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Asness Firmly in the Middle on Efficient Market's Hypothesis

Ben Johnson, CFA

Ben Johnson: I'm Ben Johnson, director of Global ETF Research with Morningstar, and today I'm excited to be joined on the sidelines of the Morningstar Investment Conference by AQR co-founder and chief investment officer Cliff Asness. Cliff, thank you for being here with me.

Cliff Asness: Thank you.

Johnson: So, Cliff, a little known or maybe not so little known biographical factoid about you, you actually spent two years as a teaching assistant to professor Eugene Fama. He was your dissertation advisor. So I'm curious to know, professor Fama being the father of the efficient market's hypothesis, what's your take on your mentor's work? Where do you stand on the market efficiency spectrum?

Asness: Sure, I stand firmly in the middle, courageously and firmly in the middle. Gene, for one, sometimes gets painted as very extreme on this, and he's still one of my investing heroes even if I'm more toward inefficient markets than he is. But for the fact that he has an open mind, he'll tell you flat out, "Markets are not perfectly efficient." 'Cause that's a very extreme hypothesis. Someone has to get paid to make them inefficient. It's a point on a spectrum. I will say it's fair to say he thinks they're more efficient than I do. I probably think they are more efficient than the average active stock-picker out there. I think behavioral biases in particular do matter. Things like value, momentum, some things that maybe could exist in the efficient market, but probably better have behavioral explanations.

I've always thought that. I wrote my dissertation for Gene on momentum which he was quite kind about, but that's a very hard one to shoehorn into efficient market theory. Over time, I've not gone over to the dark side. I still think I give a lot more credence to efficient markets than many on my side of the table. But behavioral effects, living through things like the technology bubble, the GFC, have pushed me more toward the middle. There are small efficiencies and very rarely large efficiencies. People overuse the word "bubble." They use it 10 times a day for things they don't like. I think they happen once every few decades, but they do happen. So in the middle.

Johnson: And your firm, AQR, which stands for Applied Quantitative Research, looks to go out vet stress test, a lot of these inefficiencies, some of them exploitable, others less so. Which are the ones, when it comes to actual investment practice, that are practical to try to exploit, and what are some of the frictions, the barriers to efficiently exploiting some of these market anomalies?

Asness: We actually have always implicitly been doing this exercise, but maybe six, seven years ago we explicitly sat down and go, "All right, what are the biggies we really believe in?" And to be careful, those don't mean they're the only ones you invest in. You invest proportionate to your confidence. So if you have one where you think the odds are better than even after all the issues, data mining, implementation problems, is real but small, you invest a small amount. Not interested in those. The biggies. We do them in categories and part of the way you get into these biggies is they have to work over time, not all the time but work over time for many investing decisions. One, value investing, won't surprise you at all. The second, I already mentioned, momentum investing. The third is a form of carry investing, getting paid to wait. Has very little applicability to equities largely 'cause it comes out pretty much the same as value. If you get a high dividend yield, very similar to a cheap stock.

In other markets, in currencies, in bonds, in the commodities futures markets, they can be quite different, and we find all else equal and all else is not always equal. We'd like to be paid to wait. And finally something that has come to be called quality low risk, things that are better on some very intuitive measures that I think you would all ... everyone would agree you'd want this if it were free. One is profitability, more profitable companies bidding lower less profitable companies. Another is low risk, our preferred measures in the form of market beta. A stock that doesn't respond to the market very much tends to be orphaned because 50-some odd, 60, I don't know how many years ago now, Bill Sharpe told us we should lever the market portfolio, but if you won't do that, low beta stocks are orphan. They don't help and then they get cheap. So value, momentum, carry, though not very applicable for equity investors. And then something we lump together 'cause they're similar, they're things you'd like to have in a stock if it were free, defensive and profitability or quality.

Johnson: And when you take those various factors and you think about the actual practice of assembling a portfolio that sets out to try to harness them, what's your overarching philosophy?

Asness: Well, number one is to get investors to diversify as much across these as possible. You can't always do it. Some investors believe in one style. They want value or momentum investing in U.S. equities. And we think that will win long term. And at the right fair fee, we're willing to do that for them. But if an investor comes to us and goes, "You tell us what to do for U.S. equities." We'll make a recommendation that we build a portfolio that's exposed to each of these categories. Now if an investor says, "Let me take the gloves off. We're not gonna do a hedge fund 'cause we're not gonna charge hedge fund prices, but let's walk in that direction. You're allowed to go long and short things." Suddenly we'll try to pick up this value, this momentum, this carry and this quality defensive premium in 50 different places around the world. Geographies, asset classes, bonds go long.

A cheap bond market would be one with high real yields. A good carry market would have a steep slope, momentum would be getting better lately. And defensive would be as you can imagine, a safe bond market, one that doesn't move very much. All else equal, we'd prefer to do it everywhere. So what we sit down with someone and say, "Here's what we believe in. We hope you agree. You don't have to agree, but if you agree, what are you allowed to do? What are you comfortable with? What techniques of investing and are you comfortable with doing it in as many places?" Our druthers would be to be as diversified as we can. As much as we love these things, nothing works close to all the time. When you do it in many places, you still don't get close to it all the time but you get better.

Johnson: Well, Cliff, I really appreciate you being here with me today and shedding some light on your take on market efficiency and how investors can factor reality into practice.

Asness: Thank you.

Johnson: With Morningstar, I'm Ben Johnson.