Traditionally, most portfolios have been dominated by public equities and bonds. The risks associated with the equity portion of those portfolios are typically dominated by exposure to market beta. And because equities are riskier than bonds, market beta’s share of the risk in a traditional 60/40 portfolio is actually much greater than 60%. In fact, it can be 85% or more.
The severe financial crisis of 2008 led many investors, including institutions, to search for alternatives. Among the usual suspects were private equity and hedge funds. Unfortunately, the evidence demonstrates that the correlation to equities of both these alternatives has been quite high.
For example, Niels Pedersen, Sebastien Page and Fei He—authors of the study “Asset Allocation: Risk Models for Alternative Investments,” which appeared in the May/June 2014 issue of the CFA Institute’s Financial Analysts Journal—found that the correlation of private equity and hedge funds to stocks was 0.71 and 0.79, respectively.
Most of the returns to those types of alternative investments are explained by the returns to stocks (in other words, the same market beta risk they are trying to diversify). This is the same conclusion that Cliff Asness, Robert Krail and John Liew reached in their 2001 study, “Do Hedge Funds Hedge?”
Making matters worse is that alpha has proved elusive. The historical evidence on the performance of private equity and hedge funds isn’t good.
What’s more, other traditional alternatives, such as real estate investment trusts and infrastructure, also have relatively high correlations with stocks. Among traditional alternatives, the only two that have shown almost no correlation to stocks were commodities and timberland.
For investors seeking other alternatives, in October 2013, AQR Capital Management introduced an interesting option—the AQR Style Premia Alternative Fund (QSPIX: expense ratio 1.6%). In November 2014, the firm introduced a lower-cost version (QSPRX: expense ratio 1.5%). (Full disclosure: My firm recommends AQR funds in constructing client portfolios.)
Traditional mutual funds are long-only, allowing investors to capture only a portion of a factor’s premium. On average, about half the premium from a factor comes from the short side and half from the long side. In addition, being long-only results in portfolios dominated by market beta.
Greater Factor Exposure
QSPRX, however, is a long/short fund able to capture both sides of the premium. It invests across four styles (or factors), each of which has support in the academic literature. Thus, the fund allows investors to achieve greater exposure to factors that have delivered premiums without having any net exposure to market beta (equity risk). Each of the four styles (value, momentum, carry and defensive) is backed both by economic theory and decades of data showing long-term performance across geographies and asset groups.
Further support for factor-based investing strategies is provided by Antti Ilmanen and my colleague, Jared Kizer, in their paper, “The Death of Diversification Has Been Greatly Exaggerated,” which appeared in the Spring 2012 edition of the Journal of Portfolio Management.
The paper, which won the prestigious Bernstein Fabozzi/Jacobs Levy Award, made the case that factor diversification has been much more effective at reducing portfolio volatility and market directionality than asset class diversification.
We now have more than four full years of live data for the funds. Using the higher-cost version, QSPIX, allows us to go back to November 2013, and starting in November 2014, we use QSPRX, which has expenses 10 basis points lower. Since inception, the fund has returned 8.5% with volatility of just 6.8%. That’s better than our estimated forward-looking return expectations on both counts.
It is important to understand that expected returns are the mean of a very wide potential distribution of possible returns. Thus, they are not a guarantee of future results.
Expected returns are forward-looking forecasts and are subject to numerous assumptions, risks and uncertainties, which change over time, and actual results may differ materially from those anticipated in an expected return forecast. Expected return forecasts are hypothetical in nature and should not be interpreted as a demonstration of actual performance results or be interpreted as a target return.
One negative of the fund is its relative tax inefficiency (due to high turnover and use of derivatives), with an effective tax rate of about 37% since inception. Thus, there should be a strong preference for holding the fund in tax-advantaged accounts.
A New, More-Tax-Efficient, Alternative Fund
AQR has announced it is launching a new and more tax efficient version of its alternative strategy, the Alternative Risk Premia Fund (QRPRX).* The fund has an expense ratio of 1.3%. It uses the same multistyle factor approach as QSPRX, though it adds two new factors, trend (time-series momentum) and risk variance (selling volatility insurance). That’s a total of six factors to which investors will have exposure in one fund.
Another difference between QSPRX and QRPRX is that the latter fund will not have exposure to the factors in the asset class of commodities (due to capacity constraints caused by regulatory rules). It will provide exposure to the value, momentum and trend factors across stocks, bonds and currencies; the carry factor in bonds and currencies; and the risk variance factor in stocks. Exposures are gained through the use of stocks, futures, swaps, currency forwards and options.
The correlations of the factors that QRPRX seeks to capture are low to negative, not only relative to each other, but to stocks and bonds as well. Thus, the fund’s returns should be uncorrelated with other portfolio assets.
Specifically, the targeted allocations to each factor are:
- Risk variance: 3%
- Trend: 12%
- Defensive: 15%
- Carry: 10%
- Momentum: 28%
- Value: 32%
By asset class, the targeted allocations are as follows: currencies: 24%; bonds: 23%; stocks and industries: 30%; and equity indices: 23%.
QRPRX will focus on tax-aware strategies. For example, tax losses realized by the fund’s long/short equity sleeve can be used to offset gains in other sleeves. The long/short nature of the fund means there are more opportunities to harvest losses. Also, gains will tend to be more long term, with losses being more short term.
Eliminating commodities from the fund also improves tax efficiency. The result is that the expected tax rate, at about 10-15%, is anticipated to be much lower than the 37% experienced by QSPRX. Thus, the fund would be much more suitable than QSPRX to a taxable account.
Expected Return & Volatility
QRPRX has forward-looking return expectations of 6% (or about 4.5 percentage points in excess of cash) and an expected volatility of 8%.** Thus, its Sharpe ratio is similar to QSPRX’s, but with a bit lower return and bit less volatility.
Another difference is that, due to the presence of the trend and risk variance factors, the fund will at times have slightly positive exposure to the equity market (QSPRX is market neutral at all times). Over the long term, however, it is expected to be market neutral.
The bottom line is that QRPRX provides another interesting alternative for investors to consider, as it can offer equitylike forward-looking return expectations with potentially far lower than equity risks.
Most importantly, the fund does so while providing exposure to unique sources of risk and return (factors) with histories of premiums that have been persistent and pervasive, and now in a more tax efficient manner.
The authors of the aforementioned study “Asset Allocation: Risk Models for Alternative Investments” concluded that risk premiums diversify more efficiently than traditional alternative investments.
They also concluded that the returns of an equally dollar-weighted risk premium portfolio are comparable to those of an endowment portfolio (with allocations to venture capital and hedge funds), except with far less risk.
On an interesting note, the authors also cited two studies that found a simple, 1/N diversification strategy (equal-weighting the factors the portfolio diversifies across) was as good as any of the other methods tested. This type of strategy is referred to as “risk parity.”
While diversifying across factors might not be as exciting or glamorous as investing in alternatives, it’s more likely to allow you to achieve your investment goals.
*Discussion of QSPIX, QSPRX and QRPRX is provided for informational purposes only and is not intended to serve as specific investment or financial advice. This list of funds does not constitute a recommendation to purchase a single specific security, and it should not be assumed the securities referenced herein were or will prove to be profitable. Prior to making any investment, an investor should carefully consider the fund’s risks and investment objectives and evaluate all offering materials and other documents associated with the investment.
**Again, it is important to understand expected returns are the mean of a very wide potential distribution of possible returns. Thus, they are not a guarantee of future results. Expected returns are forward-looking forecasts and are subject to numerous assumptions, risks and uncertainties, which change over time, and actual results may differ materially from those anticipated in an expected return forecast. Expected return forecasts are hypothetical in nature and should not be interpreted as a demonstration of actual performance results or be interpreted as a target return.
Larry Swedroe is the director of research for The BAM Alliance.
This commentary originally appeared March 5 on ETF.com
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