When to be Scared of the Stock Market

This post first appeared in the August Mutual Fund Observer.

Sometimes it is sensible to be scared of being in the stock market. Those times are rare. I want to describe them from the perspective of a value investor, who only cares about the future cash flows of his investments; I am not offering a method of short-term market timing.

The key fact to grasp is just how resilient corporate earnings are in a big, developed country with strong institutions. The chart below shows the per-share inflation-adjusted earnings of the S&P 500 as well as its 10-year moving average. Though there are violent swings in the per-share earnings series, the moving average shows that the normalized earnings power of U.S. publicly traded corporations grew right through them, rarely reversing for long. Over this period, the U.S. experienced the Great Depression, two world wars, the Cold War, massive corporate tax hikes, oil crises, stagflation, corrupt and incompetent leaders, the 9/11 attacks, countless scandals in leading corporations, the financial crisis and so on.

To the long-term value investor, there are really only a handful of circumstances that warrant a retreat from the stock market:

Prices are so high that the return on stocks over the long run cannot plausibly be much higher than that of other assets such as bonds. During the dot-com bubble, the cyclically-adjusted earnings yield of the market fell to a little over 2% while 30-year Treasury Inflation-Protected Securities yielded over 4%. For a value-oriented investor to have justified owning the stock market as a whole, he had to assume—dream of, really—fantastically high earnings growth.

The future earnings power of the market is severely impaired or destroyed and this fact is not reflected in prices. This scenario is apocalyptic and has never occurred in the U.S. For a large, developed country’s corporate sector to be permanently maimed, it would either have to be bombed to rubble as Germany and Japan were during World War II or property rights would have to disappear as in Russia during the Russian Revolution. Severe recessions do not noticeably dent the stock market’s future earnings power. A rule of thumb in determining whether a market’s earnings power is at risk of permanent impairment is if significant numbers of citizens are fleeing or want to flee the country for their personal safety.

Discount rates will rise a lot and stay high for a long time. In other words, investors for whatever reason will demand a much lower valuation in stocks, requiring current prices to fall a lot. During the 1970s and early 1980s, rising inflation and nominal interest rates caused investors to demand absurdly low valuations to own stocks. As inflation and interest rates ratcheted up, stock valuations kept ratcheting down. (With the benefit of hindsight, many analysts think that investors were suffering from the money illusion, using the era’s high nominal rates to discount real earnings.) This is a blessing for some. Current dollars invested in the market will take a big, permanent hit, but any future dollars invested in the market will earn a higher rate of return. A secular rise in discount rates is a massive transfer of wealth from the old, who have much of their net worth in financial assets, to the young, who have decades of earnings ahead of them that they can plow into cheap financial assets.

How does this apply to the current market outlook? Valuations are high, but not implausibly high given real yields on bonds. The U.S. stock market’s cyclically-adjusted earnings yield is around 4% while the 30-year TIPS yields less than 1%. Moreover, today’s problems are trivial compared to the existential threats that have loomed in the past. Even if the Eurozone and China blew up at the same time and threw the world into another depression, the long-run underlying earnings power of the rich world’s corporate sector will very likely not be permanently devastated. Valuations would cheapen, for sure, but that would indicate a buying opportunity. (Investors in developing markets, on the other hand, would probably take a permanent hit.)

What concerns me most is that interest rates—real and nominal—are so low everywhere. If the world were to enter an era of rising interest rates as we experienced in the 70s and early 80s, the mighty tailwind that’s boosted valuations over the past 30-plus years would turn into a long-lived headwind. This is a truly frightening scenario that implies years or even decades of puny returns in virtually all financial assets.

Contrast these considerations with media chatter. Everyone talks about and focuses on things that do not truly affect the intrinsic value of the market. The times to be scared are when 1) everyone is euphoric and realistic appraisals of future earnings cannot justify current prices, 2) people are fleeing the country or want to flee the country due to fears over personal safety, or 3) real rates enter a period of secular increases.

Every Active Fund is a Long-Short Fund: A Simple Framework for Assessing the Quality, Quantity and Cost of Active Management

This post first appeared in the June Mutual Fund Observer.

Here’s a chart of the 15-year cumulative excess return (that is, return above cash) of a long-short fund. Over this period, the fund generated an annualized excess return of 0.82% with an annualized standard deviation of 4.35%. The fund charges 0.66% and many advisors who sell it take a 5.75% commission off the top.

Though its best returns came during the financial crisis, making it a good diversifier, I suspect few would rush out to buy this fund. Its performance is inconsistent, its reward-to-risk ratio of 0.19 is mediocre, and its effective performance fee of 44% is comparable to that of a hedge fund. There are plenty of better-performing market-neutral or long-short funds with lower effective fees.

Despite the unremarkable record, about $140 billion is invested in a version of this strategy under the name of American Funds Growth Fund of America AGTHX. I simply subtracted the Standard & Poor’s 500 Index’s monthly total return from AGTHX’s monthly total return to create the long-short excess return track record (total return would include the return of cash).

This is an unconventional way of viewing a fund’s performance. But I think it is the right way, because, in a real sense, every active fund is a long-short strategy plus its benchmark.

Ignoring regulatory or legal hurdles, a fund manager can convert any long-only fund into a long-short fund by shorting the fund’s benchmark. He can also convert a long-short fund into a long-only fund by buying benchmark exposure on top of it (and closing out any residuals shorts). I could do the same thing to any fund I own through a futures account by overlaying or subtracting benchmark exposure.

Viewing funds this way has three major benefits. First, it allows you to visualize the timing and magnitude of a fund’s excess returns, which can alter your perception of a fund’s returns in major ways versus looking at a total return table or eyeballing a total return chart. Looking at a fund’s three-, five- and ten-year trailing returns tells you precious little about a fund’s consistency and the timing of its returns. The ten-year return contains the five-year return which contains the three-year return which contains the one-year return. (If someone says a fund’s returns are consistent, citing 3-, 5-, and 10-year returns, watch out!) Rolling period returns are a step up, but neither technique has the fidelity and elegance of simply cumulating a fund’s excess returns.

Second, it makes clear the price, historical quantity and historical quality of a fund’s active management. The “quantity” of a fund’s active management is its tracking error, or the volatility of the fund’s returns in excess of its benchmark. The “quality” of a fund’s management is its information ratio, or excess return divided by tracking error. Taking these two factors into consideration, it becomes clearer whether a fund has offered a good value or not. A fund shouldn’t automatically be branded expensive based on its expense ratio observed in isolation. I would happily give up my left pinky for the privilege of investing in Renaissance Technologies’ Medallion fund, which charges up to 5% of assets and 44% of net profits, and I would consider myself lucky.

Finally, it allows you to coherently assess alternative investments such as market-neutral funds on the same footing as long-only active managers. A depressingly common error in assessing long-short or market neutral funds is to compare their returns against the raw returns of long-only funds or benchmarks. A market neutral fund should be compared against the active component of a long-only manager’s returns.

To make these lessons concrete, let’s perform a simple case study with two funds: Vulcan Value Partners Small Cap VVPSX and Vanguard Market Neutral VMNFX. Here’s a total return chart for both funds since the Vulcan fund’s inception on December 30, 2009. (Note that Vanguard Market Neutral was co-managed by AXA Rosenberg until late 2010, after which Vanguard’s Quantitative Equity Group took full control.)

Given the choice between the two funds, which would you include in your portfolio? Over this period the Vanguard fund returned a paltry 3.7% annually and the Vulcan fund a blistering 14.2%. If you could only own one fund in your portfolio, the Vulcan fund is probably the better choice as it benefits from exposure to market risk and therefore has a much higher expected return. However, if you are looking for the fund that enhances the risk-adjusted return of portfolio, there isn’t enough information to say at this point; it is meaningless to compare a fund with market exposure with a market neutral fund on a total return basis.

A good alternative fund usually neutralizes benchmark-like exposure and leave only active, or skilled-based, returns. A fairer comparison of the two funds would strip out market exposure from Vulcan Small Cap (or, equivalently, add benchmark exposure to Vanguard Market Neutral). In the chart below, I subtracted the returns of the Vanguard Small Cap Value ETF VBR, which tracks the CRSP US Small Cap Value Index, from the Vulcan fund’s returns. While the Vulcan fund benchmarks itself against the Russell 2000 Value index, the Russell 2000 is terribly flawed and has historically lost about 1% to 2% a year to index reconstitution costs. Small-cap managers love the Russell 2000 and its variations because it is a much easier benchmark to beat. Technically, I’m also supposed to subtract the cash return (something like the 3-month T-bill or LIBOR rate) from Vanguard Market Neutral, but cash yields have effectively remained 0% over this period.

When comparing both funds simply based on their active returns, Vanguard Market Neutral Fund looks outstanding. Investors have paid a remarkably low management fee (0.25%) for strong and consistent outperformance. Even better, the fund’s outperformance was not correlated with broad market movements.

This is not to say that Vanguard has the better fund simply based on past performance. Historical quantitative analysis should supplement, not supplant, qualitative judgment. The quality of the managers and the process have to be taken into account when making a forecast of future outperformance as a fund’s past excess return is very loosely related to its future excess return. There is a short-term correlation, where high recent excess return predicts high future near-term excess return due to a momentum effect, but over longer horizons there is little evidence that high past return predicts high future return. Confusingly, low long-run excess returns predict low future returns, suggesting evidence of persistent negative skill. If a fund has historically displayed a long-term pattern of low active exposure and negative excess returns, its fees should either be extremely low or you shouldn’t own it at all.


There’s a puzzle here. Imagine if Vanguard Market Neutral’s managers simply overlaid static market exposure on their fund. Here’s how their fund would have performed.

A long-only fund that has beaten the market by 3.7% a year with minimal downside tracking error over five years would easily attract billions of dollars. But here Vanguard is, wallowing is relative obscurity, despite having remarkably low absolute and relative costs.

Why is this? In theory, the price of active management—in whatever form—should tend to equalize in a competitive market. However, what we see is that long-only active management tends to dominate and is often wildly expensive relative to the true exposures offered, and long-short active management tends to often repackage market beta and overcharge for it, creating pockets of outstanding value among strategies that are truly market neutral and highly active.

I think three forces are at work:

  1. Investors do not adjust a fund’s returns for its beta exposures. A high return fund, even if it’s mostly from beta, tends to attract assets despite extremely high fees for the actively managed portion.
  2. Investors focus on absolute expense ratios, often ignoring the level of active exposure obtained.
  3. Investors are uncomfortable with unconventional strategies that use leverage and derivatives and incur high tracking error.

Given these facts, a profit-maximizing fund company will be most rewarded by offering up closet index funds. Alternative managers will offer up market beta in a different form. Active managers that offer truly market neutral exposure will be punished due to their unconventionality and comparisons against forms of active management where beta exposures are baked into the track record.

 Investment Implications

When choosing among active strategies, all sources of excess return should be on a level playing field. There is no reason to compare long-only active managers against other long-only active managers. Your portfolio doesn’t care where it gets its excess returns from and neither should you.

However, because investors tend to anchor heavily on absolute expense ratios, the price of active management offered in a long-only format tends to be much more expensive per unit of exposure than in a long-short format. An efficient way to obtain active management while keeping tracking error in check is to construct a barbell of low-cost benchmark-like funds and higher-cost alternative funds.

AQR Long-Short Equity/AQR Equity Market Neutral: A Review

This analysis originally appeared in the April 2016 Mutual Fund Observer, but I'm republishing it here for completeness's sake. I've made some minor edits and updates. As always, comments welcome.

Objective and strategy

AQR offers its absolute return equity strategy in two mutual fund flavors: AQR Equity Market Neutral and AQR Long-Short Equity. Equity Market Neutral, or EMN, goes long global stocks that score well on proprietary composite measures and shorts global stocks that score poorly. AQR groups these measures into six broad “themes”:

Value is the strategy of buying stocks that are cheap on fundamental measures such as book value, earnings, dividends and cash flow.

Momentum is the strategy of buying stocks with strong recent relative performance according to measures such as price returns, abnormal returns after earnings announcements (earnings surprises), abnormal risk-adjusted returns (residual momentum), and returns of economically linked firms (indirect momentum).

Earnings quality is the strategy of buying stocks with reported earnings that are more reliable indicators of future earnings, according to measures such as accruals.

Stability is the strategy of buying stocks with defensive characteristics, such as low volatility, low beta, and low leverage.

Investor sentiment is the strategy of buying stocks with wide agreement by “smart money”, according to measures such as low short interest as a percentage of market capitalization and high commonality of holdings by elite hedge funds.

Management signaling is the strategy of buying stocks where management engages in actions that indicate financial strength or cheapness, such as debt retirement and share repurchases.

Stocks are ranked by these measures within each industry. The stocks with the highest composite scores are bought and the stocks with the lowest composite scores are shorted. Industry neutrality improves risk-adjusted returns on a wide variety of stock selection signals, perhaps because it removes persistent industry bets.

In addition, the strategy engages in country-industry pairs selection using the same six sets of signals and industry selection using only value and momentum. Because AQR dislikes concentrated bets, the country-industry pairs and industry selection strategies are allotted a smaller portion of the strategy’s overall risk than the stock-selection strategy.

The balance of the long and short sleeves is managed to produce returns uncorrelated with the MSCI World Index, a market-weighted benchmark of developed market stocks. This does not mean each sleeve has the same notional size. The long sleeve tends to exhibit lower volatility for each unit of notional exposure than the short sleeve. In order to balance them, the strategy must own more dollars of the long sleeve, creating the impression that it has net long equity exposure. The gross exposure for each sleeve has a floor of 100% NAV and a cap of 250% NAV, meaning the strategy’s gross exposure can range from 2x to 5x the net asset value of the fund. As of February end, AQR Equity Market Neutral had 190% notional long exposure and 173% notional short exposure, for a total gross notional exposure of 363%.

AQR takes steps to mitigate the risks of leverage. First, the strategy is well diversified, with over 1700 stock positions, most of them under 0.5% notional exposure and the biggest at a little under 1.7%. Single-stock concentration goes against every bone in AQR. Like most quant investors, AQR goes for seconds and thirds when it comes to the “free lunch” of diversification.

Second, AQR has a 6% annualized volatility target for the strategy, which means AQR will likely reduce gross leverage if its positions behave erratically. This is a trend-following strategy as periods of high volatility usually coincide with bad returns. For reference, the volatility target is about a third of the historical volatility of the U.S. stock market and roughly the same as the historical volatility of the Barclays Aggregate Bond Index (though in recent years the bond index’s volatility has dropped to about 3%).

Finally, the strategy applies what AQR calls a “drawdown control system”, a methodology for cutting risk when the strategy loses money and adding it back as it recoups its losses (or enough time lapses since a drawdown). The drawdown control system can cut the fund’s target volatility by up to half in the worst circumstances. AQR’s use of volatility targeting and drawdown control are common practices among quantitative investors. As a group these investors tend to cut and add risks at the same time. It is unclear whether they are influential enough to alter the nature of markets and perhaps render these methods obsolete or even harmful (think of portfolio insurance and its contribution to Black Monday in 1987, when the Dow Jones Industrial Average fell 22.6%). My guess is quantitative investors aren’t yet big enough because many more investors are counter-cyclical rebalancers over the short-run, particularly institutions. This is speculation, of course. The market is a big and wild herd that will sometimes stampede in a direction it had never gone before—a lesson AQR itself learned at least twice: during the madness of the dot-com bubble and during the great quant meltdown of 2007.



Long-Short Equity, or LSE, takes the EMN strategy (though they’re not exact clones if we’re to judge by their holdings and position sizes) and overlays a tactical equity strategy that targets an average 50% exposure to the MSCI World Index, with the ability to adjust its exposure by +/- 20% based largely on valuation and momentum. The equity exposure is obtained through futures.

In a back-test of a simplified version of the strategy, the market-timing component did not add much to the strategy’s performance while it worsened the drawdown during the financial crisis.

Adviser

AQR Capital Management, LLC, was founded in 1998 by a team of ex-Goldman Sachs quant investors led by Clifford S. Asness, David G. Kabiller, Robert J. Krail, and John M. Liew. (Krail is no longer with the firm.) AQR stands for Applied Quantitative Research. Asness, Krail and Liew met each other at the University of Chicago’s finance PhD program. The firm’s bread and butter has long been trading value and momentum together, an idea Asness studied in his dissertation under Eugene Fama, father of modern finance and one of the co-formulators of the efficient market hypothesis.

AQR is mostly owned by AQR Group LP, which in turn is owned by employees of the firm. AMG, a publicly traded asset manager, has owned a stake in AQR since 2004 and in 2014 it increased it, but remains a minority shareholder (terms of both transactions have not been disclosed). AMG largely leaves its investees to run themselves, so I am not concerned about the firm pushing AQR to do stupid things to meet or beat a quarterly target. Though the implosion of Third Avenue, an investee, may spur AMG to more actively monitor its portfolio companies, I doubt Asness and his partners gave AMG much power to meddle in AQR’s affairs.

AQR’s mutual fund business has grown rapidly in size and sophistication since 2009, when it launched arbitrage and equity momentum funds. It competes with DFA for the mantle of academic “thought leadership” among advisors, its main clients. This has put Asness in the awkward position of competing with his former mentor Fama, who is a significant shareholder in DFA and the chief intellectual architect of its approach. Like DFA, AQR emphasizes the primacy of factors in managing portfolios.



When AQR started up, it was hot. It had one of the biggest launches of any hedge-fund up to that point. Then the dot-com bubble inflated. The widening gap in valuations between value and growth stocks almost sunk AQR. According to Asness, had the bubble lasted six more months, he would have been out of business. When the bubble burst, the firm’s returns soared and so did its assets. The good times rolled on and the firm was on the verge of an IPO by late 2007. According to the New York Post, AQR had to shelve it as the subprime crisis began roiling the markets. The financial crisis shredded its returns, with its flagship Absolute Return fund falling more than 50 percent from the start of 2007 to the end of 2008. Firm-wide assets from peak-to-trough went from $39.1 billion to $17.2 billion. The good times are back: As of December-end, AQR had $142.2 billion in net assets under management.

The two near-death experiences have instilled in AQR a fear of concentrated business risks. In 2009, AQR began to diversify away from its flighty institutional clientele by launching mutual funds to entice stickier retail investors. The firm has also launched new strategies at a steady clip, including managed futures, risk parity, and global macro.

AQR has a strong academic bent. Its leadership is sprinkled with economics and finance PhDs from top universities, particularly the University of Chicago. The firm has poached academics with strong publishing records, including Andrea Frazzini, Lasse Pedersen, and Tobias Moskowitz. Its researchers and leaders are still active in publishing papers.

The firm’s principals are critical of hedge funds that charge high fees on strategies that are largely replicable. AQR’s business model is to offer up simplified quant versions of these strategies and charge relatively low fees.

Managers

Both the Equity Market Neutral and Long-Short Equity strategies are run by Jacques A. Friedman, Andrea Frazzini, and Michele L. Aghassi. Ronen Israel helps manage EMN. Hoon Kim helps manage LSE. All five are principals, or partners, in the firm.

Friedman heads AQR’s Global Stock Selection team. Prior to joining AQR at its inception in 1998, he developed quantitative stock selection strategies at Goldman Sachs. He is the principal portfolio manager and supervises Frazzini, Aghassi and Kim.

Israel heads AQR’s Global Alternative Premia Group. Prior to joining AQR in 1999, he was a senior analyst at Quantitative Financial Strategies, Inc.

Frazzini researches global stock-selection strategies. Prior to joining AQR in 2008 he was a star finance professor at the University of Chicago.

Aghassi is co-head of research of AQR’s Global Stock Selection team. Prior to joining AQR in 2005, she obtained her PhD in operations research at MIT.

Kim is the head of equity portfolio management in AQR’s Global Stock Selection team. Prior to joining AQR in 2005, he was head of quantitative equity research at Mellon Capital Management.

Israel and Friedman have master’s degrees in mathematics. Frazzini, Aghassi and Kim have PhDs.

Strategy capacity and closure

The EMN and LSE funds together have over $1.6 billion in assets. However, AQR runs hedge funds, institutional separate accounts, and foreign funds, and re-uses the same signals in different formats, such as long-only funds. The effective dollars dedicated to the signals use by the funds are almost certainly much higher than reported by the aggregate net asset values of the mutual funds.

Fortunately, AQR has a history of closing funds and ensuring its assets don’t overwhelm the capacity of its strategies. When the firm launched in 1998, it could have started with $2 billion but chose to manage only half that, according to founding partner David Kabiller. Of its mutual funds, AQR has already closed its Multi-Strategy Alternative, Diversified Arbitrage and Risk Parity mutual funds. Soon after I wrote about AQR Style Premia Alternative QSPIX and AQR Style Premia LV QSLIX in the September 2015 edition of MFO, AQR announced a soft close of the funds. It went into effect on March 31, 2016. AQR will meet additional demand by launching funds that are tweaked to have more capacity. 

Management’s stake in the funds

As of December 31, 2014, the funds’ managers had relatively low investments in the mutual funds.

Friedman had $50,001 to $100,000 in the EMN fund and $100,001 to $500,000 in the LSE fund.

Israel had no investment in the EMN fund.

Frazzini had $10,001 to $50,000 in both funds.

Aghassi had no investments in either fund.

Kim had no investment in the LSE fund.

The low levels of investment should not be held against the managers. It is cheaper and more tax efficient for them to invest in the strategies through AQR’s hedge funds. They also have a direct interest in the success of the firm. Unlike many other hedge funds, AQR does not compensate partners and employees largely based on the profits attributable to them. The team-based nature of AQR’s quantitative process means profits cannot be cleanly attributable to a given employee. Moreover, there is a huge element of luck in the performance of a given strategy and AQR rightly does not want to overwhelmingly tie compensation to it. All the portfolio managers of the funds are partners and so earn a payout based on the firm’s earnings and their relative ownership stakes. AQR grants ownership stakes based on “cumulative research, leadership and other contributions.”

I expect that over time the managers’ stakes will rise as a matter of window-dressing for consultants who take a check-the-box approach to due diligence (most of them). There is evidence that window-dressing has occurred: Some of AQR’s principals own both the low- and high-volatility versions of the same strategy, which is strange because it is costlier to own the low-volatility version per unit of exposure.

Comments

Since its October 2014 inception, AQR Equity Market Neutral Fund I QMNIX has returned 18.6% annualized with a standard deviation of 7.0%, for a Sharpe ratio of 2.66. Since its July 2013 inception, AQR Long-Short Equity Fund I QLEIX has returned 14.4% above its benchmark (a 50-50 blend of the MSCI World Index and cash) with a standard deviation of 5.8%, for a Sharpe ratio of 2.46. Almost all of the abnormal returns were driven by the market-neutral equity stock selection sleeve; AQR’s tactical market timing in the LSE strategy contributed zilch to the fund’s returns from inception to the end of 2015.

These are not sustainable numbers. A more reasonable, conservative long-run Sharpe ratio is 0.5. Translated to a raw return, that’s 3% above cash for a market-neutral strategy that runs at a 6% volatility.

While AQR’s absolute return global stock selection strategy has done well, its long-only funds have not. Since the LSE fund launched in 2013, its active returns (that is, returns above its benchmark) have far outstripped the active returns of the AQR Multi-Style funds. In the chart below I plotted the cumulative active returns of AQR Long-Short Equity (which has a longer live track record than AQR Equity Market Neutral) against a sum of the active returns of AQR Large Cap Multi-Style I QCELX and AQR International Multi-Style I QICLX. The long-only funds have stagnated, while the long-short fund has consistently made lots of money. While I doubt this divergence will remain big and persistent, I’m confident that it’s well worth paying up for AQR’s long-short strategy.

While past performance by itself is usually not predictive, there are logical reasons to believe AQR's long-short stock selection strategy will maintain its edge over AQR's multi-style long-only stock selection strategies. First, AQR's long-short strategy is much more diversified than its long-only strategies. AQR uses many more signals, owns many more stocks, and turns over its portfolio much more aggressively (AQR Large Cap Multi-Style's turnover is 60%; AQR Equity Market Neutral's is 383%). The superior diversification and breadth of the portfolio should result in a superior risk-adjusted return. Second, AQR cannot justify a higher fee on its long-short strategies without offering higher expected returns. More cynically, it makes economic sense for AQR to put its better, limited-capacity signals in its smaller, higher-fee mandates.

I have almost a third of my net worth in AQR Long-Short Equity and none in AQR's Multi-Style funds. I'm putting my money where my mouth is.

Bottom line

AQR’s long-short global stock-selection strategy is well worth the money and a better deal than its long-only stock funds.