built from dozens of strategies and thousands of positions, aggregated to nine categories based on the Credit Suisse Hedge Fund Index. Hedge fund premia are useful for many hedge fund investors as they easily fit a box. In contrast to many hedge funds, we believe Hedge Fund Premia should be: More liquid, systematic, and transparent Better diversified across strategies (riskbalanced across volatility-targeted strategies) Alternative beta premia are alternative because they are captured through dynamic long-short strategies rather than long-only asset class exposures; they are not alternative in the sense of investing in less-liquid alternative asset classes such as private equity or infrastructure. They are called beta premia because, like any form of beta, the return sources are economically-intuitive, systematic and persistent due to behavioral biases, structural inefficiencies or compensation for bearing risk. 1 Less market-directional than hedge fund indices and hedge fund replicators (unbundle alternative beta premia from the market premia) More cost-effective (lower fees; emphasis on efficient portfolio construction and execution) Primarily relative value (more focus on crosssectional opportunities than tactical timing decisions) and mainly rules-based (with some discretion in tactical tilts and model design) Alternative beta premia can offer attractive riskadjusted returns and effective diversification, but 1 They are also called alternative risk premia but they may reflect either rational risk premia or persistent market inefficiencies. Other names include hedge fund premia, hedge fund betas, smart betas, dynamic betas, and exotic betas. Exhibit 1 shows the simulated performance of nine hedge fund premia and their equal volatilityweighted combination. Given space constraints, we focus on risk-adjusted returns (Sharpe ratios) and diversification ability (correlation of each premium with global equities). In contrast to the correlation
2 Alternative Thinking The Role of Alternative Beta Premia creep seen across the hedge fund industry in aggregate, hedge fund premia can be built to deliver diversifying returns. 2 Style Premia researchers have studied. 3 The purity of style premia is a conceptual advantage and reduces datamining concerns; and the pervasiveness of evidence gives cross-validation to results in other asset classes. A complementary way to classify alternative beta premia is by style, which includes value (long cheap assets based on valuation ratios, short expensive), momentum/trend (long recent outperformers, short laggards), carry (long high-yielding assets, short lowyielders), and defensive (long low-risk / high-quality assets, short high-risk / low-quality). These style premia have historically delivered positive long-run profits in virtually every asset class we and other However, it can be debated which styles should be included and which indicators within each style. Another disadvantage is the exclusion of classic hedge fund strategies such as event driven (e.g., merger arbitrage) and convertible arbitrage, which do not fit well into the above four styles. 4 Exhibit 2 provides evidence of style premia, again highlighting the positive risk-adjusted returns and Exhibit 1 Hypothetical Hedge Fund Premia, 1995 2011 Convert Arb Eq Mkt Neutral L/S Equity Ded. Short Event Driven Mgd. Futures Emg. Mkts. Fixed-Inc Rel. Val. Global Macro Hypothetical Composite Annual Excess Return 10.7% 4.6% 5.9% 1.7% 8.6% 6.9% 4.2% 8.9% 11.2% 14.3% Annual Volatility 10% 10% 10% 10% 10% 10% 10% 10% 10% 10% Sharpe Ratio 1.07 0.46 0.59 0.17 0.86 0.69 0.42 0.89 1.12 1.43 Correl to MSCI World -0.12 0.04 0.25-0.18 0.15-0.16 0.42 0.22 0.09 0.13 Source: AQR.. Hedge fund premia backtests are designed to target 10% volatility for the full 1995-2011 sample. Excess returns (excl. cash income) are shown gross of fees but net of estimated trading costs and with some discounting of backtest returns (larger in distant returns), including a directionality hedge overlay. Hypothetical data has inherent limitations, some of which are disclosed at the end Exhibit 2 Hypothetical Style Premia, 1995 2011 Across Stocks Across Asset Classes Value Momentum Carry Defensive Value Momentum Carry Defensive Annual Excess Return 4.6% 3.8% 2.8% 9.9% 4.9% 7.7% 13.0% 4.9% Annual Volatility 10% 10% 10% 10% 10% 10% 10% 10% Sharpe Ratio 0.46 0.38 0.28 0.99 0.49 0.76 1.30 0.49 Correl to MSCI World 0.02-0.07-0.23-0.19 0.17 0.06 0.23 0.05 Source: AQR. Across Stocks include four major regions, within industries. Across Asset Classes are across equity indices, bond indices, interest rate futures, G-10 currencies, emerging currencies, commodities. Style premia bactktests are designed to target 10% volatility for the full 1995-2011 sample. Excess returns (excl. cash income) are shown gross of fees but net of estimated trading costs, with no discounting of backtest returns or directionality hedges. Hypothetical data has inherent limitations, some of which are disclosed at the end. 2 Each hedge fund premium portfolio has benefited from broad diversification and volatility weighting among constituent strategies. See Berger-Israel-McLennan (2011): Building a Better Alternatives Portfolio: The AQR Multi-Strategy Approach for further information on these hedge fund premia. 3 For examples of AQR s research on style premia, see Asness (1997): The Interaction Between Value and Momentum Strategies (Financial Analysts Journal), Asness, Liew and Stevens (1997): Parallels Between the Cross-sectional Predictability of Stock and Country Returns (Journal of Portfolio Management), Asness, Moskowitz and Pedersen (2008): Value and Momentum Everywhere, Frazzini and Pedersen (2010): Betting Against Beta, Koijen, Moskowitz, Pedersen and Vrugt (2012): Carry, as well as an overview in Ilmanen (2011): Expected Returns. 4 These strategies may also be excluded because they are more liquidity and capacity challenged than other hedge fund strategies. Style premia may stress good liquidity, high capacity, and low costs even more than hedge fund premia.
Alternative Thinking The Role of Alternative Beta Premia 3 low correlations to equities. Similar to hedge fund premia, these style premia are broadly-diversified and volatility-targeted. For example, across asset classes the value style premium is risk-balanced across six asset classes. Alternative Beta Premia and the 5 Percent Solution Compared to many illiquid alternative sources of returns, we believe that hedge fund premia and style premia are highly effective tools to improve riskadjusted returns. We believe liquid portfolios should contain a combination of alternative beta premia with market risk premia, which we believe offer investors a more reliable way to reach CPI+5% targets. 5 5 See Asness and Ilmanen (2012): The 5 Percent Solution (Institutional Investor) for more on achieving CPI+5% over the long term.
4 Alternative Thinking The Role of Alternative Beta Premia Important Disclosures The information set forth herein has been obtained or derived from sources believed by the author and AQR Capital Management, LLC ( AQR ) to be reliable. However, the author and AQR do not make any representation or warranty, express or implied, as to the information s accuracy or completeness, nor does AQR recommend that the attached information serve as the basis of any investment decision. This document has been provided to you for information purposes and does not constitute an offer or solicitation of an offer, or any advice or recommendation, to purchase any securities or other financial instruments, and may not be construed as such. This document is intended exclusively for the use of the person to whom it has been delivered by AQR and it is not to be reproduced or redistributed to any other person. AQR hereby disclaims any duty to provide any updates or changes to the analyses contained in this document. This document has been prepared solely for informational purposes. The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Charts and graphs provided herein are for illustrative purposes only. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. There can be no assurance that an investment strategy will be successful. Historic market trends are not reliable indicators of actual future market behavior or future performance of any particular investment which may differ materially, and should not be relied upon as such. Target allocations contained herein are subject to change. The information in this document may contain projections or other forward looking statements regarding future events, targets, forecasts or expectations regarding the strategies described herein, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved, and may be significantly different from that shown here. The information in this presentation, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Performance of all cited indices is calculated on a total return basis with dividends reinvested. The indices do not include any expenses, fees or charges and are unmanaged and should not be considered investments. The investment strategy and themes discussed herein may be unsuitable for investors depending on their specific investment objectives and financial situation. Please note that changes in the rate of exchange of a currency may affect the value, price or income of an investment adversely. Neither AQR nor the authors assumes any duty to, nor undertakes to update forward looking statements. No representation or warranty, express or implied, is made or given by or on behalf of AQR, the authors or any other person as to the accuracy and completeness or fairness of the information contained in this presentation, and no responsibility or liability is accepted for any such information. By accepting this document in its entirety, the recipient acknowledges its understanding and acceptance of the foregoing statement. Diversification does not eliminate the risk of experiencing investment losses. PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE PERFORMANCE. Hypothetical performance results (e.g., quantitative backtests) have many inherent limitations, some of which, but not all, are described herein. No representation is being made that any fund or account will or is likely to achieve profits or losses similar to those shown herein. In fact, there are frequently sharp differences between hypothetical performance results and the actual results subsequently realized by any particular trading program. One of the limitations of hypothetical performance results is that they are generally prepared with the benefit of hindsight. In addition, hypothetical trading does not involve financial risk, and no hypothetical trading record can completely account for the impact of financial risk in actual trading. For example, the ability to withstand losses or adhere to a particular trading program in spite of trading losses are material points which can adversely affect actual trading results. The hypothetical performance results contained herein represent the application of the quantitative models as currently in effect on the date first written above and there can be no assurance that the models will remain the same in the future or that an application of the current models in the future will produce similar results because the relevant market and economic conditions that prevailed during the hypothetical performance period will not necessarily recur. There are numerous other factors related to the markets in general or to the implementation of any specific trading program which cannot be fully accounted for in the preparation of hypothetical performance results, all of which can adversely affect actual trading results. Discounting factors may be applied to reduce suspected anomalies. This backtest s return, for this period, may vary depending on the date it is run. Hypothetical performance results are presented for illustrative purposes only. Gross performance results do not reflect the deduction of investment advisory fees, which would reduce an investor s actual return. For example, assume that $1 million is invested in an account with the Firm, and this account achieves a 10% compounded annualized return, gross of fees, for five years. At the end of five years that account would grow to $1,610,510 before the deduction of management fees. Assuming management fees of 1.00% per year are deducted monthly from the account, the value of the account at the end of five years would be $1,532,886 and the annualized rate of return would be 8.92%. For a 10-year period, the ending dollar values before and after fees would be $2,593,742 and $2,349,739, respectively. AQR s asset based fees may range up to 2.85% of assets under management, and are generally billed monthly or quarterly at the commencement of the calendar month or quarter during which AQR will perform the services to which the fees relate. Where applicable, performance fees are generally equal
Alternative Thinking The Role of Alternative Beta Premia 5 to 20% of net realized and unrealized profits each year, after restoration of any losses carried forward from prior years. In addition, AQR funds incur expenses (including start-up, legal, accounting, audit, administrative and regulatory expenses) and may have redemption or withdrawal charges up to 2% based on gross redemption or withdrawal proceeds. Please refer to AQR s ADV Part 2A for more information on fees. Consultants supplied with gross results are to use this data in accordance with SEC, CFTC, NFA or the applicable jurisdiction s guidelines. There is a risk of substantial loss associated with trading commodities, futures, options, derivatives and other financial instruments. Before trading, investors should carefully consider their financial position and risk tolerance to determine if the proposed trading style is appropriate. Investors should realize that when trading futures, commodities, options, derivatives and other financial instruments one could lose the full balance of their account. It is also possible to lose more than the initial deposit when trading derivatives or using leverage. All funds committed to such a trading strategy should be purely risk capital. AQR backtests of Value, Momentum, Carry and Defensive theoretical long/short style components are based on monthly returns, undiscounted, gross of fees and transaction costs, excess of a cash rate proxied by the Merrill Lynch 3-Month T-Bill Index, and scaled to 12% annualized volatility. Each strategy is designed to take long positions in the assets with the strongest style attributes and short positions in the assets with the weakest style attributes, while seeking to ensure the portfolio is market-neutral. Please see below for a description of the Universe selection. Stock and Industry Selection: approximately 1,500 stocks across Europe, Japan, U.K. and U.S. Country Equity Indices: Developed Markets: Australia, Canada, Eurozone, Hong Kong, Japan, Sweden, Switzerland, U.K., U.S. Within Europe: Italy, France, Germany, Netherlands, Spain. Emerging Markets: Brazil, China, India, Russia, South Africa, South Korea, Taiwan. Bond Futures: Australia, Canada, Germany, Japan, U.K., U.S. Interest Rate Futures: Australia, Canada, Europe (Euribor), U.K. and U.S. Currencies: Developed Markets: Australia, Canada, Euro, Japan, New Zealand, Norway, Sweden, Switzerland, U.K., U.S. Emerging Markets: Brazil, India, Mexico, Poland, Russia, Singapore, South Korea, Taiwan, Turkey. Commodity Selection: Silver, Copper, Gold, Crude, Brent Oil, Natural Gas, Corn, Soybeans. The white papers discussed herein can be provided upon request.
AQR Capital Management, LLC Two Greenwich Plaza, Greenwich, CT 06830 p: +1.203.742.3600 I f: +1.203.742.3100 I w: aqr.com