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A Better Approach to Alternative Investing AQR’S Multi-Strategy Solution for Australian Investors

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A Better Approach to Alternative Investing AQR’S Multi-Strategy Solution for Australian Investors C A P I T A L AQR M A N A G E M E N T Ronen Israel May 2013 Principal Michael Angwin National Distribution Manager AQR Australia Dan Villalon Vice President A Better Approach to Alternative Investing AQR’s Multi-Strategy Solution for Australian Investors Preface Australian financial advisers continue to seek true alternatives as a way to deliver better portfolio outcomes to their clients. However, they have had a range of previous experiences, in part driven by the reality that 'alternatives' is somewhat of a catch-all category encompassing a range of strategies that perform differently through market cycles. Added to this, product structuring and risk management failures have left some questioning the actual value of alternatives in a portfolio context. Investor caution is therefore understandable, as the rules for investing in alternatives are less well-known than for their traditional counterparts. What are the criteria for choosing an alternative investment? How many should be included in a portfolio? How do you allocate strategically, and when do you change that allocation? What are the practical challenges for implementation? This paper presents AQR's thinking on these parameters. We end with the case for liquid multi-strategy alternative funds, which we believe should form the core of most investor's alternatives allocation. We thank Cliff Asness, Arthur Fischer-Zernin, Marco Hanig, David Kabiller, John Liew and Simon Wills for helpful comments and suggestions; and Georgi Georgiev and Ryan Kim for data and analysis. We also thank Jennifer Buck for design and layout. Please read important disclosures at the end of this paper. AQR Capital Management, LLC I Two Greenwich Plaza, Third Floor I Greenwich, CT 06830 I T : 203.742.3600 I F : 203.742.3100 I www.aqr.com FOR INVESTMENT PROFESSIONAL USE ONLY A Better Approach to Alternative Investing I. Alternatives Should Be Uncorrelated In the real world, many managed funds with an 'alternatives' label are often more like the 0.7 correlated asset, than they are Today, most investors, especially those focused on the long the uncorrelated asset. Exhibit B shows the correlation of term, understand that the goal of a portfolio is to maximise alternative managed funds3 operating in Australia to an not just return, but also risk-adjusted return. Adding example 60/40 portfolio as described in Exhibit A. For alternative investments to a traditional portfolio is a way to investors who want a diversifying return source, the results on potentially do this, reducing downside risk while maintaining average are not encouraging. or even increasing the portfolio's expected return. However, not all alternatives are created equal. Those that are II. Alternatives Should Be Packaged highly correlated with traditional assets do little to improve a Appropriately portfolio's efficiency. Exhibit A shows a starting 60/40 portfolio that makes an allocation to three different alternative Beyond risk-adjusted returns and correlation benefits, investments. Each alternative has the same expected return investors also need to carefully consider the investment structure used to gain exposure to alternative strategies. The and volatility of returns, but different degrees of correlation to the starting portfolio. The asset with zero correlation has the issues certain fund managers faced in 2008/2009 highlighted most favorable impact on the portfolio's Sharpe ratio1, and on how the fund structure can be just as important as the underlying investments. important risk measures such as volatility, realised drawdown and worst 3-year return. The improvement in Sharpe ratio Liquidity Mismatch Risk comes from a reduction in portfolio volatility, but the benefits can also extend to a higher expected long-term return - if All investors prefer more liquid investments – daily if they can investors pursue more aggressive strategies elsewhere or are get it. However, many investment strategies that fall under the better able to stick with the portfolio through a full market- 'alternatives' category do not naturally provide that level of cycle.2 liquidity (indeed, certain strategies attempt to harvest an illiquidity premium, as discussed in the following section). These less-liquid strategies can be valuable portfolio EXHIBIT A: Low correlations matter inclusions for those who are willing and able to accept that a Effect of adding assets with identical return and portion of their portfolio may not be able to be redeemed on volatility, but different correlations any given day. (January 1994 – December 2012) 0.35 More importantly, when considering an investment in an 0.30 alternative fund, investors should consider whether the 0.25 liquidity of the underlying investment matches the liquidity terms offered by the fund to its investors (liquidity matching). 0.20 Sharpe Sharpe Ratio A fund which offers its investors a level of liquidity which it 0.15 cannot match in times of market stress, can lead to dire 0.10 outcomes - such as suspended redemptions or fund 60/40 Adding 0.7 Adding 0.4 Adding 0.0 Correlated Correlated Correlated terminations - if the fund manager cannot free up enough Asset Asset Asset capital to satisfy redemption requests in a timely manner. Source: AQR, Dow Jones Credit Suisse, Hedge Fund Research Inc. Note: 60/40 portfolio consists of 30% S&P/ASX 300 Index, 20% MSCI World ex-Australia Index, 10% S&P/ASX 200 A-REIT Index, 20% UBS Australian Composite Bond Index, 15% Transparency Barclay/Lehman Global Aggregate Index, and 5% cash. Subsequent bars take 80% of the 60/40 portfolio and 20% of the new asset. The 0.7 correlated asset is the HFRI Equity Hedge Index, the 0.4 correlated asset is the DJCS Convertible Arbitrage Index, and the 0.0 correlated asset is the DJCS Managed Futures Index. Each of these indices is scaled to the Alternative managers are notoriously opaque, often providing same return and volatility as the 60/40 portfolio. little or no timely information as to their sources of return. Due to the nature of the strategies, managers do need to be cautious regarding their public disclosures; however, we 1 Sharpe ratio is used to measure risk-adjusted performance. It is calculated by believe that investors should, at a minimum, be enabled to dividing the portfolio's excess return (portfolio return less the risk free rate) by the standard deviation of portfolio returns. Standard deviation is a measurement of understand their fund manager's investment strategy, risk and the investment's volatility. The higher the Sharpe Ratio, the better the portfolio's return characteristics, performance attribution and current return in risk adjusted terms. 2 We believe lowering the risk, even if the expected return remains the same, positioning. This level of transparency allows investors to yields a higher expected return across a full market-cycle, since investors are more likely to stick with their portfolio rather than taking risk down after realising losses. 3 Alternative managed funds as categorised by Morningstar. 2 FOR INVESTMENT PROFESSIONAL USE ONLY AQR Capital Management, LLC A Better Approach to Alternative Investing 0.9 EXHIBIT B: Many alternative managed funds are not diversifying enough 0.8 Correlations of 12 alternative managed funds to a 60/40 portfolio 0.7 (January 2006 – December 2012) 0.6 0.9 0.8 0.5 0.7 0.6 0.4 0.5 0.4 0.3 0.3 0.2 Correlation 0.2 0.1 0.1 0.0 0 -0.1 Fund 2 Fund 3 Fund 4 Fund 1 Fund 8 Fund 5 Funddata 6 Fund 7 Fund 11 Fund 9 Fund 10 Fund 12 Long-Short Global Macro Multi-Alternative Source: AQR, Morningstar Note: For simplicity, we have selected the 12 funds in December 2012 that have existed since January 2006. This introduces a “survivorship bias”, but we think that the effects of this are small, as correlations of many alternative managed funds launched since 2006 are similar to those shown above. managed with sufficient liquidity and without high levels of improve their knowledge of the fund's investment approach leverage. and its role within their broader portfolio, and to identify any changes of approach through time, such as style drift (where a Low Correlation to Traditional Assets manager deviates from their stated strategy) or changes to the fund's liquidity or leverage profile. One way to achieve low correlation is to focus on strategies that take advantage of a mispricing between relatively similar Reasonable Fees assets, i.e., relative value opportunities. By going long (buying) the cheaper assets and shorting (selling) the more Alternative managers have historically charged higher fees expensive assets, relative value strategies position themselves compared to their traditional counterparts. This is often to make money when normal pricing is restored, while being warranted, as alternative strategies often require greater hedged to general market movements. Strategies that take implementation skill than long only traditional assets such as directional positions may also be valuable alternatives, but the equities and bonds. Our view is that investors should pay fees magnitude of these positions should be managed and they commensurate with the expected risk-adjusted returns and should not be a source of passive long exposure. That is, they diversification potential of the strategy being delivered. We should not be biased over time to have a long exposure to feel investors shouldn't have to pay '2% + 20%' fees to get markets as this will necessarily increase correlations to the rest exposure to well-known alternative strategies that are of a portfolio's assets. For example, a managed futures strategy uncorrelated with traditional equity and bond markets; and might be directionally long or short the stock market, but the they certainly shouldn’t pay high fees when those returns are, strategy's total long position will be capped, and the average in fact, highly correlated with traditional equity and bond equity exposure over time should be close to zero.
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