One of my favorite people in our industry is Cliff Asness, founder and current mouthpiece for AQR, one of the mutual fund companies that we use.
His academic background is very strong, he got his PhD in finance from the University of Chicago, the intellectual home of efficient markets, but wrote his dissertation on momentum, the most significant critique of the efficient market hypothesis. His advisor was none other than Gene Fama, the high priest of efficient markets, who still refers to momentum as the greatest embarrassment to his theory.
Asness left academic and went to work at Goldman Sachs on Wall Street, where he put the ideas he worked on at University of Chicago into practice and earned outsized returns. His big insight was to combine value investing with momentum, not just in stocks but across all asset types like bonds, commodities and currencies.
Ultimately, he left Goldman to found AQR (short for Applied Quantitative Research), which has grown into a powerhouse, managing more than $105 billion. Unlike most academics, Asness has real world experience. And unlike most practitioners, he made important contributions to the field and continues to earn prestigious awards for his ongoing research.
What I really like, though, is that he’s funny.
Last night, I was listening to Steve Forbes interview Asness (here’s the link) and Asness was making a lot of good points. One of them was that nothing works all of the time.
What he said, though was much funnier: ‘I’m in a business where if 52 percent of the days I’m right, I’m doing pretty well over the long-term. That’s not so easy to live with on a daily basis. When I say a strategy works, I kind of mean six or seven out of 10 years. A little more than half the days. If your car worked like this, you’d fire your mechanic.’
Let’s take value investing, for example. Using the Fama-French research data starting in June 1927 and ending in March 2014, large cap value stocks earned 11.3 percent per year, versus 9.95 percent for the S&P 500.
That’s a big win – 1.35 percent of excess return per year, compounded. A single dollar invested in the S&P 500 would have turned into $3,779 over this period, while large value stocks would have grown to $10,872. That’s how powerful a small edge can be when compounded over time.
Even though the strategy clearly ‘worked’ (and there are more detailed statistics that back it up), it was often a tough ride. Asness said that he would do well to ‘win’ 52 percent of the time. It turns out that value stocks beat the S&P 500 53.6 percent of the time, 558 out of 1,042 months (I don’t have daily numbers, it may well be lower daily).
In fact, Asness was pretty accurate – value won six out of every 10 years (54 out of 86). We’ve been lucky – yes, lucky – that value has won seven out of the last 10 years. In 2007, the S&P 500 earned 5.49 percent, but value stocks, perhaps because they are more sensitive to the economy, fell by -6.52 percent, and therefore underperformed by -12.02 percent.
The next year wasn’t much better – when the S&P 500 lost 37.00 percent, large cap value stocks lost -44.60 percent, a 7.60 percent underperformance. During those two years, value stocks suffered an 18.71 percent relative loss to the S&P 500. And, yet, despite that pain, value stocks still beat the S&P 500 by 0.20 percent per year.
That’s a small win, I know. It could have been much worse, though. In the decade that ended in July 1960, the S&P 500 gained 401.9 percent cumulatively (17.5 percent annually). During the same time frame, value investors only earned 290.6 percent cumulatively (14.6 percent annually). That’s a long stretch of underperformance, although maybe it was somewhat palatable since 14.6 per year, is still a fantastic result.
Still, I remember during the tech bubble that a lot of value managers struggled to maintain their clients. In the 10 years that ended in February, 2000, the S&P 500 gained 425 percent, but value stocks only earned 341 percent, cumulatively (18.0 and 16.0 percent respectively). Instead of being happy about earning 16 percent, a lot of investors were unhappy that they didn’t earn 18 percent – or worse – that they didn’t earn 30+ percent that stocks were earning.
So, while I absolutely agree with Asness that don’t win all of the time, I want to add that the periods of losing can be long and painful. To help blunt the pain, we diversify, like adding in momentum to compliment value. The two strategies work well together since they are lowly correlated (or more specifically, the premiums are negatively correlated), but there will always be periods of underperformance.
To date, no one has invested a magic money machine that wins all of the time. For a while, it looked like Bernie Madoff had one, but that turned out to be much, much worse. He appeared to win 96 percent of the time, but that last month was a doozy.