Applied Investment Rigor

Barron’s cover article this weekend featured AQR, one of the fund companies that we use.  You can find the article here, but a subscription is required.

The article was great, really explaining the firm and many of their processes – so much so that one of the online commenters asked, ‘what is this, an ad?’

My only disappointment was that the article really highlighted their alternative mutual funds, strategies like managed futures and long-short equities.  However, it makes perfect sense to focus on these funds for two reasons.

First, AQR has really done a terrific job delivering positive returns in their alternative funds during the current market correction.  Most alternative mutual funds are far more tied to the stock market than they advertise, but AQR’s promise of low correlation has panned out so far in most of their funds.

Second, most of the money that AQR manages in mutual funds is in the liquid alternatives category.  While the firm manages more than $140 billion, only $23 billion of that is in mutual funds.  AQR started as a hedge fund and mostly serves institutional investors – the mutual fund business is relatively new with their first launch in 2009.

Of the $23 billion in mutual fund assets, $17 billion follows alternative investment strategies and only $6 billion is traditional, long-only stock strategies – what we do.

I wish the Barron’s article had dedicated some ink to how they were the first mutual fund (or ETF for that matter) to launch a momentum-only stock mutual fund or combine value and momentum in a systematic way.

I’ve been onboard with AQR since they first launched mutual funds.  In fact, I made my own first investment in their funds within the first few months of their first launch, when they only had $7.5 million in their mutual fund business (yes, $7.5 million with an ‘m’).

I wrote an article back in 2010 that Morningstar published about why advisors were more interested in AQR’s alternative funds as opposed to their traditional ‘beat-the-benchmark’ funds.

I offered three theories for why advisors weren’t interested in AQR’s long-only funds compared to the alternative funds, and they are all pretty critical of advisors.

First, I thought the alternative funds represented driving in the rearview mirror since the alternative funds would have done better than stocks in the 2008 crash.  Second, using alternatives for a small segment of the portfolio was much less impactful than incorporating momentum; and third, I thought advisors were having fun with alternatives because they were the ‘new, new thing.’

All of those arguments hold up as I reread the article more than five years later and I would like to add a fourth argument, which I’ve covered in other Daily Insights (found here).

The basic idea is that alternative funds are basically black boxes, unlike the long-only funds, which are relatively transparent.  I like the black box funds, but, by design, they will lose 20-25 percent in one year at some point in the future.

That alone isn’t so bad (we know stocks could lose more), but what makes it hard is that you won’t know why it’s losing.  If it’s doing its job correctly, it will be losing when other investments are doing fine and you’ll wonder whether it’s just a bad time for the strategy or whether the black box is broken.

The alternative funds use leverage and derivatives, two of the dirty words in finance, which would make the bad period all the scarier.  The AQR funds that we use do not use leverage or derivatives (well, a tiny amount, but so does every fund including Vanguard index funds – I will cover this another day).

In any case, it’s great to see such terrific press for one of the fund families that we use, even if they don’t really mention the specific funds that we use.  Good press is good press.