Advisor Briefing Why Alternatives? Key Ideas Alternative strategies generally seek to provide positive returns with low correlation to traditional assets, such as stocks and bonds By incorporating alternative strategies, investors may enhance returns and lower portfolio volatility, thus potentially improving risk-adjusted returns Portfolios that include alternative investments have shown more consistent performance across difficult market environments Please read important disclosures at the end of this paper. AQR Capital Management, LLC Two Greenwich Plaza Greenwich, CT 06830 p: +1.203.742.3600 f: +1.203.742.3100 w: aqr.com
Advisor Briefing: Why Alternatives? 1 The Evolution of Alternative Investments Traditionally, alternatives were characterized by limited transparency, illiquidity and high investment minimums; they were investments accessible only to institutional investors. But the alternative investing framework has evolved, and now many of these strategies are available as mutual funds a structure that addresses investor concerns over transparency and liquidity. Mutual funds can offer various benefits to investors: they are subject to greater regulations, offer daily liquidity and provide transparency in holdings. Additionally, alternatives offered in a mutual fund structure may also have lower fees than their private fund counterparts. In this briefing, we focus on liquid alternative strategies and provide insight into why we believe advisors should include alternatives in their asset allocation decisions. What Are Alternatives? Alternatives are typically thought of as investments other than long-only stocks and bonds. Generally they can be divided into two categories: alternative asset classes, such as commodities or real estate; and alternative strategies, such as classic styles or hedge fund investments. Alternative asset classes are usually long-only and benchmark-oriented, while alternative strategies are commonly long/short and compared to their peers or a cash benchmark. Alternative strategies have flexibility with regard to their investment approach for example, a long/short strategy has the opportunity to profit in a stock s rise or decline and, as such, offers the potential to perform well in up or down markets. This paper focuses on long/short alternative strategies, which are described in Exhibit 1. The exhibit includes traditional hedge fund strategies and classic styles, both of which can be thought of as alternative risk premia. These strategies are well-known, empirically-tested, uncorrelated potential sources of returns that can be systematically harvested through dynamic long/short strategies. 1 The general aim of investing in an alternative strategy is to add a complementary source (or sources) of return; one that doesn t necessarily move in lock-step with traditional long-only assets, whether they be equities or fixed income. In the case of convertible arbitrage, the source of return is the convertible bond premium, or roughly the difference in price between the convertible bond and its underlying components. Historically this convertible arbitrage premium, or the returns from convertible arbitrage investing, has provided a positive return with a fairly low correlation to a portfolio of 60% equities and 40% bonds. Another way to achieve low correlation is to focus on strategies that seek to take advantage of a mis-pricing between relatively similar assets (i.e., relative value opportunities, such as equity market neutral). 1 Style exposures such as smart betas and other systematic tilts can be used to improve long-only portfolios, but we believe investors can maximize style benefits by using long/short strategies.
2 Advisor Briefing: Why Alternatives? Exhibit 1 Objectives of Alternative Strategies Major Hedge Fund Strategies Convertible Arbitrage Dedicated Short Bias Emerging Markets Equity Market Neutral Event Driven Capture the discount of convertible bonds relative to the fair value of their constituent parts (bond + equity call option) Profit from the inability of many investors to go short companies that are overpriced relative to their fundamentals Pursue strategies including Global Macro and various equity strategies by trading securities and currencies of emerging markets Capture systematic mispricing in global equity markets, typically between different stocks in the same sector Trade mispriced securities whose value should converge in a corporate event Fixed Income Arbitrage Global Macro Long/Short Equity Managed Futures Capture a range of mis-pricings in global bond and currency markets, including those created by market participants who are not profit-maximizing Capture mis-pricings across major global asset classes, including stock, bond, currency, and commodity markets Pursue a range of opportunities in global stock markets, including relative value between sectors and growth-based stockpicking Profit from the tendency of assets to exhibit short- and long-term trends Style Premia Strategies Value Momentum Carry Take advantage of the tendency for relatively cheap assets to outperform relatively expensive ones Profit from the tendency for an asset s recent relative performance to continue in the near future Capture the benefits of higher-yielding assets providing higher returns than loweryielding assets Defensive Pursue assets with lower risk and higher quality in order to generate higher riskadjusted returns Source: AQR. These objectives may be subject to change and there is no guarantee they will be achieved. Note: These descriptions are meant to provide insight into the drivers of the above alternative strategy returns. While this list is not exhaustive, we believe it describes the major strategies pursued by alternatives managers.
Excess of Cash Return Advisor Briefing: Why Alternatives? 3 Diversification Benefits of Alternatives Exhibit 2 provides a framework for how alternatives can improve a portfolio s risk/return profile. 2 It shows possible combinations of risk and return for two different portfolios: one that allocates only to traditional investments, such as stocks and bonds (the purple line), and another that incorporates alternative investments (the green line). Investors who allocate only to stocks and bonds may have a portfolio with risk/return characteristics shown by point A. To enhance returns beyond the level at point A, investors in traditional assets can increase their allocation to equities; 3 thereby moving along the purple line to the right of point A. However, these higher returns are achieved by adding additional risk to the portfolio. If, on the other hand, a portfolio can allocate to dissimilar (namely, uncorrelated) strategies in addition to stocks and bonds, it may be able to achieve a higher return without having to increase risk. This is shown by the move from point A on the purple stocks/bonds-only line, to point B on the green line which also includes alternatives. The results in Exhibit 2 show that a portfolio that used alternatives was able to achieve higher returns without having to take on more risk (i.e., move from risk/return point A to point B), or realize the same return by actually taking less risk (move from A to C). Exhibit 2 Alternatives Can Be Used To Enhance Returns or Lower Portfolio Risk 1990 2013 8% 7% B 6% 5% C A 4% 3% 2% 2% 5% 8% 11% 14% 17% Risk Note: Risk is defined as volatility or standard deviation. Source: AQR. Equities are the S&P 500, bonds are the Barclays Aggregate, and alternatives are the HFRI Fund-Weighted Composite Index. Equities and bonds are gross of fees, but alternatives are net of fees. A movement along the line from left to right represents an increasing allocation to stocks, and a decreasing allocation to bonds. The green line maintains a 20% static allocation to alternatives, and varying allocations to equities and bonds based on the same methodology. This example assumes no leverage, so the weights are constrained to sum to one. For illustrative purposes only. 2 Risk is defined as standard deviation, or portfolio volatility. 3 The model assumes no leverage. Returns could also be enhanced through leverage, without having to allocate away from bonds towards equities.
4 Advisor Briefing: Why Alternatives? Portfolios with Alternative Investments May Have More Resilient Performance Even the best-performing individual strategies can realize substantial short-term drawdowns and go through extended periods of low returns. In contrast, a well-diversified portfolio may be more resilient to market turmoil. To assess this, we can look at the performance of various portfolios over time. We can model how a seemingly well-diversified portfolio one with capital allocation of 60% stocks and 40% bonds compares to one that allocates 20% 4 to alternatives, away from equities and bonds on a pro-rata basis. 5 We have chosen a pro-rata reduction so as not to make assumptions about investor allocation preferences. If an investor chooses to allocate to alternatives from equities typically they would want to invest in a similar-volatility alternative strategy, whereas those who fund from bonds would typically choose a lower-volatility strategy. 6 Different volatility alternatives can also be used to address investor s objectives. If the investor is satisfied with current return expectations, but wants to reduce portfolio risk they may look to incorporate a more conservative alternative (i.e., a lower-volatility alternative) that behaves differently than the existing assets in the portfolio. 7 Conversely, if the investor is more concerned with increasing portfolio returns they may opt for a more aggressive alternative (i.e., a highervolatility alternative) to enhance returns. In Exhibit 3 we use a broadly diversified hedge fund composite (HFRI) 8 to show how alternatives can be used in different ways to accomplish different goals. 9 We show that incorporating a more aggressive version of the alternative can help enhance returns, and that a more conservative approach can lower risk. The first row of the table shows that including alternatives improved excess of cash returns: from 5% for a traditional 60/40 portfolio to 5.4% for a portfolio with an allocation to a more conservative alternative to 6.5% for a portfolio with an allocation to a more aggressive alternative. And these higher returns were achieved without having to take on more portfolio volatility. As a result, the risk-adjusted return, or Sharpe ratio, improved from 0.54 for a 60/40 portfolio to as high as 0.70 for the more aggressive alternative. 10 But return enhancement may not be the only goal for investors; we can also look at risk. The second column of Exhibit 3 shows that incorporating a more conservative alternative meaningfully lowered portfolio risk: from overall volatility of 9.2% for the 60/40 portfolio to 8.4% for one that incorporated a more conservative alternative. Lower risk in a portfolio may translate into a smoother ride during tough times. 4 Institutional investors often allocate more than 20% or their portfolios to alternatives; but the right percent allocation will vary based on each investor s needs. 5 A central challenge for the 60/40 portfolio is its dependence on the equity premium. Though the portfolio has 40% in bonds, the overall performance tends to be driven by equity market performance, meaning a bad year (or decade) for equities is likely to be a bad year (or decade) for the 60/40 portfolio. As a result, reallocating capital away from equities can provide the greatest benefit to diversification (due to the concentrated equity risk). In this case we have chosen to reallocate away in a pro-rata sense, reducing equities 12% and bonds 8%. 6 From the period 1990-2013 the volatility of the S&P500 was 15%, while the volatility of the Barclays Aggregate Bond Index was 4%. 7 In other words, the alternative should be uncorrelated to existing assets. Alternatives that are highly correlated with traditional assets do little to improve a portfolio s efficiency. 8 HFRI indices may have somewhat overstated returns due to various selection biases. 9 We look at two versions of the HFRI Fund Weighted Composite Index: the low volatility approach realizes roughly 7% over the period, while the high volatility version is scaled up to 12%. 10 The more aggressive alternative only realizes 12% volatility lower than that of equities.
Advisor Briefing: Why Alternatives? 5 Exhibit 3 Incorporating Alternatives May Improve Risk-Adjusted Returns Simulated Growth of $100 1990 2013 $1,440 60/40 Portfolio 20% Allocation to Low Vol Alternatives 20% Allocation to High Vol Alternatives $720 $360 $180 $90 1990 1995 2000 2005 2010 60/40 Portfolio Incorporating a Risk Reducing Alternative 20% Allocation to Low Volatility Alternatives Incorporating a Return Enhancing Alternative 20% Allocation to High Volatility Alternatives Excess of Cash Return 5.0% 5.4% 6.5% Volatility 9.2% 8.4% 9.3% Sharpe Ratio 0.54 0.64 0.70 Source: AQR. The 60/40 portfolio weights 60% in equities (represented by the S&P 500) and 40% in bonds (the Barclays Aggregate). Alternatives are the HFRI Fund-Weighted Composite Index. Stocks and bonds are gross of fees, but alternatives are net of fees. The low volatility version realizes 7% volatility over the period, while the high volatility version is scaled up to 12% volatility. The Exhibit shows the logarithmic returns. Past performance is not a guarantee of future performance.
Excess of Cash Returns 6 Advisor Briefing: Why Alternatives? Alternatives Can Protect Against Adverse Market Environments Portfolios can also be viewed by their sensitivities to macroeconomic risks. For example, stocks tend to suffer when economic growth contracts or is lower than expected. Similarly, bonds tend to suffer when inflation picks up or is higher than expected. But what about other environments, such as illiquid or volatile markets? And what about alternative investments which macro risk factors are they exposed to? We believe that an understanding of these relations can help investors build better portfolios, portfolios that may be more resilient to adverse market conditions. With this mind, we look at performance during five difficult environments: 1. Economic Contraction: when growth is down and the economy is stagnating 2. Inflationary Environments: periods where inflation has been increasing 3. Rising Real Yields: when real yields are higher on a year over year basis 4. Volatile Environments: unstable market conditions or general periods of turmoil 5. Illiquid Environments: tightening market liquidity Exhibit 4 examines excess of cash returns in these challenging environments for the three portfolios previously outlined. The results show that in each environment over the period, a more diversified portfolio was able to achieve higher excess returns. Adding alternatives to a 60/40 portfolio meaningfully improved performance when growth was down, inflation was up, real yields were rising, volatility was up, or illiquidity was increasing. In our view, diversified portfolios that incorporate alternatives can be good hedges against economic uncertainty. Exhibit 4 Portfolios of Traditional and Alternative Investments in Different Environments 1990 2013 10% 9.1% 60/40 Portfolio 20% Allocation to Low Vol Alternatives 20% Allocation to High Vol Alternatives 8% 7.1% 7.7% 6% Higher Returns 5.0% 4% 2.8% 3.7% 3.2% 3.9% 2.7% 3.0% 3.6% 2% 2.0% 0% -2% 0.1% -0.1% -0.6% Growth Down Inflation Up Real Yields Up Volatility Up Illiquidity Up Source: AQR. The 60/40 portfolio weights 60% in equities (represented by the S&P 500) and 40% in bonds (the Barclays Aggregate). Alternatives are the HFRI Fund-Weighted Composite Index. Stocks and bonds are gross of fees, but alternatives are net of fees. The low volatility version realizes 7% volatility over the period, while the high volatility version is scaled up to 12% volatility. Past performance is not a guarantee of future performance
Advisor Briefing: Why Alternatives? 7 Conclusion Alternatives matter because many portfolios rely on only two sources of returns stocks and bonds. Alternatives can provide a new source, one that could potentially add value even when traditional assets struggle. When used in a prudent manner, we believe these investments can play a key role in a portfolio: they can enhance returns, provide steadier performance, and may be more resilient across adverse market environments.
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Advisor Briefing: Why Alternatives? 9 Disclosures This document has been provided to you solely 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. The factual information set forth herein has been obtained or derived from sources believed by the author and AQR Capital Management, LLC ( AQR ) to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. 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. The information set forth herein has been provided to you as secondary information and should not be the primary source for any investment or allocation decision. This document is subject to further review and revision. Past performance is not a guarantee of future performance This presentation is not research and should not be treated as research. This presentation does not represent valuation judgments with respect to any financial instrument, issuer, security or sector that may be described or referenced herein and does not represent a formal or official view of AQR. The views expressed reflect the current views as of the date hereof and neither the speaker nor AQR undertakes to advise you of any changes in the views expressed herein. It should not be assumed that the speaker or AQR will make investment recommendations in the future that are consistent with the views expressed herein, or use any or all of the techniques or methods of analysis described herein in managing client accounts. AQR and its affiliates may have positions (long or short) or engage in securities transactions that are not consistent with the information and views expressed in this presentation. 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. The information in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, neither AQR nor the speaker guarantees the accuracy, adequacy or completeness of such information. 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. There is no assurance that the target allocations will be achieved, and actual allocations may be significantly different than that shown here. This presentation should not be viewed as a current or past recommendation or a solicitation of an offer to buy or sell any securities or to adopt any investment strategy. The information in this presentation 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 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 author 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 author 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 presentation in its entirety, the recipient acknowledges its understanding and acceptance of the foregoing statement. 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 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. Broad-based securities indices are unmanaged and are not subject to fees and expenses typically associated with managed accounts or investment funds. Investments cannot be made directly in an index. S&P 500 Index: a market value weighted index consisting of 500 stocks chosen for market size, liquidity, and industry grouping, and is meant to reflect the risk/return characteristics of the large cap universe. Barclays Capital Aggregate Bond Index: is a broad-based index used to represent investment grade bonds being traded in the United States. HFRI Fund Weighted Composite Index: a broadly-used index of hedge fund manager returns, weighted by assets under management.
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