Targeting value, momentum, and other styles should continue to produce excess returns, but it is critical to implement them efficiently, says AQR's Ronen Israel.
Alex Bryan: For Morningstar, I'm Alex Bryan. I'm joined today by Ronen Israel, a principal and portfolio manager at AQR.
Ronen, in your presentation today, you talked about four investment styles that have historically worked pretty well: value, momentum, defensive, and, I believe, carry as well. Could you briefly describe each of these styles?
Ronen Israel: Sure. Let's start off with value. Value is probably the most common, well-known one. It has a very simple definition. It's the tendency for cheap assets to outperform the expensive ones. Momentum is also a very well-known style; that's the tendency for outperformers to continue to outperform and underperformers to continue to underperform. Carry, as you mentioned, is about higher-yielding assets delivering higher returns than lower-yielding assets. And then, finally, the defensive style that you brought up is about low-risk, high-quality assets outperforming high-risk low-quality assets.
Bryan: So, what gives you confidence that the historical success of these investment styles is not just a product of data mining?
Israel: Not only is the empirical evidence for these style is very strong but they are also backed up by economic intuition--and that economic intuition is very important. It gives us the confidence that these returns are likely to persist in the future.
The economic intuition can come from two schools of thought. There is a risk-based or efficient-markets view of the world that would argue that the reason you get compensated is because you are bearing a risk that others may not want bear. But there is also a behavioral view that would argue that investors don't always act optimally and that creates profit opportunities for investors who are able to recognize and then take the other side of those trades.
Bryan: And how do you have confidence that these styles will continue to work--especially now that a lot of investors know about these styles?
Israel: That's a very good question--and, by the way, it's a question that could be asked of any strategy. We have not seen any evidence that as assets or as popularity has grown in these styles that the returns have gone away. We think, again, that there is an economic intuition behind them. A lot of that economic intuition has to do with behavioral or institutional biases, and it's not clear that there is enough capital to overcome those biases.
But let's just take a step back for a moment and imagine that these styles are not as good as they are going forward. Imagine even if you took the returns and you cut them in half; the results are still very compelling. There are still long-term risk-adjusted returns to be had in these styles even if they are becoming more popular.
Bryan: Going back to the historical evidence: A lot of the academic researchers who have looked at each of these styles, they've had the benefit of not looking at transaction costs. They're looking at a frictionless world. They are looking at a multidecade period. What are some of the implementation challenges, if you actually try to put these strategies into a portfolio?
Israel: Funny enough, we actually have. In fact, a paper written by a colleague of mine named Toby Moskowitz at the University of Chicago, Andrea Frazzini, and I put together a paper that looked at transaction costs and whether these styles survive them. So, we actually did an in-depth study doing exactly that. We also wrote a paper, Toby and I, looking at taxes to see whether these styles survive taxes as well. So, we actually have taken exactly your point and tried to focus on the practical considerations when you implement styles.
But to address the second part of your question: There are a couple of things that you need to take into consideration when you implement styles. We think one of the most important things is to put styles together in an integrated framework--such that you can take into account the natural synergies and the interaction effects of these styles and "net off"--when these styles are giving you conflicting information to net that off in an integrated framework such that you're able to reduce the turnover of the portfolio.
Generally, you want to be concerned about turnover; you want to be concerned about how you trade--to reduce your transaction costs and make sure you trade in a very smart way to provide liquidity rather than take liquidity. In general, if you think about style investing, it's a very straightforward idea, but the implementation of it requires a tremendous amount of craftsmanship, smart portfolio construction, smart and efficient trading, and rigorous risk management.
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Bryan: AQR Core Equity is one of those funds that actually tries to up these ideas into practice. It tries to take advantage of value, momentum, and profitability. Where does profitably fit into this framework that you talked about with these different styles?
Israel: We think that profitability, on a standalone basis, is a long-term good source of return. But we also think of it as part of a broader suite, which we would call "quality" or "defensive" in terms of trying to assess the characteristics of an asset that delivers good long-term sources of return. So, this notion of defensive, as I described earlier on, is the idea that low-risk, high-quality assets tend to outperform--certainly on a risk-adjusted basis--high-risk low-quality assets.
Profitability is another dimension of that. It is a way of determining the quality of an asset, along with other measures, such as the balance sheet stability of a company, its earnings variability, and so forth. So, we think profitability fits very nicely into this style-investing framework.
Bryan: Could you explain some of the benefits of combining these different styles together in a single strategy?
Israel: First of all, we think there are tremendous benefits for combining these styles together into an integrated portfolio. The reason for it is that these styles tend to be lowly or in some cases--for example, take value and momentum--negatively correlated with one another.
Another way to think about that is that all of these styles go through good times and bad times. They tend to go through good times and bad times, though, at different times. And that's the diversification at work. That's why we believe in putting together an integrated, multistyle portfolio to lead to more consistent returns over time.
Bryan: Now, AQR Style Premia Alternative fund (QSPNX) basically incorporates all these four styles that you talked about across several different asset classes, and it does that in a long-short format. Could you talk about some of the benefits of this approach relative to a long-only approach?
Israel: We think there are a number of benefits to a long-short implementation. The first benefit is that you're getting a diversified source of return. In other words, you're not getting a return that is highly correlated with what most traditional investors already have in their portfolio. Take a traditional 60-40 portfolio: You are very much dependent on equity-market risk. By putting together a long-short portfolio, you provide a source of return that is uncorrelated to that equity market risk.
The other benefit of a long-short implementation is that you are able to more efficiently capture the returns to styles. These styles work both on the long side (or the overweight side in a long-only context) and on the short side (or on the underweight side in a long-only context). The problem with a long-only implementation is that you are capturing both the overweights and the underweights but you are limited in how much you can underweight a security. You are limited by its weight in the benchmark. In a long-short framework, you are able to relax those constraints. If you really wanted to express a negative view on a security, you could do so more fully. So, we believe a long-short implementation is a more efficient and a more diversifying way to capture style exposure.
Bryan: But clearly there is some risks that come along with a long-short implementation. Could you talk about some of those additional risks that are added to the equation?
Israel: Absolutely. When you implement a long-short, multistyle, multi-asset class portfolio, it requires the use of leverage, shorting, and derivatives--what we jokingly refer to as LSD. The shorting is there, clearly, because you are going long and short. The derivatives are there because the most efficient way to implement asset classes beyond equities, oftentimes, are via derivatives. And the leverage is there because you are taking a very diversified, multi-asset, multistyle portfolio and trying to raise the risk and return target of that very diversified risk-adjusted return.
Now, obviously, there are risks to LSD--and here, again, I'm referring to the portfolio, not any recreational use. But we think those risks can be managed. And we think that the way to manage them is by having rigorous risk management to control the risks of that portfolio through time, making sure that you are investing in liquid assets and making sure that you are maintaining adequate levels of cash to sustain the portfolio without needing to trade right away to maintain the characteristics of the portfolio.
Bryan: Thank you. For Morningstar, I'm Alex Bryan.
