Hedge Funds, Hedge Fund Beta, and the Future for Both
Clifford Asness Managing and Founding Principal AQR Capital Management, LLC
C A P I T A L AQR M A N A G E M E N T An Alternative Future
Seven years ago, I wrote a paper about hedge funds in general (and ten years ago about whether they actually hedge)
I was smart enough to present the pros and cons of hedge fund investing
C A P I T A L 1 AQR M A N A G E M E N T An Alternative Future
Seven years ago, I wrote a paper about hedge funds in general (and ten years ago about whether they actually hedge)
I was smart enough to present the pros and cons of hedge fund investing, i.e., I hedged
C A P I T A L 2 AQR M A N A G E M E N T An Alternative Future
Seven years ago, I wrote a paper about hedge funds in general (and ten years ago about whether they actually hedge)
I was smart enough to present the pros and cons of hedge fund investing, i.e., I hedged
The basic conclusion was that something like index funds and hedge funds represent the future, but not yet…
C A P I T A L 3 AQR M A N A G E M E N T Sources of Portfolio Returns
WHAT • Active strategies (“alpha”) HEDGE • Unique to certain managers FUNDS • Cynics and believers disagree on Skill its existence SAY • Pure value Dynamic • Pure momentum Returns • Arbitrage strategies WHAT • Many agree on return premium HEDGE • Global equities FUNDS • Global bonds DO Market Returns • Commodities • Most agree on return premium
C A P I T A L 4 AQR M A N A G E M E N T Two Definitions of Hedge Funds
A strategy that: Investment pools that are:
Trades relatively liquid assets Unconstrained Unregulated Seeks to make positive High fees average returns over time Illiquid Non-transparent Provides diversification versus Supposed to make money all traditional stock and bonds the time markets Run for rich people in Geneva by rich people in Greenwich
A Portfolio Tool A Compensation Structure
Source: “An Alternative Future”. Diversification does not eliminate the risk of experiencing investment losses.
C A P I T A L 5 AQR M A N A G E M E N T Hedge Fund Styles
Event Convertible Global Driven Arbitrage Macro
Fixed Equity Long/Short Income Market Equity Arbitrage Neutral
Dedicated Emerging Managed Short Bias Markets Futures
C A P I T A L 6 AQR M A N A G E M E N T Hedge Funds: The Good News
1. Hedge funds offer a diversifying, positive expected return 2. This can improve almost any portfolio’s risk-adjusted return
Realized Efficient Frontier Jan 1994 – June 2011 10% 100% Hedge Funds 9% 100% Stocks
8%
Return 7%
6% 100% Bonds Stocks & Bonds Stocks, Bonds & Hedge Funds 5% 2% 4% 6% 8% 10% 12% 14% 16% Volatility Note: We believe index results are exaggerated by illiquidity and survivorship bias, but are in the right direction Source: Hedge Funds: DJ CS Total Hedge Fund Index, Stocks: S&P 500, Bonds: Barclays Capital Aggregate. For illustration only. Past performance is not an indication of future results. Diversification does not eliminate the risk of experiencing investment losses.
C A P I T A L 7 AQR M A N A G E M E N T Growth of Hedge Fund Assets
Hedge Fund Industry AUM (Jan 1990 – Jun 2011, billions) $2,200 $2,000 $1,800 $1,600 $1,400 $1,200 $1,000 $800 $600 $400 $200 $0
Source: Hedge Fund Research Inc.
C A P I T A L 8 AQR M A N A G E M E N T The “Dark Sides” of Hedge Funds (2004)
1. Lags in Mark to Market [Illiquidity] 2. Correlation 3. Momentum Strategies 4. Survivorship Bias 5. Option Writing 6. Performance Fee Option Maximization 7. Taxes 8. Spotty Historical Track Record 9. Hot Money 10. High-Water Mark Abuse 11. Structured / Levered / Guaranteed Products 12. Crowded Strategies
Source: “An Alternative Future”
C A P I T A L 9 AQR M A N A G E M E N T High & Rising Correlations
Hedge funds have high and increasing levels of passive market exposure
Popular Hedge Fund Indices’ Correlations with MSCI World (Rolling quarterly hedge fund index returns through August 2011)
Since Inception 10Yrs 7Yrs 5Yrs 3Yrs
Dow Jones Credit Suisse 0.66 0.86 0.90 0.90 0.92 Hedge Fund Index
HFRI Hedge Fund Index 0.82 0.94 0.94 0.95 0.96
Source: Dow Jones Credit Suisse Hedge Fund Index (data from January 1994 – June 2011) and HFRI Hedge Fund Index (data from January 1990 – June 2011). Past performance is not an indication of future results.
C A P I T A L 10 AQR M A N A G E M E N T Illiquidity Still a Big Problem
5-Year Rolling Regression of HFRI on S&P 500 and Lagged Quarter Graph Below is T-stat on Lagged Quarter
5.0
4.0
3.0
Stat
- T 2.0
1.0
0.0 1995 1997 1999 2001 2003 2005 2007 2009 2011
Source: HFRI Hedge Fund Index. For illustrative purposes only.
C A P I T A L 11 AQR M A N A G E M E N T What Happened in 2008?
1. Spectacular Asset Growth 2. Scaling Up Non-Scalable Strategies Load up on beta (no longer “alternative”) Load up on leverage (no longer “investment”) Reduce liquidity (no longer “marketable”) 3. A Series of Unfortunate Events Market Crisis (prices fall = bad for beta) Financing Crisis (capital evaporates = bad for leverage) Liquidity Crisis (everyone sells = bad for liquidity)
C A P I T A L 12 AQR M A N A G E M E N T Still, Not Too Bad…
Credit Crisis Last 10 Years (Jul. 2007 – Mar. 2009) (Jul. 2001 – Jun. 2011) Cumulative Return Annualized Return
S&P 500 -45% -2%
MSCI World -48% 4%
Hedge Funds* -19 to -15% +4 to +7%
Hedge Funds outperformed equities in the credit crisis, but if you went into the crisis thinking hedge funds were “uncorrelated”, you had to be somewhat disappointed.
* To proxy for the range of hedge fund returns, we use the maximum/minimum of the HFR Fund of Funds Index and the Dow Jones Credit Suisse Hedge Fund Index. For illustrative purposes only. Past performance is not an indication of future results.
C A P I T A L 13 AQR M A N A G E M E N T Is There Still an Alternative Future?
Hedge Funds have a role in asset allocation if they:
1. Offer positive expected returns 2. Are uncorrelated (or at least low correlation) to markets, especially equities 3. Are relatively liquid (if not please call them something else)
Can this be done?
C A P I T A L 14 AQR M A N A G E M E N T How Alpha Becomes Beta
ALPHA ALPHA ALPHA HEDGE FUND BETA NON- ALPHA TRADITIONAL NON- BETA TRADITIONAL BETA TRADITIONAL BETA TRADITIONAL TRADITIONAL BETA BETA
Prior to Equity Traditional Non-Traditional Hedge Fund Indices Beta introduced Beta introduced Beta introduced ‒ Returns viewed as Examples: Examples: Examples: alpha – S&P 500 Index – Commodity Indices – Merger Arbitrage – Barclays Aggregate – Real Estate – Convertible Arbitrage
Time
C A P I T A L 15 AQR M A N A G E M E N T Why Might Alternative Returns Exist?
Liquidity Needs • Companies need financing on good terms (convertible arbitrage) • Supply and demand for capital not always balanced (carry trades) Risk Aversion • Investors don’t want to wait for mergers to close (merger arbitrage) • General aversion to short stocks (short bias) Suboptimal Investor Behavior • Slow reaction to news, tendency to sell winners (managed futures) • Avoid investments with bad news / poor results (value) Manager Expertise • Some people may be able to predict the future better than others • Manager “craftsmanship”
C A P I T A L 16 AQR M A N A G E M E N T Hedge Fund Beta
We think investors can access many hedge fund strategies through hedge fund betas Hedge Fund Beta is the set of risks shared by hedge fund managers pursuing similar strategies It can be invested in directly at low cost vs. hedge funds Potential Advantages of investing in Hedge Fund Beta • Diversified • Economically Intuitive • Lower Cost / Liquid • Transparent • Alternative • Can be run hedged
Diversification does not eliminate the risk of experiencing investment losses.
C A P I T A L 17 AQR M A N A G E M E N T Hedge Fund Beta Everywhere
Event Convertible Global Driven Arbitrage Macro
Fixed Equity Long/Short Income Market Equity Arbitrage Neutral
Dedicated Emerging Managed Short Bias Markets Futures
C A P I T A L 18 AQR M A N A G E M E N T HF Beta ≠ Replication
Hedge Fund Hedge Fund Beta Replication Primary Maximize diversifying High R2 to hedge fund Objective: returns indices Strategy Bottom-up Top-down Construction: Investment Dynamic strategies using Regression using prior Approach: current information returns Building Individual securities Broad indices Blocks: Traditional Tactical and kept at Beta Potentially large modest levels Exposure: Diversification does not eliminate the risk of experiencing investment losses.
C A P I T A L 19 AQR M A N A G E M E N T Drawing the Right Lessons
Some lessons from the crisis for hedge fund investors:
• Know where returns come from (alpha, hedge fund beta, market beta) • Be conscious of fees for each return source • Build a portfolio based on this separation
Hopefully these steps pave the way to a brighter alternative future for all of us
C A P I T A L 20 AQR M A N A G E M E N T Disclosures
The information set forth herein has been obtained or derived from sources believed by AQR Capital Management, LLC (“AQR”) to be reliable. However, AQR does not make any representation or warranty, express or implied, as to the information’s accuracy or completeness, nor does AQR recommend that the attached information serve as the basis of any investment decision. 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 financial instruments, and may not be construed as such. This document is intended exclusively for the use of the person to whom it has been delivered by AQR, and it is not to be reproduced or redistributed to any other person. This document is subject to further review and revision.
There are many risks associated with convertible securities including but not limited to liquidity risk, equity risk, interest rate risk, and credit risk of the underlying bond. Convertible bond securities may be considered illiquid securities, which cannot be sold or disposed of in the ordinary course of business at approximately the prices at which they are valued. Difficulty in selling securities may also result in a loss or may be costly to the portfolio. There is a risk of substantial loss associated with trading commodities, futures, options, derivatives and other financial instruments. Before trading, investors should carefully consider their financial position and risk tolerance to determine if the proposed trading style is appropriate. Investors should realize that when trading futures, commodities, options, derivatives and other financial 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.
C A P I T A L 21 AQR M A N A G E M E N T