Alternative Thinking The Role of Alternative Beta Premia While risk parity strategies are our highest-capacity answer for investing in long-only, core asset classes, alternative beta premia – dynamic long-short strategies, are another highly effective way to further seek diversified sources of return. Alternative beta premiums can be classified in many ways ‒ by asset class, liquidity, long/short volatility, convergent/divergent, etc. To us, the most useful classifications are hedge fund strategy premia and style premia – two complementary perspectives. AQR Capital Management, LLC Two Greenwich Plaza Greenwich, CT 06830 Third Quarter 2012 p: +1.203.742.3600 f: +1.203.742.3100 w: aqr.com Alternative Thinking | The Role of Alternative Beta Premia 1 The Role of Alternative Beta Premia they require some use of derivatives, leverage and/or short-selling. Alternative beta premia can be Executive Summary classified in many ways ‒ by asset class, liquidity, Alternative Beta Premia are long-short sources long/short volatility, convergent/divergent, etc. To of returns that are economically-intuitive, us, the most useful classifications are hedge fund systematic and persistent due to behavioral strategy premia and style premia – two biases, structural inefficiencies or compensation complementary perspectives. for bearing risk. Hedge Fund Premia We believe the two most useful classifications of Alternative Beta Premia are 1) hedge fund Hedge fund strategy premia are returns of long- strategy premia and 2) style premia. short strategies traditionally employed by hedge We believe liquid portfolios should contain a funds. AQR’s takes a bottom-up approach in combination of alternative beta premia with building a collection of these premia, built from market risk premia, which we believe offer dozens of strategies and thousands of positions, investors a more reliable way to reach CPI+5% aggregated to nine categories based on the Credit targets. Suisse Hedge Fund Index. Hedge fund premia are useful for many hedge fund investors as they easily Two Complementary Perspectives “fit a box”. While our risk parity strategies are our highest- In contrast to many hedge funds, we believe Hedge capacity answer for investing in long-only, core Fund Premia should be: asset classes, alternative beta premia are another highly effective way to further seek diversified More liquid, systematic, and transparent sources of return. Importantly, risk parity and alternative beta premia are best viewed as Better diversified across strategies (risk- complements in well-constructed portfolios. balanced across volatility-targeted strategies) Alternative beta premia are “alternative” because Less market-directional than hedge fund indices they are captured through dynamic long-short and hedge fund replicators (unbundle strategies rather than long-only asset class alternative beta premia from the market premia) exposures; they are not “alternative” in the sense of investing in less-liquid alternative asset classes such More cost-effective (lower fees; emphasis on as private equity or infrastructure. They are called efficient portfolio construction and execution) “beta premia” because, like any form of “beta”, the return sources are economically-intuitive, Primarily relative value (more focus on cross- systematic and persistent due to behavioral biases, sectional opportunities than tactical timing structural inefficiencies or compensation for bearing decisions) and mainly rules-based (with some risk.1 discretion in tactical tilts and model design) Alternative beta premia can offer attractive risk- Exhibit 1 shows the simulated performance of nine adjusted returns and effective diversification, but hedge fund premia and their equal volatility- weighted combination. Given space constraints, we focus on risk-adjusted returns (Sharpe ratios) and 1 They are also called “alternative risk premia” but they may reflect either diversification ability (correlation of each premium rational risk premia or persistent market inefficiencies. Other names include hedge fund premia, hedge fund betas, smart betas, dynamic with global equities). In contrast to the “correlation betas, and exotic betas. 2 Alternative Thinking | The Role of Alternative Beta Premia creep” seen across the hedge fund industry in researchers have studied.3 The purity of style aggregate, hedge fund premia can be built to deliver premia is a conceptual advantage and reduces data- diversifying returns.2 mining concerns; and the pervasiveness of evidence gives cross-validation to results in other asset Style Premia classes. A complementary way to classify alternative beta However, it can be debated which styles should be premia is by style, which includes value (long cheap included and which indicators within each style. assets based on valuation ratios, short expensive), Another disadvantage is the exclusion of classic momentum/trend (long recent outperformers, short hedge fund strategies such as event driven (e.g., laggards), carry (long high-yielding assets, short low- merger arbitrage) and convertible arbitrage, which yielders), and defensive (long low-risk / high-quality do not fit well into the above four styles.4 assets, short high-risk / low-quality). These style premia have historically delivered positive long-run Exhibit 2 provides evidence of style premia, again profits in virtually every asset class we and other highlighting the positive risk-adjusted returns and Exhibit 1 | Hypothetical Hedge Fund Premia, 1995‒2011 Convert Eq Mkt L/S Ded. Event Mgd. Emg. Fixed-Inc Global Hypothetical Arb Neutral Equity Short Driven Futures Mkts. Rel. Val. Macro Composite Annual Excess Return 10.7% 4.6% 5.9% 1.7% 8.6% 6.9% 4.2% 8.9% 11.2% 14.3% Annual Volatility 10% 10% 10% 10% 10% 10% 10% 10% 10% 10% Sharpe Ratio 1.07 0.46 0.59 0.17 0.86 0.69 0.42 0.89 1.12 1.43 Correl to MSCI World -0.12 0.04 0.25 -0.18 0.15 -0.16 0.42 0.22 0.09 0.13 Source: AQR. Hedge fund premia backtests are designed to target 10% volatility for the full 1995-2011 sample. Excess returns (excl. cash income) are shown gross of fees but net of estimated trading costs and with some discounting of backtest returns (larger in distant returns), including a directionality hedge overlay. Hypothetical data has inherent limitations, some of which are disclosed at the end Exhibit 2 | Hypothetical Style Premia, 1995‒2011 Across Stocks Across Asset Classes Value Momentum Carry Defensive Value Momentum Carry Defensive Annual Excess Return 4.6% 3.8% 2.8% 9.9% 4.9% 7.7% 13.0% 4.9% Annual Volatility 10% 10% 10% 10% 10% 10% 10% 10% Sharpe Ratio 0.46 0.38 0.28 0.99 0.49 0.76 1.30 0.49 Correl to MSCI World 0.02 -0.07 -0.23 -0.19 0.17 0.06 0.23 0.05 Source: AQR. “Across Stocks” include four major regions, within industries. “Across Asset Classes” are across equity indices, bond indices, interest rate futures, G-10 currencies, emerging currencies, commodities. Style premia bactktests are designed to target 10% volatility for the full 1995-2011 sample. Excess returns (excl. cash income) are shown gross of fees but net of estimated trading costs, with no discounting of backtest returns or directionality hedges. Hypothetical data has inherent limitations, some of which are disclosed at the end. 3 For examples of AQR’s research on style premia, see Asness (1997): The Interaction Between Value and Momentum Strategies (Financial Analysts Journal), Asness, Liew and Stevens (1997): Parallels Between the Cross-sectional Predictability of Stock and Country Returns (Journal of Portfolio Management), Asness, Moskowitz and Pedersen (2008): Value and Momentum Everywhere, Frazzini and Pedersen (2010): Betting Against Beta, Koijen, Moskowitz, Pedersen and Vrugt (2012): Carry, as 2 Each hedge fund premium portfolio has benefited from broad well as an overview in Ilmanen (2011): Expected Returns. diversification and volatility weighting among constituent strategies. See 4 These strategies may also be excluded because they are more liquidity Berger-Israel-McLennan (2011): Building a Better Alternatives Portfolio: and capacity challenged than other hedge fund strategies. Style premia The AQR Multi-Strategy Approach for further information on these hedge may stress good liquidity, high capacity, and low costs even more than fund premia. hedge fund premia. Alternative Thinking | The Role of Alternative Beta Premia 3 low correlations to equities. Similar to hedge fund premia, these style premia are broadly-diversified and volatility-targeted. For example, across asset classes the value style premium is risk-balanced across six asset classes. Alternative Beta Premia and the 5 Percent Solution Compared to many illiquid “alternative” sources of returns, we believe that hedge fund premia and style premia are highly effective tools to improve risk- adjusted returns. We believe liquid portfolios should contain a combination of alternative beta premia with market risk premia, which we believe offer investors a more reliable way to reach CPI+5% targets.5 5 See Asness and Ilmanen (2012):“The 5 Percent Solution” (Institutional Investor) for more on achieving CPI+5% over the long term. 4 Alternative Thinking | The Role of Alternative Beta Premia Important Disclosures The information set forth herein has been obtained or derived from sources believed by the author and AQR Capital Management, LLC (“AQR”) to be reliable. However, the author and AQR do 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. 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