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AQR Dominates

But is it the Vanguard of alternative investing?

Alternative investments are different. Not just in what they buy and how they perform (where, of course, acting differently is the whole point), but in how the industry operates. The rules that govern other segments of the fund business often don’t apply to alternatives.

For example, alternative exchange-traded funds have yet to make their mark. Whereas ETFs have siphoned customers away from traditional mutual funds—initially with domestic stocks, then international stocks, and now taxable bonds—they are an afterthought with alternatives investors. While leveraged ETFs have sold pretty well, they are not true alternative funds in the sense of being uncorrelated with the major markets. The real thing—categories such as long-short credit or managed futures—hold less than $4 billion in ETF assets.

In a related point, active investors dominate in this space. ETFs, after all, rely on indexes, and alternatives don’t easily lend themselves to indexing. They are strategies. We can measure the U.S. stock market, then create an index to replicate that measurement. We can’t do the same with a market-neutral strategy. To be sure, we can build an ETF by devising a representative strategy, then call our invention an “index.” But, clearly, such a construction is less natural than a marketplace index, and investors have responded accordingly.

Because index funds pose little competitive threat, expense ratios for the leading alternative funds are far higher than elsewhere in the industry. These days, the vast majority of conventional fund sales go into funds that have expense ratios of less than 0.6%—usually much less. With alternatives, on the other hand, a 1% expense ratio is considered low-cost. Most of the larger funds have expense ratios approaching 1.5%, which would doom them were they not alternatives.

One AQR to Rule Them Given all these differences, it's not surprising that, for alternatives, industry leadership is upside down. The giants are absent. Among them, Vanguard, BlackRock, Fidelity, Capital Research, and T. Rowe Price run a grand total of $7 billion in alternative mutual funds. In contrast, the management firm AQR controls $29 billion. It is, one might say, the Vanguard of the alternatives business.

EXHIBIT 1 compares the net monthly sales since November 2012 of AQR against those of alternative funds from 164 other mutual fund managers combined. AQR took a while to gather momentum—of course, so did Vanguard back in its day—but starting about three years ago, AQR moved into first place. Since then, it has steadily gathered new assets while its rivals have mostly suffered net redemptions. (As is the nature of aggregations, the bars representing AQR’s competitors hide the occasional outliers; it’s not as if every fund company besides AQR has being losing alternatives assets. Rest assured, though, AQR has comfortably led the way.)

EXHIBIT 2 shows how AQR has succeeded. It depicts AQR’s four best-selling funds for the year through October 2017. They have attracted $4 billion in new assets, counting all share classes. I have selected the highest-selling share class for each fund. (Portraying the results of multiple share classes of the same fund is messy and adds no useful information in this case.) Each fund’s relative total returns, as measured by its trailing three-year ranking within its Morningstar Category, is shown in the first bar. Costs relative to each fund’s broad Morningstar Fee Level Group are shown in the second.

For both bars, higher is better. The best-performing fund would have a performance bar that reaches the top percentile, and the cheapest fund would have an expenses bar at the top percentile.

Blue-Ribbon Returns AQR won the old-fashioned way: Its funds beat everybody else's. AQR Long-Short Equity QLEIX finished first in its category. AQR Equity Market Neutral QMNIX was first in its category. AQR Style Premia Alternative QSPIX was first in its category. Of the four, only AQR Managed Futures Strategy HV QMHRX had a mediocre showing. Outgaining other funds succeeds in the mutual fund industry. That was true when grandpa drove the Oldsmobile, true when your father did so, and it remains true today.

AQR’s expenses haven’t been bad, either; with the share classes shown here all somewhat cheaper than the norm. Clearly, though, the funds’ performance has been their main attraction. Also, this illustration favors AQR, because three of those fund share classes are institutional, and the fourth is an R6 share class, which is priced even below the institutional classes. (R6 is a “clean” share class, meaning that it does not share any revenue with the companies that distribute AQR funds.) If retail funds are removed from the comparison group, AQR’s relative cost advantage declines.

Low-Cost Leaders Now, let's look at Vanguard's chart in EXHIBIT 3 . As with AQR's figures, Vanguard's are generated for its four top-selling mutual funds for the year through October: Vanguard Total Stock Market Index VITSX, Vanguard 500 Index VFIAX, Vanguard Total International Bond Market Index VTABX, and Vanguard Total International Stock Index VTIAX.

Again, the first bar in each set represents relative total returns and the second shows relative expenses. (The particular share classes shown here were the most popular ones with records of at least three years.) It’s almost certainly what you expected: Cost triumphs. All of the Vanguard funds are among the cheapest 3% in their group—and these share classes aren’t necessarily the cheapest available for each fund.

The performance bars also follow the customary Vanguard formula. None of them reach the top, because index funds don’t generally place first in their categories, but three of the four funds place in their category’s top quartile. That is a typical achievement for a bargain-priced index fund: Land somewhere near the first quartile for three years, then gradually move up the rankings over time, because the expense advantage is ongoing, while relative performance comes and goes.

Half True Which, rather neatly, brings us to the conclusion. Is AQR the Vanguard for alternative investing? Yes and no. Yes, in that AQR rules its (much smaller, albeit highly profitable) roost. The nonconformity of alternatives has enabled somebody besides Vanguard to prevail within that portion of the industry, and AQR has become that somebody. No, in that AQR's formula is different. It relies on performance, not costs. That means that AQR faces the greater challenge of the two firms in maintaining its supremacy. Staying cheap is not hard. Staying number one most certainly is.

This article originally appeared in the February/March 2018 issue of Morningstar magazine. To learn more about Morningstar magazine, please visit our corporate website.

The opinions expressed here are the author’s. Morningstar values diversity of thought and publishes a broad range of viewpoints.

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