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Fitting Factors Into the Formula

Factor investing and asset allocation are two roads to the same destination, Cliff Asness and Rob Arnott say.

Paul Justice, 10/12/2012

This article originally appeared in the October/November 2012 issue of MorningstarAdvisor magazine.  To subscribe, please call 1-800-384-4000. 

Quantitative analysis in fund investing has well-established roots in the realm of attribution analysis. However, some of the observed anomalies that can lead to better practical results for investors have proved difficult to access for financial advisors. That doesn’t have to be the case.

For this issue’s Morningstar Conversation, we talk with two quant-investing legends— Cliff Asness, co-founder of AQR Capital Management, and Robert Arnott, chairman of Research Affiliates—to gain insights on where academic theory is being practically applied in the marketplace. AQR, a hedge fund shop, recently rolled out a suite of factor-exploiting products in the mutual fund arena. Gone are the days of 2-and-20 fees for access to exotic betas a la carte. Research Affiliates, through its subadvisory of PIMCO All Asset PAAIX and its Fundamental Indexing concepts, has taken active quant investing to the masses (with strong performance, to boot).

While both of these investors are renowned in both academic and practitioner circles for their cutting-edge work in quantitative analysis, they haven’t always seen eye to eye. In this conversation, we focus not on where the disagreements reside, but instead on where there is common ground. The result is some sage advice on how investors can assess and implement factor-based investing strategies today. Our discussion took place Aug. 21. It has been edited for clarity and length.

Paul Justice: Let’s start with the comparison of style and size factors. For many years, investors have used models based on asset classes. But now, we’re seeing a shift, as investors become more interested in risk factors. You guys certainly have got some skin in the game. What are your thoughts on this approach?

Cliff Asness: First, we still think a factor-based approach can make sense within an asset class. Being able to tilt a portfolio has benefits, if you’re tilting toward something good.

What you call “style,” which I would call the “value strategy” or the “value factor,” we definitely think it’s good. Within a standard long-only portfolio, a tilt toward that factor makes sense. But by its nature, that’s a very constrained position. It’s a small amount of tracking error, and more importantly, it’s very one-sided. That portfolio can own long stocks, but it’s very limited in what it can underweight.

We think a lot of these factors, not just value, are two-sided. They add value, both from what they like and what they dislike. Some people actually think that they add value more from what they dislike. We disagree with that, too. We’ve done our studies and written papers on this, and we’re very balanced on this. Most of the factors seem to be fairly symmetric. But a traditional tilted-long portfolio really only can give you one side. And a factor-based approach is generally a long/short portfolio. The value factor is not just long cheap stocks; it’s a relatively market-neutral portfolio that’s long cheap and short expensive.

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