Risk Managed Equities: Unmasking the wizards
AQR Capital Management tries to direct its clients’ attention away from the supposed insights of market ‘wizards’ and back on to what makes markets tick. Martin Steward caught up with some of its senior leadership in its new London office
At the heart of both the investment and client-relationship philosophies of the approximately $63bn (€49bn) quantitative asset manager AQR is the observation that many investors get two major things wrong: they have a sizeable unintended bias to directional equity exposure; and they spend far too much time searching for ‘alpha’.
One of the Connecticut-based firm’s founding principals, David Kabiller, invites us to think of the market opportunity as a pyramid. At its base lie all the traditional market betas that are readily and cheaply available in index form. Much of what any investor needs is in there, Kabiller argues, and AQR improves upon it via portfolio construction methodologies – chiefly risk diversification, which sees these betas combined so that they all contribute to the overall portfolio volatility in a more balanced way. The middle section of the pyramid is still beta – in the sense of systematic risk premia – but this time it is ‘alternative beta’, from which hedge funds and other managers generate much of their active return. At the very tip is alpha – the truly non-systematic risk associated with idiosyncratic manager skill.
“How much true alpha is out there?” Kabiller asks. “Is it scaleable and repeatable? Can all these massive pension fund institutions really fulfil their return objectives by focusing on that tiny tip of the pyramid? Probably not. And yet so much of their discussion, time and the effort is focused on that, often resulting in pro-cyclical, three-year processes of hiring an active manager when they are outperforming the market, then firing the active manager if returns revert to the mean. We are trying to help clients to identify more consistent sources of return.”
The good news is that the implication is that much of what gets called ‘alpha’ and which investors have been happy to pay 2-and-20 for can actually be financially-engineered and delivered systematically, at lower cost.
At the end of The Wizard of Oz, the dreadful eponymous sorcerer is famously revealed to be an old man operating an impressive bunch of machinery. Similarly, AQR describes a lot of its quantitative research and client strategies effort as ‘Unmasking the Wizard’.
The most revered wizard in the investment world is probably Warren Buffett. Every year he auctions a dinner date for charity and would-be Buffetts are so desperate for insights into his stockpicking prowess that this year’s auction attracted a winning bid of almost $3.5m.
What does the lucky winner learn over his steak? Probably not much, if he spends the time asking the wrong questions. AQR thinks it hit upon the right questions in its paper, ‘Buffett’s Alpha’, a study of the Wizard of Omaha’s systematic sources of risk and return.
“Buffet’s success is not just about stockpicking,” Kabiller says. “It’s also about being consistently exposed to certain factors.”
Those factors include value – widely recognised as being both at the heart of Buffett’s investment style and a consistently rewarded risk premium – but also quality and low-beta, two characteristics that describe ‘defensive’ investing. Intentionally or not, Buffett has long exploited the tendency for defensive stocks, on a risk-adjusted basis, to outperform aggressive stocks over time – the foundation of many modern ‘minimum variance’ strategies.
“But there’s more to it than that,” says Kabiller. “His brilliance also lies in how he has applied financial engineering to this portfolio, leveraging Berkshire’s entire portfolio 1.6-times.”
Investing the money turns out to be the ‘easy’, systematic bit. It’s generating the money to invest in the first place that turns out to be the true Buffett genius. By selling tail event risk protection in the form of re-insurance, and taking on a contingent liability, Berkshire Hathaway takes in billions of premiums up-front – effectively interest-free financing that is ploughed into its investment portfolio. It is notable that Berkshire Hathaway’s stockpicking is being taken over by two recently-hired hedge fund managers, Todd Combs and Ted Weschler, whereas the CEO position seems likely to be kept for Anil Jain, the long-serving head of the re-insurance business.
“There’s a reason for that,” Kabiller says. “The re-insurance premiums are the secret sauce – a critical ingredient to Berkshire’s returns. We think re-insurance risk is a risk premium that most pension funds are under-exposed to, despite the fact that it is largely uncorrelated with any financial markets risk. So how do we use what we’ve learned? We’ve hired a team of people including professionals from Lloyds of London to run a Bermuda-based re-insurance company, and are working on combining a portfolio of diversified re-insurance risks with our financial risk portfolios. By unmasking these wizards our goal is to give institutional investors a better understanding of exemplary performance and insights into how it is generated.”
However, some of these concepts can sound scary to the pensions world. With so many people advising them to buy tail-risk protection, isn’t it a bit of a leap of faith to start selling it? And wasn’t leverage the thing that destroyed so many investors during the 2007–08 crisis?
This is where deeper discussions with investors start to pay off. Christopher Palazzolo, the managing director who is heading up AQR’s new London office, its first permanent physical presence in Europe, points to the leverage embedded across the average pension fund’s portfolio. It can be massive in a swaps or repo-based LDI programme. But it probably also has 15–20% of its growth portfolio in private equity LBO and real estate, too. The balance sheets of its listed equities will be carrying debt, as well. And that leverage is not only poorly rewarded – it is often unrecognised.
“There has been a preference for buying the more speculative, riskier assets to try and improve expected returns, rather than any exploration of the possibility of buying lower-risk assets, and indeed more liquid assets, and applying leverage,” he says.
“Of course there was the issue of all the hedge funds that levered up on low-vol return streams before the financial crisis,” Kabiller concedes. “But there is so much leverage aversion in general that investors are paid over time to take that risk, and, in liquid assets, it is more easily managed through drawdown controls. The takeaway from 2008 was about avoiding leveraging illiquid stuff, not about abandoning leverage altogether.”
There is a leading edge of European pension fund investors who have already bought into these concepts – focusing on systematic sources of return, and taking some tail risk either by leveraging low-risk assets or directly selling re-insurance. Palazzolo cites Denmark’s ATP, with its highly-leveraged LDI programme and risk-parity approach to multi-asset investing, but also its compatriot PKA.
AQR’s investment philosophy, as adviser, is very clear in PKA’s newly-restructured equity portfolio. It exemplifies the pyramid view of market opportunities. Traditional sector and regional equity asset classes have been replaced with a wide range of risk factors, or risk premia, grouped into traditional beta – developed markets risk premium and frontier markets risk premium, for example – and alternative beta. Within the alternative beta, PKA is employing index strategies such as low volatility, value, momentum and quality, but also including several hedge fund-like risk premia – such as merger arbitrage and liquidity events.
The day after we spoke, the AQR team went to meet the CIO of a major UK pension fund that is considering how it might restructure its alternative investments.
“We’ve been working on these relationships from the US for four or five years, but it makes a huge difference having a base here in the UK,” says Palazzolo. “This year, with Antti [Ilmanen, head of global portfolio solutions] we’ve spent a lot of time with those larger institutions doing educational presentations delving into the factor-based investing concepts from Antti’s new book, Expected Returns.”
As Palazzolo indicates, it’s no wonder that the firm felt the need to establish a real presence in Europe. This approach doesn’t work if you’re content to send a couple of product specialists over on the plane twice a year to sell stuff. Moreover, despite the emphasis being on systematic investment strategies, maintaining that close relationship as mandates evolve is important, not least because risk parity and risk-managed equity strategies can go through periods of extended underperformance when markets rally.
“Every investment strategy has its cyclicality – there are no real money machines,” as Kabiller puts it. “So while there is certainly a big up-front effort in terms of discussing risk profiles and customising portfolios, there also has to be a dedication to educating clients and helping them understand what is happening once the strategy is in place.”
The message from AQR to Europe’s institutional investors is clear: expect a lot of challenging discussion about better ways to harvest traditional betas, de-mystifying hedge fund returns, and combining low risk with prudent leverage; but also, perhaps, the pleasant surprise that a lot of the most elemental aspects of good investing are simpler than they currently appear.