From the October 2009 issue of Investment Advisor • Subscribe!

October 1, 2009

Danger & Opportunity: He's Got the Momentum

Cliff Asness is known as a hedge fund manager who caters to institutions, is a true believer in momentum investing, and despite his University of Chicago credentials, a heretic who rejected Fama-French dogma on the efficient markets to build his own investing doctrine using the often-criticized concept called momentum investing. But these days, the shop he helped found in August 1988, AQR (for Applied Quantitative Investing) Capital Management, based in hedge fund's downtown, Greenwich, Connecticut, has entered the mutual fund world. Three funds were launched in July, all with $5,000 minimums: AQR Momentum (AMOMX) in large caps; AQR Small Cap Momentum (ASMOX) in small caps, and AQR International Momentum (AIMOX) in international, all of which use his momentum strategy and are available on the Schwab and Fidelity platforms. Earlier this year the firm launched the AQR Diversified Arbitrage fund (ADANX), which uses multiple arbitrage strategies. Asness and his partners are now quite interested in reaching the ears and pocketbooks of advisors and their high-net-worth clients.

He spoke to Editor Jamie Green during the Schwab Impact 2009 conference in San Diego in mid-September, just before he presented his case to the assembled advisors in a conference session. Ebullient but also self-effacing, Asness nevertheless remains a true believer in his shop's unique approach to investing, despite the naysayers.

How much does AQR manage now, and what's the mix of clients and vehicles? We manage about $22 billion, with about two-thirds in traditional investments, trying to beat the benchmarks, and a third in hedge fund assets. Most of the money is from institutions, very little from the high net worth; our clients tend to be endowments, pension funds, and state plans.

Is it easier to invest on behalf of institutions, which have a much longer time horizon, than it is for individual clients, who may be more swayed by emotion and a shorter time horizon? Institutions can be as bad as individuals. And retail investors have one advantage: they're masters of their own fates. The only way to not do well for your clients is to pay too much for Wall Street.

Why have you gotten into the mutual fund world now? We've defied easy labels for a long time. We started building this [mutual fund] effort three to four years ago, though I admit the timing now is fortuitous. We're trying to diversify using the same set of models and beliefs that we've used [in the institutional business].

As for the mutual funds we've introduced so far, we first asked, what do we do that we think--this is our opinion--is missing from the mutual fund world? Pretty quickly we came up with three different momentum funds and a diversified arbitrage fund. We have three momentum funds: large cap, small cap, and international. They're different in that they are different securities, but not in spirit.

Let me mention diversified arbitrage. In the hedge fund world, we've done each of the so-called arbitrage strategies: merger arbitrage, convertible arbitrage, closed-end arbitrage. For maybe 10 years now, we do them in a similar geek-like fashion: we don't do much in the way of individual meetings with management, but we build very diversified risk-controlled portfolios: we give up looking for the one right merger, but we also give up the cost of putting all your eggs in one basket and choosing the wrong merger. We try to pick up the general premium--and this has been a huge premium for 30 years--that mergers close more often than they don't. Even when they don't close, it's like an insurance company: when somebody dies early, you pay off a lot more than the policy, but you're betting on net that the policies cover it. We try to do it a little better, and if I call it an index approach the guys back home will yell at me, but it's largely a much more diversified, focusing-on-costs and getting-exposure approach.

We looked and found there are a few people who do various aspects of arbitrage in the mutual fund world, but no one does a diversified set of many of the strategies. Mergers is the cleanest, easiest example that everybody knows of. Convertible arbitrage is now a bigger part of the portfolio: you buy the convertible bond and try to hedge away as much of the risk as you can, and they tend to trade fairly cheaply; it looks like a piece of equity and a piece of credit exposure.

If you try to hedge them away, you tend to make money for a long time; you lost a lot of money in 2008 and you made a ton of it back in 2009. We wrote a paper, called The Limits of Convertible Arbitrage, about the ride in convertible arbitrage [see InvestmentAdvisor.com to access the paper].

What we noticed was that no one was doing the full set of arbitrage strategies; even in the first quarter of this year, even last year, it was a fairly low-volatility portfolio.

These are famous last words, but the good news is that it's hard to lose all your money doing a very diversified set of these strategies; the bad news is that you're never going to post an up 50% in a year either. We're up about 10% for this year in the arb fund. The stock market is up more than that now, but we were up in the first quarter as well.

The point is that we've had a very low correlation to the equities market and very low volatility. I said this in the Barron's interview recently (August 31), but if we're ever up 50% in a year with this fund, you should do an expose of that. We look at this fund as having bond-like volatility but not very correlated to equities or bonds.

By the way, we think the word arbitrage is misused: if you're long and short the same thing, it's not riskless.

Tell me about the origins of your beliefs in momentum investing, and how you use it in building portfolios. [Narasim] Jegadeesh and [Sheridan] Titman wrote first about momentum research in the late 1980s. We don't think the markets are totally efficient, and that in addition to the Fama-French three-factor model, there's a fourth factor [to explain stock market performance]: price momentum.

In a way, the formula is simple: we buy what's going up, and we sell what's going down. I did my dissertation on momentum investing at the University of Chicago [Variables That Explain Stock Returns, 1994, available at AQR.com]. Eugene Fama is one of my heroes, but I was nervous when I told him I wanted to write on momentum investing. But he told me, "If it's in the data, write it."

Fama-French is all about size and value. If there's any magic to adding value and momentum, it's that they hedge each other over time. Momentum is a good substitute for growth. [For more on momentum, see AQR's research paper, The Case for Momentum Investing, by Adam Berger, Ronen Israel, and Tobias Moskowitz, at AQR.com].

What part of an ideal portfolio would be momentum? If I were building my own portfolio, it would be roughly half value, half momentum.

Since you are a quant shop, do you worry about the macro economic and political environment? In momentum, we're doing a relative value bet, not a market direction trade, but I do think the economic recovery will be slow. These new tariffs on China worry me [the Administration announced on September 11 that it was slapping steep tariffs on Chinese-made tires that were causing "market disruption"]. It's textbook: if you want to turn a recession into a depression, become protectionist.

I'm also still University of Chicago through and through: when you print a lot of money, it's going to have an effect on the economy. If you invest your fears, it's a bad idea. But all of these worries, hopefully [they won't] affect our investing.

What are your feelings on leverage these days? We've always preferred strategies with lower leverage--our diversified arbitrage fund, for example, is levered 1.3 to 1. But last year was not a fun year, and the scariest thing about leverage is that you have to borrow it from someone else, and that someone will want it back: the cost of leverage is always higher than you think.

I think 2008 was an acid test: who survived and who didn't; who managed leverage well, and who didn't.

Do you invest in your own funds?

We invest in all our funds, but most of my wealth is in the business.


Group Editor-in-Chief Jamie Green can be reached at jgreen@investmentadvisor.com.

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