Building a Better Alternatives Portfolio

Adam Berger, CFA Autumn 2 0 1 1 Portfolio Solutions Group

Ronen Israel Principal

Mark McLennan, CFA Regional Director

Building a Better Alternatives Portfolio: The AQR Global Relative Value Approach

Executive Summary

Once available only as offshore, unregistered private funds, alternative strategies are becoming widely accessible as Undertakings for Collective Investment in Transferable Securities (UCITS). While the regulated UCITS structure may have signifi cant benefi ts to traditional investors, the rules for investing in alternatives are less well-known. What are the criteria for choosing an ? How many should be included in a portfolio? How do you allocate strategically, and when do you change that allocation? And what are the practical challenges for implementation?

This paper presents AQR’s thinking on these parameters. We end with the case for global relative value funds, which we believe should be at the core of an alternatives allocation.

We thank , Arthur Fischer-Zernin, Marco Hanig, David Kabiller, John Liew and Daniel Villalon 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 : +1.203.742.3600 I F : +1.203.742.3100 I www.aqr.com

AQR Capital Management, LLC FOR INVESTMENT PROFESSIONAL USE ONLY 1 FOR INVESTMENT PROFESSIONAL USE ONLY Building a Better Alternatives Portfolio

I. Alternatives Should Be Uncorrelated In the real world, many UCITS funds with an “alternatives” label are more like the 0.7 correlated asset than the uncorrelated Today most investors, especially those focused on the long term, asset. Exhibit B shows the correlation of large alternative UCITS 2 understand that the goal is to maximise not simply return, but funds to a standard 60/40 portfolio. For investors who want also risk-adjusted return. Adding alternative investments to a a diversifying return source, the results on average are not traditional portfolio is typically viewed as a way to do just this, encouraging. minimising downside risk while maintaining or even increasing total expected return. EXHIBIT A: Low Correlations Matter

However, not all alternatives are created equal. Those that are Effect of adding assets with identical return and volatility, but different correlations highly correlated with traditional assets do little to improve (January 1994 - June 2011) a portfolio’s effi ciency. Exhibit A shows a starting portfolio 0.45 of 60/40 stocks/bonds that makes an allocation to three different alternative investments. Each alternative has the same 0.40 volatility and expected return, but different correlations to the starting portfolio. The asset with zero correlation has the 0.35

most favourable impact on the portfolio’s Sharpe ratio, and on Ratio Sharpe important risk measures such as volatility, realised drawdown, and worst 3-year return. The improvement in Sharpe ratio 0.30 60/40 Adding 0.8 Adding 0.4 Adding 0.0 comes from a reduction in risk, but the portfolio benefi t can be Correlated Correlated Correlated Asset Asset Asset a higher expected long-term return, if investors pursue more aggressive strategies elsewhere or are able to stick with the Source: AQR, Dow Jones Credit Suisse, Fund Research Inc. 1 Note: 60/40 portfolio is 60 per cent MSCI All Countries World Index (ACWI) and 40 per cent portfolio through a full market-cycle. Barclays Global Aggregate Bond Index. The 0.8 correlated asset is the HFRI Equity Hedge Index, the 0.4 correlated asset is the DJCS Convertible Index, and the 0.0 correlated asset is the DJCS Managed Futures Index. Each of these indexes is scaled to the same return and volatility as the 60/40 portfolio.

EXHIBIT B: Many Alternative UCITS Funds Are Not Diversifying Enough

Correlations of 20 Largest Alternative UCITS Funds to a Global 60/40 Portfolio (January 2006 – June 2011) 1. 0 0. 9 0. 8 0. 7 0. 6 0. 5 0. 4 Correlation 0. 3 0. 2 0. 1 0. 0 Fund 1 Fund 2 Fund 3 Fund 4 Fund 5 Fund 6 Fund 7 Fund 8 Fund 9 Fund Fund 10 Fund 11 Fund 12 Fund 13 Fund 14 Fund 15 Fund 16 Fund 17 Fund 18 Fund 19 Fund 20 Fund

Long/ Debt Multistrategy Volatility Equity Long/Short Equity Debt Arbitrage FOF

Source: AQR, Morningstar. Note: For simplicity, we have selected the 20 largest funds in August 2011 that have existed since January 2006. This introduces a “survivorship bias”, however we think that the effects of this are small, as correlations of many alternative UCITS funds launched since 2006 are similar to those shown above.

1 We believe lowering the risk, even if the expected return remains the same, 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. 2 Alternative UCITS funds as categorised by Morningstar.

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II. Identifying Attractive Alternatives Three Categories Strategies that meet our investment criteria tend to be “classic” Our investment approach is to build a global relative value strategies, most of which hedge fund managers strategy from the bottom up. Before we can get to that stage, have been pursuing for decades.5 They focus on relative value we need to identify strategies that offer a low correlation to opportunities and typically take long and short positions in similar traditional asset classes, attractive expected returns, and that can securities. We group the alternative strategies in our portfolios into be run with suffi cient liquidity and moderate leverage. three broad categories: arbitrage strategies, which capture relative mis-pricing between two related assets; equity-oriented strategies, which take advantage of market ineffi ciencies in stocks; and Low Correlation to Traditional Assets macro strategies, which profi t from dislocations in global equity, One way to achieve low correlation is to focus on strategies that bond, currency, and commodity markets, including those driven take advantage of a mis-pricing between relatively similar assets, by investors’ behavioural biases and by the actions of market i.e. relative value opportunities. By going long the cheaper assets participants whose goal is not investment profi ts (e.g., central and short the more expensive assets, relative value strategies banks). At a more granular level, the Dow Jones Credit Suisse position themselves to make money when normal pricing is Hedge Fund Index categorises liquid alternatives into nine strategy families. Exhibit C summarises the underlying economic intuition restored, while being hedged to directional market exposures. behind each of these “classic” strategies.

Attractive Expected Returns EXHIBIT C: Objectives of Classic To evaluate expected returns, investors often examine historical Alternative Strategies performance data. Such analysis has some value, but we prefer alternatives in which there is also an economically intuitive reason : Capture the discount of many convertible bonds relative to the fair value of their constituent parts (bond + for positive returns to continue. We apply this test when assessing call option) potential alternative strategies. Dedicated Short Bias: Profit from the inability of many investors to go short companies that are overpriced relative to their fundamentals Consider convertible bond arbitrage. Convertible arbitrageurs seek to capture the difference between the price of a convertible bond Emerging Markets: Pursue strategies including Global Macro and various equity strategies by trading securities and currencies of and the value of its underlying parts (a corporate bond and a call emerging markets option on the issuer’s stock). There are two economic drivers of this difference in price: convertible bonds are generally less liquid Equity Market Neutral: Capture systematic mispricing in global equity markets, typically between different stocks in the same sector than stocks and bonds; and companies that may otherwise have diffi culty accessing credit markets often pay a premium to issue Event Driven: Trade mispriced securities whose value should con- convertible bonds more easily.3 verge in a corporate event

Fixed Income Arbitrage: Capture a range of mis-pricings in global Other alternative strategies have similar intuitive explanations. bond and currency markets, including those created by market participants who are not profit-maximizing Managed futures seeks to profi t from the tendency of different asset 4 classes to exhibit trend-like behaviour. Equity market neutral Global Macro: Capture mis-pricings across major global asset strategies benefi t from discrepancies across stock prices, such as classes, including stock, bond, currency, and commodity markets the value effect (underpriced and otherwise out-of-favour stocks Long/Short Equity: Pursue a range of opportunities in global tend to offer higher prospective returns than their peers). Global stock markets, including relative value between sectors and macro strategies benefi t from a range of opportunities across global growth-based stockpicking asset classes, such as the carry trade (which can take advantage Managed Futures: Profit from the tendency of assets to exhibit of imbalances in supply and demand for fi nancing in different short- and long-term trends by investing in liquid futures contracts economies). Source: AQR Note: These descriptions are meant to provide insight into the drivers of the above alternative strategy returns, and are not exhaustive.

3 Please see AQR white paper “Arbitrage: A Brief Introduction” for more details. Available upon request. 4 Please see AQR white paper “Understanding Managed Futures” for more details. Available upon request. 5 Classic strategies are defi ned in more depth in BNY Mellon’s April 2009 “Thought Leadership Series”.

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III. Building Each Alternative Strategy correlation. For example, most equity strategies (large, small, growth, value, global, etc.) are highly correlated with each 6 As investors, AQR seeks to build portfolios that capture the other, so adding more has only limited value (as witnessed in return sources we have identifi ed. For example, to implement 2008). convertible arbitrage, we buy a portfolio of bonds and hedge However, if the strategies being considered are uncorrelated to the unwanted risks related to stock, credit, and interest rate each other, including more of them can generally improve the exposure from the bond. This allows us, over time, to capture portfolio’s risk-adjusted return. In practice, alternatives tend to the discount inherent in convertible bonds. For managed have very low correlations with each other (the strategies in futures, we look for trends (short-, medium- and long-term) in Exhibit D have an average pairwise correlation of 0.06), which a range of asset classes and position our portfolio appropriately. means that there is real value in getting more strategies into In global macro, we take a range of long and short positions in a portfolio. However, investors should remember there is a different broad indexes for stock and bond markets, as well as limited set of liquid alternatives strategies with low correlations different currencies. and attractive returns. They should not relax their investment criteria simply to get more strategies into the portfolio. Our approach to building alternative strategies focuses on diversifi cation. In the case of convertible arbitrage, we diversify EXHIBIT D: Signifi cant Diversifi cation Potential across a broad range of bonds such that the performance of Within Alternatives any single convertible bond or issuer does not dominate the Correlations of Hypothetical Alternative Strategies portfolio’s performance. In order to maximise expected return (1990-2010) and minimise risk, we focus on bonds that we believe are Ded Fixed Convert Short Emg Eq Mkt Event Inc Global Mgd L/S trading at a meaningful discount to fair value and that we can Arb Bias Mkts Neutral Driv en Arb Mac r o Fut Equity put on effective hedges against unwanted risk factors (equity, Convert Arb 1.00 credit, and interest rate risk). For managed futures, we seek Ded Short Bias 0.18 1.00 Emg Markets -0.09 -0.26 1.00 to include the broadest possible range of liquid futures, such Eq Mkt Neutral 0.06 0.10 0.02 1.00 that poor performance in one asset class has a minimal effect Event Driven 0.04 0.00 0.05 0.21 1.00 on strategy performance. Likewise, our global macro strategy Fixed Inc Arb -0.06 0.03 0.17 0.03 -0.05 1.00 includes a wide range of stock, bond and currency exposures, Global Macro -0.11 -0.08 0.37 0.10 0.09 0.37 1.00 Mgd Futures -0.11 0.06 -0.07 0.08 -0.10 0.18 0.39 1.00 rather than just focusing on one or two pairs-trades. L/S Equity -0.07 -0.25 0.26 0.33 0.11 0.12 0.29 0.21 1.00 Median -0.06 0.01 0.04 0.09 0.05 0.08 0.19 0.07 0.16 Across all strategies, we seek to trade effi ciently using proprietary Source: AQR trading systems to minimise transaction costs. Note: Correlations for alternative strategies are calculated using hypothetical AQR performance. Please see important risk disclosures relating to hypothetical results at the end of this paper.

IV. Putting the Pieces Together How to Allocate? Not by Dollars, but by Risk.

For traditional equity investors, market-cap weighting is the While the success of an alternatives portfolio is dependent on standard approach to allocation. But for alternatives investors, individual strategy performance, the relationship among the this results in a concentrated portfolio (Exhibit E), as the strategies is at least as important. There are three major issues majority of assets are in just a few strategies. In 2011, for in effective portfolio construction: example, three hedge fund styles had approximately 75 per cent • How many strategies to include? of all hedge fund AUM. This “market-cap” alternatives portfolio • How to allocate to each strategy over the long term? is highly concentrated, meaning investors miss out on much of • How to adjust on a tactical basis? the benefi ts of diversifi cation. Furthermore, allocation by market cap can lead to systematically being overweight those styles that may be over-capitalised. Equal-dollar weighting is another How Many Strategies? More Is (Generally) Better. common approach, but here strategies with higher volatility per dollar make a disproportionate contribution to overall risk. Adding more strategies, as discussed earlier, does not guarantee a more-diversifi ed portfolio because diversifi cation depends on

6 One representative set of equity indexes we constructed had an average pairwise correlation of 0.8.

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We prefer to set allocations such that each strategy makes a EXHIBIT E: The Alternatives Industry As A roughly equal contribution to the overall risk of the portfolio.7 Whole Is Not Diversifi ed To illustrate the importance of diversifi cation, Exhibit F shows the hypothetical returns to nine alternative strategies and two Market Cap (AUM) Weighting ways of diversifying them (green bars). Allocating by market cap <1% Event Driven does diversify the overall portfolio, but allocating by risk leads to 2% 3% Long/Short Equity meaningfully higher risk-adjusted returns. 6% Global Macro 7% 28% Emerging Markets 8% Why? Even the best-performing individual strategies can realise substantial short-term drawdowns and go through extended Managed Futures 23% periods of anemic returns (bottom of Exhibit F). Each of the 23% Equity Market Neutral nine alternative strategies has realised a double-digit drawdown Convertible Arbitrage historically (some exceeding -30 per cent). A portfolio that Dedicated Short Bias is dominated by just a handful of these strategies may suffer disproportionately in periods of underperformance. By contrast, Source: AQR, Dow Jones Credit Suisse Note: Chart is for illustrative purposes only. a portfolio that is diversifi ed by risk tends to be more resilient. Note that historically, each of the single strategies has a three- value. One reason AQR makes tactical tilts is that alternative year period of fl at or negative returns, while the worst three-year strategies are inherently capacity-constrained. Because of this, period for the risk-allocated portfolio was positive. large capital fl ows into strategies can degrade forward-looking returns, and undercapitalised strategies may offer better-than- normal returns going forward. The fact that alternatives investors Tactical Tilts? Look for Qualitative and in aggregate seem to chase managers and strategies with strong Model-Driven Signals. performance can magnify these tactical opportunities for contrarian After setting a strategic allocation, investors must decide whether investors. and how to make tactical shifts, typically to increase exposure to strategies that have become more attractive, and reduce exposure We identify tactical opportunities by using expected return to strategies that have become less so. models, and through qualitative assessments of market conditions. AQR’s models consider a range of criteria including We believe the primary source of returns comes from the strategic capital fl ows and the relative size of different strategies, but also allocation to alternatives, but that tactical tilts can also add some price (“Are convertible bonds unusually cheap relative to fair

EXHIBIT F: Diversifying by Risk Can Improve Portfolios

Performance Characteristics of Hypothetical AQR Strategies, 1994-2010 (all strategies scaled to 10% volatility) 1.6 1.4 1.2 1.0 0.8 0.6 Sharpe Ratio Sharpe 0.4 0.2 0.0 Equity Allocating Dedicated Long/Short Managed Market Emerging Convert Fixed Global Event by Market Allocating Short Bias Equity Futures Neutral Markets Arb Income Arb Macro Driven Cap by Risk Worst Drawdown -40% -30% -20% -33% -24% -46% -19% -16% -16% -24% -18%

Worst 3-yr Cumulative Perf -30% -29% -15% -19% -21% -32% -3% -8% -3% -10% 3%

Source: AQR, Dow Jones Credit Suisse Note: Strategies shown above are backtests of hypothetical AQR global relative value portfolios, targeting 10 per cent annual volatility, gross of fees and net of assumed transaction costs. “Allocating by Market Cap” builds a portfolio of the hypothetical alternative strategies shown above using the strategy weights of the Dow Jones Credit Suisse Index. “Allocating by Risk” builds a portfolio of the same strategies using AQR’s risk-based approach to strategic allocation. Hypothetical performance has inherent limitations. Please see important disclosures relating to hypothetical performance at the end of this paper.

7 This “risk balanced” allocation can be thought of in a number of ways, but the core idea is that results of each strategy will make a comparable contribution to the long-term results of the strategy, if the long-term effi cacy of each is similar.

AQR Capital Management, LLC FOR INVESTMENT PROFESSIONAL USE ONLY 4 Building a Better Alternatives Portfolio value?”) and conviction (“Are the short- and long-term trends in V. Implementation for UCITS Investors managed futures pointing in the same direction?”). Exhibit G shows the power of a well-constructed alternatives Our qualitative inputs take advantage of our participation portfolio. We diversify a traditional 60/40 portfolio by reducing across asset classes and global markets. Relationships across equity exposure (the dominant risk) and adding exposure to our counterparties and prime brokers provide an additional hypothetical global relative value alternatives portfolio. Even at 10 dimension to qualitative information, including asset fl ows, state per cent of the total portfolio, average return (from 7.1 per cent to of credit markets, and other external factors that may infl uence 8.0 per cent) and Sharpe ratio (from 0.33 to 0.48) both increase returns. Qualitative inputs are particularly important in allowing meaningfully, with less volatility and a smaller worst drawdown. us to identify situations where our model-driven views may not fully capture systemic risks (or opportunities) that could drive Investors looking for a core alternatives allocation within the near-term performance. To make effective tactical tilts, one needs UCITS framework now have signifi cant choice. While institutional to be actively engaged in the actual markets. investors have long embraced alternative strategies due to their long-term effi cacy, these strategies have also come with costs. A Note on Risk Management These costs have ranged from lack of transparency, an unregulated A relative value, diversifi ed alternatives portfolio is intrinsically structure and lack of liquidity. The UCITS framework addresses lower-risk than the equity market, yet has other risks to be these issues. However, not all alternative UCITS strategies provide monitored and actively managed. Managers have many tools for the same level of diversifi cation. The AQR global relative value assessing risk, from simple measures such as volatility and value- approach seeks to provide a risk-balanced, diversifi ed approach at-risk, to more sophisticated ones such as leverage risk, liquidity to classic hedge fund strategies that are truly hedged, thereby risk, correlations, and left-tail risk. All should be considered providing maximum potential diversifi cation versus traditional in the allocation process. Additionally, we employ drawdown portfolios. control, exposure and leverage limits, and maintain suffi cient cash liquidity – all of which require substantial infrastructure, and which we believe are critical to managing global relative value funds.

EXHIBIT G: Adding Alternatives Can Improve a Traditional Portfolio

60/40 10% Allocation 20% Allocation Portfolio to Alternatives to Alternatives

MSCI World BarCap Global Agg AQR Global Relative Value Alternative

Hypothetical Performance, 1990-2010

Average Return 7.1% 8.0% 9.0% Volatility 10.2% 9.0% 8.0% Sharpe Ratio 0.33 0.48 0.66 Worst Drawdown -36% -31% -26%

Source: AQR. Data starts February 1990, as that is when the Barclays Aggregate data begins. Note: The alternative global relative value allocation above uses monthly data from a hypothetical AQR global relative value alternative portfolio, and is gross of fees and net of transaction costs. Please see important disclosures relating to hypothetical performance at the end of this paper.

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Disclosures:

This document has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other fi nancial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. This document is intended exclusively for the use of the person to whom it has been delivered and it is not to be reproduced or redistributed to any other person.

The views and opinions expressed herein are those of the author and do not necessarily refl ect the views of AQR Capital Management, LLC its affi liates, or its employees. Past performance is not an indication of future performance.

Diversifi cation does not eliminate the risk of experiencing investment losses.

Gross performance results do not refl ect the deduction of investment advisory fees, which would reduce an investor’s actual return. For example, assume that $1 million is invested in an account with the Firm, and this account achieves a 10 per cent compounded annualised return, gross of fees, for fi ve years. At the end of f ve years that account would grow to $1,610,510 before the deduction of management fees. Assuming management fees of 1.00 per cent per year are deducted monthly from the account, the value of the account at the end of fi ve years would be $1,532,886 and the annualised rate of return would be 8.92 per cent. For a ten-year period, the ending dollar values before and after fees would be $2,593,742 and $2,349,739, respectively. AQR’s asset based fees may range up to 2.85 per cent of , and are generally billed monthly or quarterly at the commencement of the calendar month or quarter during which AQR will perform the services to which the fees relate. Performance fees are generally equal to 20 per cent of net realised and unrealised profi ts each year, after restoration of any losses carried forward from prior years. In addition, AQR funds incur expenses (including start-up, legal, accounting, audit, administrative and regulatory expenses) and may have redemption or withdrawal charges up to 2 per cent based on gross redemption or withdrawal proceeds. Please refer to AQR ‘s ADV Part 2A, for more information on fees. Consultants supplied with gross results are to use this data in accordance with SEC, CFTC, NFA or the applicable jurisdiction’s guidelines.

Hypothetical performance results (e.g., quantitative backtests) have many inherent limitations, some of which, but not all, are described herein. No representation is being made that any fund or account will or is likely to achieve profi ts or losses similar to those shown herein. In fact, there are frequently sharp differences between hypothetical performance results and the actual results subsequently realised by any particular trading programme. One of the limitations of hypothetical performance results is that they are generally prepared with the benefi t of hindsight. In addition, hypothetical trading does not involve fi nancial risk, and no hypothetical trading record can completely account for the impact of fi nancial risk in actual trading. For example, the ability to withstand losses or adhere to a particular trading programme in spite of trading losses are material points which can adversely affect actual trading results. The hypothetical performance results contained herein represent the application of the quantitative models as currently in effect on the date fi rst written above and there can be no assurance that the models will remain the same in the future or that an application of the current models in the future will produce similar results because the relevant market and economic conditions that prevailed during the hypothetical performance period will not necessarily recur. There are numerous other factors related to the markets in general or to the implementation of any specifi c trading programme which cannot be fully accounted for in the preparation of hypothetical performance results, all of which can adversely affect actual trading results. Discounting factors may be applied to reduce suspected anomalies. Hypothetical performance results are presented for illustrative purposes only.

There is a risk of substantial loss associated with trading commodities, futures, options, derivatives and other fi nancial instruments. Before trading, investors should carefully consider their fi nancial position and risk tolerance to determine if the proposed trading style is appropriate. Investors should realise that when trading futures, commodities, options, derivatives and other fi nancial instruments one could lose the full balance of their account. It is also possible to lose more than the initial deposit when trading derivatives or using leverage. All funds committed to such a trading strategy should be purely risk capital.

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