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IN CONVERSATION

The power of innovation

From allocating assets in order to achieve a healthy funding status, to keeping up with technology that analyses portfolio risk, the challenges of asset owners are relentlessly evolving. For asset managers, like AQR, the key to their own evolution and success is how to be more relevant to clients.

AQR keeps clients’ needs firmly within its sights. In January it conducted a workshop on how to be even more relevant to clients, which among other things discussed how to better use technology to give clients’ continuous access to their portfolio’s performance.

Co-founder, David Kabiller, says clients are at the centre of the innovation at the firm, with the organisational culture centred around how to recruit the right people and create fertile ground to innovate.

“We have “applied” in our name so our work needs to be relevant and practical. We are interested in practical innovation,” Kabiller says.

All employees of AQR have deep shared values about the power of intellectual rigour, a respect for markets and a belief that there’s an ‘efficient amount of inefficiency’.

“We believe that through intensive research you can beat markets, but it’s not easy,” Kabiller says. “We believe our strategies have a statistical edge and an intellectual honesty.”

The aim is that this research-oriented approach will be economically intuitive, pervasive and persistent through time, but a business risk is “group think”.

“Every now and then we hire professionals who think differently and challenge thoughts,” Kabiller says, naming Michael Mendelson, a principal who is also a portfolio manager of AQR’s risk parity strategies, as an example.

But 16 years since the launch of the firm, something is working. The manager now has more than $100 billion under management, up from $19 billion almost exactly five years ago.

Part of the success Kabiller attributes to an innovation intensity stemming from a “depression-era mentality” earned primarily during the firm’s difficult first year and a half.

“You have to differentiate between a bad period in a good process versus a broken process – you need judgment and research to do that. In 1999 everyone was making money and we were having a difficult time, but then in 2000-01 we performed very well,” he says. “We learnt a lot through that – including humility- but also how to be better investment managers and risk managers as well as the value and importance of client communication.”

This humility, among over-achievers, is a cornerstone of the culture, with Kabiller and his co-founders constantly asking themselves philosophical questions and challenging themselves to make their processes better.

“As a firm we think we always have a lot to prove. There is no substitute for good judgement and for acknowledging that we don’t have all the answers so we have to keep asking questions, keep searching for new and pragmatic ideas,” he says.

AQR now offers 24 funds categorised across alternative investment, momentum, risk parity and equity, and while it’s tempting for a research-based, intellectually rigorous firm to innovate because they can, any innovation comes in the form of improving the offering to clients.

Ultimately, what the innovation question leads to is an enquiry about alpha. Is alpha in portfolio construction or risk control?

“When you realise alpha is ephemeral, it’s difficult to scale, it’s imperative that you properly structure betas,” Kabiller says. “We try to focus on what matters.”

One of the more successful innovations at AQR has been the examination of and conviction in factor styles, which has led to the Style Premia Alternative Fund, but also the ability to empirically decomposes investments and makes each component a building block available to clients.

“We can offer a menu of different risk profiles and exposures to clients. By doing this we can make investment more understandable because we can decompose it. Then our clients can pick and choose, reassemble and customise according to their own risk appetite and need,” Kabiller says.

It’s one way the question of how to become more relevant to clients is being answered.

Principal and head of the global alternative premia group, Ronen Israel, describes the breakdown of the building blocks as consisting of four styles and six asset groups all being captured in a consistent long-term framework.

“The building blocks possess the characteristics we’re trying to capture. Characteristics change through time and the underlying positions can change, sometimes frequently for style rebalancing,” Israel says.

A lot of work has gone into determining, and agreeing to the building blocks: the four styles of value, momentum, carry and defensive and the six asset groups of stocks, industries, equity indices, bonds, currencies, interest rates, and commodities.

“We picked those four styles because they can be applied across those multiple asset groups, they have the most long-term evidence and can be implemented in liquid portfolios,” Israel says.

For Cliff Asness, managing and founding principal, it’s personal.

“A lot of years went into getting the four – to agreeing to those factors I can plant my flag on and say we will get it right seven out of 10 years,” he says.

Asness says the advantage is this building block approach is an exposure to the characteristics it is trying to capture can consistently be achieved.

It’s shifting the focus from specific stocks to factors.

“We can fairly guarantee, in the individual stock world, that no one stocks’ event will kill us or make our year,” he says. “We can’t guarantee this is always going to work but we are taking out small idiosyncratic exposures we don’t have an opinion on.”

Israel says the empirical and economic evidence of the four underlying factors is very similar so allocations are spread equally among all of them in order to avoid a long term tilt. It’s a market-neutral long /short strategy across the six asset groups and four styles.

One of the client/manager crossroads at AQR is about market views and timing.

Given its quantitative nature, most of what AQR employs has little to do with market views. But as Asness points out: “clients care so we care”.

Interestingly the quant nature of the firm, and Asness biases, doesn’t stop him having a view on markets, however.

“It is a fair global statement to say that US stocks and bonds are expensive relative to prices in the last century or so. However we don’t use that information for market timing, we use it for setting expectations. And if we are forecasting 10-year returns then stocks and bonds look expensive versus the history,” he says.

Many of AQR’s clients are US pension funds, which on an average have an 8 per cent return target.

“This is unrealistic,” Asness says, making a quick calculation.

According to his numbers US stock 10 year numbers are 4.5 per cent real, with inflation of 2.5 per cent, that’s 7 per cent on 60 per cent of the portfolio. Bonds are less with real yields barely positive. This means 60 per cent of the portfolio at a 7 per cent return, and 40 per cent at 3 per cent, gives 4.2 per cent plus 1.2 per cent which is a return expectation of 5.4 per cent before fees.

“There is nothing to save us, but realistic expectations and more contributions,” he says of pension funds.

 

 

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