AQR: Multiple Risk Factors Are Better than One

Investors could reap diversification benefits and higher returns from various asset classes by combining different factors, the firm has said.

Investing across a combination of risk factors—or ‘styles’—rather than individual ones may deliver uncorrelated premia, deliver higher returns, and reduce risk, according to AQR.

In a paper, the hedge fund group argued that investors tend to focus on value, momentum, carry, and defensive factors separately, missing out on potential diversification benefits. The firm added investors are likely to overpay in costs and fees by chasing these alternative sources of return.

“Just as multi-strategy alternatives seek to benefit from diversification across strategies to provide investors more consistent outperformance, so can a combination of styles,” AQR said.

The firm applied the four styles across six different asset groups—ranging from stocks to currencies to commodities—during a set period from January 1990 to June 2013, and found positive risk-adjusted returns and low correlations to the equity market.

Never miss a story — sign up for CIO newsletters to stay up-to-date on the latest institutional investment industry news.

Sharpe ratios ranged from 0.9 to 1.3 while correlation to equities varied from -0.15 to 0.22. These factors also diversified one another, with cross-correlations from -0.6 to 0.22.

While certain pairings of factors and asset class may outperform others, AQR said a comprehensive combination of styles would be most efficient in building a “well-balanced, diversified portfolio.” It would also avoid “strategically over- or under-weighting certain styles,” the firm added.

According to the firm’s data, a multi-style composite portfolio was able to provide high risk-adjusted returns—a Sharpe ratio of 1.02—with just 0.01 of correlation to equities.  

The correlation between the factor portfolio and a 60/40 portfolio from 1990 to 2013 was just 0.02 while its correlation to the Credit Suisse hedge fund index was higher at 0.16.

Adding composite factor exposure to the traditional portfolio also reduced volatility, from 9.5% in the 60/40 portfolio to 7.3% with 30% of style premia.

AQR launched its style premia alternative fund last year.

AQR Style Premia2

AQR Style Premia1

Related Content: Can Risk Premia Really Capture Alpha?, Risk Parity Losing to Risk Factors, Study Finds

Moore’s Law and Managing Money

A backward-looking, statistical view of risk where volatility dominates does not serve us well, writes former Schroders CIO Alan Brown.

CIOE1214-Col_StoryIn the 1950s and 1960s, Harry Markowitz and Bill Sharpe set the scene for portfolio management as we know it today. The economists won a Nobel Prize for their efforts; their work was a giant step forward for its time.

But since then, the exponential growth in computing power—as predicted by Intel founder Gordon Moore in his 1965 paper—has the potential to revolutionise our understanding of risk and the way we manage it. It has exposed the investment management industry’s dangerously oversimplified view of what risk really is.

“Moore’s Law,” as it has come to be known, has given us the power to make another step change in our understanding of risk and return. In the future, successful asset owners and asset managers are going to listen to Albert Einstein’s advice that we should always make things as simple as we can—but no simpler. They will acknowledge:

  • Tail events are much more likely than a normally distributed world envisaged by Sharpe would suggest, and they will not be surprised when these occur.
  • Naïve use of volatility as a risk measure serves little purpose. Markowitz’s idea of mean-variance optimisation will become a thing of the past. We will use the power that Moore’s Law has given us to move our models closer to reality, which means at a minimum:
    • Moving from time- to money-weighted returns.
    • Recognising that valuation risk is investor specific.
  • There are risks and opportunities that no backward-looking statistical measure will ever capture. However, we will be foolish in the extreme if we do not try to take into account within our portfolios things that we really should expect to happen. What will be our excuse for having ignored climate change when disruptive technologies make large parts of our portfolios obsolete? To do this we must think and act as long-term investors.

Markowitz’s 1952 work, “Portfolio Selection,” introduced the concept of mean-variance efficient portfolios, where risk was defined as the volatility (standard deviation) of returns. An efficient portfolio was one that gave the highest return for a given level of risk. All this was well and good in theory, but it was impossible to implement at the time: We simply did not have the computing power to handle the large scale matrices of returns, volatilities, and correlations involved.

For more stories like this, sign up for the CIO Alert newsletter.

Sharpe published his seminal paper on the Capital Asset Pricing Model in 1964. The ideas set out finally made the concepts of Markowitz’s work tractable. Sharpe made the entirely plausible assumption that return and risk were linearly correlated. After all, why would an investor accept higher volatility if it was not compensated by higher return? This simple idea allowed Sharpe to introduce a single risk measure—beta, the volatility of an asset relative to the market. In so doing, the computational limitations of Markowitz model were overcome.

Falling out of this work were two other conclusions: Returns should be independent and identically distributed or follow a normal distribution, and the market portfolio provided the highest possible return-to-risk ratio.

As Moore’s Law rolled forward, not only did computing power grow exponentially, but so did the data we had on stock prices and markets. This allowed us to test Sharpe’s assumptions. We found that returns and volatility were not linearly related, returns were not independent, and distributions were not normal.

All of Sharpe’s key assumptions were wrong. That does not mean that the market portfolio is easy to beat. It isn’t. We still have the truism that the return to all investors is the market return minus costs. Investors as a whole must earn less than the market.

That returns are not normally distributed, but fat-tailed, means we should expect outlier returns or tail events to be far more common than we would expect from an efficient market as described by Markowitz and Sharpe. To our cost, we have experienced exactly that.

If our regulators allow us, the smart part of the industry will start to act in a counter-cyclical fashion. That, after all, is how you buy low and sell dear. To do that, asset owners and asset managers will need to reorganise themselves and adopt a different governance model. Market-related benchmarks will become secondary. Real-world outcome benchmarks will take centre stage. That should be welcomed by asset owners and managers alike.

Alan Brown is the former Group CIO of Schroders.

«