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 alternative investment? 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 Cliff Asness, 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, Hedge 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 Arbitrage 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/Short Debt Multistrategy Volatility Equity Market Neutral Long/Short Equity Debt Arbitrage Global Macro 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. AQR Capital Management, LLC FOR INVESTMENT PROFESSIONAL USE ONLY 1 Building a Better Alternatives Portfolio 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 hedge fund 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 Convertible Arbitrage: 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- 3 verge in a corporate event convertible bonds more easily. 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”.