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Style Investing: the Long and the Long/Short of It

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Style Investing: the Long and the Long/Short of It SPONSORED COMMENTARY Style Investing: The Long and the Long/Short of It any investors agree that applying sys- a small amount of “smart.” In contrast, long/short Building a long/short style portfolio tematic tilts away from a passive, cap- approaches seek to capture the entire style premium We believe an even broader, more diversified and italization-weighted portfolio is a good and none of the beta, thus we think their fees should more efficient approach is to combine long/short idea; fewer agree on how best to capture reasonably be higher (they typically offer several styles in multiple asset classes. The use of leverage, these style-based returns. times more style exposure – and thus have lower shorting and derivatives may enable the efficient and MLong-only, or “smart beta”, strategies apply tilts capacity – than a smart beta portfolio). As such, in- market-neutral implementation of styles in many (typically within equities) to give exposure to styles vestors should try to determine how much they are contexts, while also allowing for reasonable risk and such as value, momentum, size or low-risk – that is, paying for cheaply accessible market beta versus un- return targets given the increased diversification and they overweight stocks that are relatively cheap, have correlated style premia. pursuit of higher risk-adjusted returns. Four styles – recently outperformed peers, have a small market value, momentum, carry and defensive3 – have gener- cap, or are classified as low risk or high quality. These Building a long-only style portfolio ated positive returns in many different contexts, in- tilts aren’t always explicit, as some smart beta strate- The first step is to identify the most useful styles. cluding stock and industry selection, equity country gies emphasise a portfolio goal rather than a rule for Within equities, we find decades of evidence across selection, fixed income, currencies and commodities.4 picking securities, for example, maximum diversifi- multiple geographies for a few styles. For example, An analysis of market data from January 1990 to cation or minimum volatility. However, all these ap- AQR’s research1 analyzing historical data on value, June 20135 found that diversified style premia theo- proaches result in deviations from market capitaliza- momentum and profitability in US stocks has shown retical portfolios delivered both positive risk-adjust- tion weights that in practice imply certain systematic that the stocks that rank the highest on each style ed returns (Sharpe ratios ranging from 0.9 to 1.3) and style tilts. have significantly outperformed stocks that rank diversification from equity-directional risk (correla- The same principles can be applied in a long/short the lowest.2 Strikingly, we find that this tendency tions to global equities ranging from approximately context. That is, going long cheap assets and short is “monotonic” – within each style, the top quintile –0.1 to +0.2). Thus, a well-diversified combination of expensive ones, long outperformers and short under- outperformed the second-best quintile; the second- style strategies in several asset classes may provide performers, etc. These strategies are variously called best outperformed the third-best, and so on (see attractive risk-adjusted returns uncorrelated with “alternative betas” or “alternative risk premia” (and Figure 1). long-only asset-class premia (see Figure 2). even other names); in this piece, we refer to them as While data is useful for identifying promising “style premia.” Unlike smart beta, we find that style styles, it’s also important to have economic expla- Making the most of style investing premia can be applied in multiple asset classes, with nations for why these styles have performed well Whether investors choose long-only smart beta or little or no traditional beta exposure. and may be expected to continue to do so over the long/short “style premia,” we think they should long-term. The excess returns from value, for exam- broadly agree on two other portfolio design choices: Long-only versus long/short ple, might be compensation for the risk of invest- 1) more styles are better than only one and 2) strategic Each approach to style investing has its merits, and ing in distressed companies more likely to suffer in diversification is better than tactical style exposure. we see a role for both applications, even for the same weak markets (cheap companies might be cheap for institution. There is little doubt that long/short ap- a reason) or might be explained by “glamour” stocks 1. Many or just one? proaches can provide better diversification to portfo- being overpriced by investors willing to pay for Relative to a single-style approach, we generally find lios dominated by market-directional risks, and they (over-extrapolated) growth prospects. As with many multistyle approaches provide better diversification, can more efficiently capture style premia. However, economic phenomena, it’s likely that there isn’t one reduce transaction and other costs, and promote long-only approaches are typically easier for many certain explanation; rather, multiple theories in com- patience.6 Two of the best-known and most-studied institutions to adopt because they involve less peer bination can explain the performance of styles. The styles – value and momentum – have been shown to risk (they have lower tracking error to conventional key is that there exist reasonable and intuitive expla- possess the rare combination of positive historical portfolios and benchmarks), they have greater capac- nations to provide comfort that the performance of returns and negative correlations to one another. We ity, and they do not require the use of leverage, short- styles may likely persist. think incorporating both styles should lead to more ing or derivatives. Style premia can be effectively harvested in a long- efficient risk-taking. So why do so many investors Before turning to practical examples of long-only only portfolio of stocks by evaluating each stock pursue just one, or pursue value in one fund and mo- and long/short applications of style investing, we against several lowly-correlated styles, and then mentum in another, which can be less efficient? note that this distinction has clear implications for over- or underweighting according to its combined Some investors may prefer the apparent versatil- fees. Long-only smart beta returns are dominated attractiveness. The resulting tilts can be scaled to en- ity of this à la carte, single-style approach. They may by their market beta, which can be accessed at very sure a meaningful and manageable amount of active choose the “best of breed” manager for each style tilt, low cost. As a result, we think smart beta fees should risk, while avoiding the use of leverage, shorting or but this approach can have its pitfalls – for instance, reflect the fact that they are mostly market beta with derivatives. an inability to net positions, which reduces costs. Re- Figure 1: Three Intuitive Styles for a Long-Only Equity Portfolio US Stocks Sorted by Value US Stocks Sorted by Momentum US Stocks Sorted by Profitability (July 1951 - September 2013) (July 1951 - September 2013) (July 1951 - September 2013) 22% 22% 22% 20% 20% 20% 18% 18% 18% 16% 16% 16% 14% 14% 14% 12% 12% 12% 10% 10% 10% 8% 8% 8% 2 3 4 2 3 4 2 3 4 Cheap Losers Winners Expensive Book to Market Quintiles Momentum Quintiles Gross Profits to Assets Quintiles Profitable Unprofitable Sources: Ken French Data Library, AQR. Value and Momentum quintiles based on decile-level information provided by Ken French. Profitability quintiles are based on CRSP/Compustat data, using the same uni- verse as the Ken French Value and Momentum series. The profitability quintiles are based on a single factor – Gross Profits over Assets (GPOA). Returns are gross of transaction costs. call the low correlations between these styles, which Figure 2: Long/Short Style Premia May Offer Attractive and Uncorrelated Sources of suggest that stocks that are attractive on the basis of Return value are unlikely to be simultaneously attractive on the basis of momentum. Thus the pure value man- Hypothetical Sharpe Ratios Hypothetical Correlations ager is likely to be overweight (or long) many of the (January 1990 - June 2013) (January 1990 - June 2013) same stocks that the pure momentum manager is 1.5 1.0 underweight (or short), in some cases resulting in a 0.5 combined portfolio that looks a lot like the index, but 1.0 0.0 with a lot more trading. We think these costs may be 0.5 Correlation Average correlation to other 3 styles saved by a single manager who trades only on the Sharpe Ratio -0.5 net signal, overweighting a stock that is attractive on Correlation to equities 0.0 -1.0 both value and momentum. Value Momentum Carry Defensive Value Momentum Carry Defensive There’s another benefit to combining styles: pa- tience. Single styles have at times experienced (and may continue to experience) years of underper- Source: AQR. Hypothetical performance of theoretical style portfolios, gross of transaction costs. Correlations are based on monthly returns. “Equities” is MSCI World Index. Each style is applied in multiple asset contexts, including stock and industry selection, equity country selec- formance, many of which have been (and will be) tion, fixed income, currencies and commodities Each strategy is designed to take long positions in the assets with the strongest style attrib- quite painful. Because styles have shown potentially utes and short positions in the assets with the weakest style attributes, while seeking to ensure the portfolio is market-neutral. Hypothetical strong diversification benefits to one another, we be- results have certain inherent limitations, and are for illustrative purposes only and not based on an actual portfolio AQR manages. PAST lieve a combination of many is likely to deliver more PERFORMANCE IS NOT A GUARANTEE OF FUTURE PERFORMANCE.
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