Podcast Summary
Understanding the Evolution of Factor Investing: Institutions should consider their unique goals, risk tolerance, and resources when implementing factor investing strategies, which have evolved to include short selling, derivatives, and leverage.
The use of factors in investing has become much more widespread and mainstream over the past few decades, as institutions have increasingly recognized their potential to generate attractive returns. Cliff Astor, a founding principal at AQR Capital Management, shares his insights on this topic, drawing on his experience as an original quant researcher and long-time observer of the market. He emphasizes that there is no one-size-fits-all approach to factor investing, and that institutions should consider their specific goals, risk tolerance, and resources when deciding how to incorporate factors into their portfolios. From his perspective, the most significant changes have been the growing acceptance of short selling, the use of derivatives, and the application of leverage, which have expanded the possibilities for generating alpha. Overall, Astor sees factor investing as a powerful tool for eking out returns in a complex and ever-changing market environment.
Balancing risk and return in investment strategies: Invest in a multi-factor portfolio, leverage low-risk factors, deleverage high-risk ones, consider worst-case scenarios, and find the right balance between risk and return.
The optimal investment strategy involves a multi-factor long-short portfolio, leveraging low-risk factors and deleveraging high-risk ones, while maintaining roughly comparable contributions to each factor. However, in practice, investors may not be able to put all their resources into every factor due to various constraints, including risk tolerance and unconventionality. It's essential to consider the worst-case scenarios and be prepared to tolerate fluctuations, even if they seem unconventional or ex post imprudent. While the goal is to maximize risk-adjusted returns, it's important to remember that the best strategy is not always the one that can be stuck with, and investors should consider their risk tolerance, unconventionality, and ability to tolerate worst-case scenarios when making investment decisions. Ultimately, finding the right balance between risk and return is the key to a successful investment strategy.
Concerns about too much money in investment strategies like factor investing: Stay informed about historical valuation measure ranges and watch for signs of compression to assess potential impact of too much money on factor investing strategies.
During tough economic times, concerns about the effectiveness of investment strategies, such as factor investing, are common. One specific concern that arises is the possibility that there is too much money in a particular strategy, leading to its potential arbitrage and decreased effectiveness. However, it's important to note that the strategy itself is not ruined by knowledge of it, but rather the actions of those implementing it. To determine if there is too much money in a strategy, one could look for signs of compression in valuation measures, which would indicate that the price difference between expensive and cheap stocks is shrinking. Historically, the expensive stocks have traded within a certain range of the price of the cheap stocks, with the exception of the technology bubble in late 1999 and 2000. It's important to remember that the world doesn't have a common language for measuring the impact of too much money on investment strategies, and the answer may vary depending on the specific factors being considered. However, staying informed about the historical ranges of valuation measures and being aware of any significant deviations can help investors better understand the potential impact of too much money on their investment strategies.
The Price to Book value factor remains relevant despite tech dominance: Evidence from past 100 years shows Price to Book value factor remains robust for identifying undervalued stocks, despite tech sector dominance and recent poor performance. Diversifying across multiple value measures and taking industry-specific risks strengthens argument.
The Price to Book value factor, which has historically been used to identify undervalued stocks, has been subject to criticism regarding its relevance in today's economy due to the dominance of a few tech stocks. However, the speaker argues that the evidence from the past 100 years across various asset classes, geographies, and technological changes suggests that the factor remains robust. The speaker's investment strategy, which involves diversifying across multiple value measures and taking industry-specific risks, further strengthens the argument against the idea that a few dominating stocks have changed the world. The speaker also emphasizes that the recent poor performance of systematic value factors is not solely due to the tech sector and that value has had a tough time since the Global Financial Crisis. Overall, the speaker maintains that the Price to Book value factor remains a valuable tool for identifying undervalued stocks despite the ongoing technological changes.
Understanding investment performance involves acknowledging market unpredictability: Despite the effectiveness of investment strategies, markets are unpredictable and there will be years when certain styles underperform or don't fully compensate. Maintaining a balance between sharing research and keeping proprietary information is crucial for success.
While it's important to understand the individual factors driving investment performance, it's also crucial to remember that markets are complex and unpredictable. The speaker acknowledges that in some years, certain investment styles like value may underperform, while others like momentum may not fully compensate. However, they believe in the long-term effectiveness of their investment strategies and accept that there will be years when things don't go as planned. They also discuss the balance between sharing research openly and maintaining proprietary information, acknowledging that there are things they keep private to protect their clients and maintain a competitive edge. Ultimately, they view their role as providing excellent versions of well-known investment strategies, while continuously striving to improve upon them through proprietary aspects.
Using both bottom-up and top-down approaches for investment research: While price-to-book ratio was once a profitable strategy, it's no longer a secret. Research involves academic papers, external researchers, and post-friction considerations.
While price-to-book ratio was once a profitable strategy with an informational edge, it's no longer a secret and therefore, not a reliable source of alpha. The research process at the firm involves both bottom-up and top-down approaches. The bottom-up approach includes individual researchers reading academic papers and identifying potential investment opportunities. The top-down approach involves bringing in external researchers to present their latest findings and testing their theories across various asset classes and time periods. The goal is to maintain an academic finance faculty that focuses on making money while being mindful of post-friction considerations, which were often overlooked in early academic research.
AQR's Investment Approach: Top-Down and Bottom-Up with a Dash of Machine Learning: AQR combines top-down and bottom-up investing with machine learning to find nonlinearities and interaction effects, while requiring an economic explanation for their findings and staying committed to their academic approach.
At AQR, they employ a top-down and bottom-up approach to investing, inspired by their academic backgrounds and the rigorous Tuesday afternoon finance seminar at the University of Chicago. They value the scientific method and the use of big tools like least squares regression, but are also open to new approaches like machine learning. They aim to find nonlinearities and interaction effects in the data, but always require an economic explanation for these findings. Machine learning is seen as a tool to enhance their understanding, not replace it. They are cautious about making revolutionary changes without a solid economic foundation and a thorough understanding of the potential risks. Their approach is evolutionary, not revolutionary. They continue to look for new, untested ideas and economic stories, recognizing the excitement and uncertainty that comes with exploring uncharted territory. They remain committed to their rigorous, academic approach, while staying open to new tools and techniques to improve their investment process.
Ethical considerations and market efficiency: Belief in ethical responsibility to adjust strategies when spreads fall below a certain threshold, acknowledging market inefficiencies and rare extreme events, and learning from clients' unconventional questions.
Ethical considerations and long-term performance are crucial factors in investment decision-making. The speaker, Cliff Asness, shares his belief that if spreads, which represent the difference in price between buying and selling an asset, were to consistently fall below a certain threshold, it would be an ethical failing for their firm, AQR, to continue their current investment strategies. He emphasizes that this is based on the assumption that markets are not always efficient and that extreme market events are rare. Throughout their 20-year history, AQR has faced three major market downturns, but the good times have outweighed the bad. The speaker acknowledges that there are ethical dilemmas that come with investing, and even though they have not encountered a situation where the market's sharp ratio is zero, he believes that he would shut down their investment strategies if that were to happen. Cliff Asness also mentions that clients ask thoughtful and sometimes unconventional questions, and while they may not always be right, it's important to pay attention and learn from these experiences. In summary, the takeaway is that ethical considerations and long-term performance are essential factors in investment decision-making, and being willing to adapt and learn from market events is crucial for success.
Lessons from selling an attractive investment: Investors should consider their risk tolerance and time horizon before selling an attractive investment, even if it underperforms. Access to high-return, low-risk strategies is rare and usually not accessible to the average investor.
Even the most attractive investments in a portfolio may not always align with an investor's risk tolerance or time horizon. The speaker shared an experience of a client selling their most attractive investment due to its underperformance and the long wait to recoup losses. He emphasized that such situations are not uncommon and can serve as valuable learning experiences. Moreover, the speaker discussed the concept of 3 sharp ratio strategies, which are often used as a pejorative term at their firm. These strategies are known for their high returns and low risk, but they are rare and usually not accessible to the average investor. The speaker acknowledged that firms like Renaissance Technologies have achieved such returns, but emphasized that even if an investor finds a genuine 3 sharp ratio strategy, they may not be able to access it due to exclusivity or high minimum investments. Instead, the speaker recommended targeting a Sharpe ratio of around 0.5 to 1 for real-life strategies, which have proven to be effective in various portfolios. He acknowledged that these numbers are based on estimates and that all investing involves some degree of uncertainty. Overall, the speaker emphasized the importance of understanding what not to do in investing and the value of staying committed to a well-researched and diversified strategy.
Strategies with lower risk-adjusted returns but higher total returns can create more economic value for clients.: Strategies with lower risk-adjusted returns, but higher total returns, can provide significant value to clients despite being harder to live with.
While strategies with high risk-adjusted returns like those with a Sharpe ratio of 3 or more can be attractive, strategies with lower risk-adjusted returns, but higher total returns, can create more economic value for clients, even if they are harder to live with. The industry sometimes overlooks the importance of total return and focuses too much on risk-adjusted returns. However, if a strategy is "real" and has passed rigorous tests, it may have an economically natural Sharpe ratio that is tolerable, but not easy to achieve. The equity risk premium story is compelling, and even low-Sharpe ratio strategies like value investing can survive due to the strong underlying story. The same ideas of value, momentum, and volatility apply at the asset allocation level, but the attractiveness of these factors may vary.
Understanding the power of value and momentum in driving returns: Value and momentum are consistent drivers of returns, measured through metrics like low beta and purchasing power parity in asset allocation. Their relationship with other factors like carry varies across asset classes. Applying simple value strategies to countries can be effective, but timing the market with value and momentum is weaker.
The concepts of value and momentum, often viewed differently in various investment contexts, have shown consistent power in driving returns. Value, which can be measured through metrics like low beta and purchasing power parity, has been influential in the world of asset allocation. However, the relationship between value and other factors, such as carry, can vary greatly depending on the asset class. For instance, in currencies, value is less connected to carry due to its focus on short-term rates. When it comes to asset allocation, treating countries as individual stocks and applying simple value strategies can be effective, although less volatile and less cross-sectional compared to individual stocks. However, attempting to time the stock market using value and momentum strategies is much weaker in the author's view. Overall, understanding the underlying principles of value and momentum and their application across different investment contexts can lead to valuable insights for investors.
Understanding the limitations of the Shiller CAPE ratio for investment strategies: The Shiller CAPE ratio can provide useful insights for setting expectations and guiding investment strategies, but its predictive power is not perfect and should be used with caution. A value strategy based on the CAPE ratio has historically produced positive returns, but fees and market trends/momentum can impact performance.
The Shiller CAPE ratio, a popular valuation metric, can be a useful tool for setting rational expectations and guiding investment strategies, but its predictive power is not perfect and should be used with caution. The speaker, who is a believer in the CAPE ratio, acknowledges the limitations of the metric, including its sensitivity to priors and the challenges of measuring its statistical power over long time horizons. However, he also argues that a value strategy based on the CAPE ratio has historically produced positive returns, even if the edge is narrow. The speaker also touches on the importance of trend and momentum as market timing tools and the potential downward pressure on fees in the investment industry. Ultimately, he suggests a cautious and humble approach to market timing, emphasizing the importance of diversification and a long-term perspective.
The Role of Active Managers in a Market Economy: Despite the growth of indexing, active managers remain important for evaluating individual stocks and making informed decisions. However, not everyone can or wants to manage indexes, and challenges in private markets may limit further indexing.
While indexing has seen significant growth in recent years, there's still a need for active managers in the market economy. The competition among smart people setting prices creates a positive externality, but not everyone can or wants to manage indexes. Traditional managers are necessary to evaluate individual stocks and make informed decisions. However, there might be room for further indexing, but we may not reach a world where everyone is copying an index fund. The rise of private markets presents challenges, such as opacity and high fees, but there are still enough publicly traded stocks for diversification. DFA's perspective is that there is still value in publicly traded securities.
Learning from Market Crises: Public vs Private Markets: Market crises highlight the benefits of private markets, including not having to mark investments to market daily, but also remind us that even private equity funds are not immune to downturns and require flexibility to weather the storm
The speaker experienced firsthand the difference between public and private markets during a market crisis. During this crisis, the speaker's team was flat while others were experiencing significant losses. This experience gave them a taste of the benefits of not having to mark their investments to market every day, which made their performance look better than it actually was. However, the speaker also recognized that this was not the same as being in a private equity fund, as their directional bets were paying off during the crisis. The speaker also learned that even those in the private equity world were not immune to market downturns, but they had the flexibility to hold onto their investments until the market recovered. The speaker's perspective on private equity shifted after this experience, recognizing that it was not as simple as he had previously thought.
Private equity's illiquidity benefits investors: Private equity's illiquidity allows for more risk-taking and better long-term investment decisions, as investors don't need to mark portfolios to market regularly and can avoid regulatory pressures for companies to go public.
Private equity's illiquidity, while often seen as a negative, can provide benefits for investors by allowing them to take on more risk and make better long-term investment decisions. This is because private equity investors do not have to mark their portfolios to market regularly, providing them with more flexibility and confidence in their investments. Additionally, the rise of private equity can be attributed to both the demand for return-smoothed assets and the lack of desire for companies to go public due to regulatory pressures. Top researchers, like those at AQR, share common attributes such as raw intelligence, genuine curiosity, and a strong drive to make meaningful discoveries that can generate value for their clients.
Exploring the Future of Finance with Intellectual Curiosity: Finance professionals can maximize present value by staying curious and excited about the process, whether it's through exploring new technologies or applying ideas to new areas.
Maximizing present value for oneself in the world of finance isn't just about making the right investment choices based on data and research. It's also about getting excited and curious about the process. This was a key theme that emerged during a discussion between two finance professionals. One of them, who is currently exploring the potential of machine learning in finance, expressed optimism about the future of this field but acknowledged that there's still much to learn. Another area that excites him is fixed income, which he sees as a new frontier for his business. As a business person, he's intellectually curious about the potential of applying the same ideas to this area, even though it's more logistically challenging due to the complexity of fixed income benchmarks. If they had to have a conversation of similar length and detail but not about finance, they might talk about raising four children born a year and a half apart. When it comes to teaching them about business and investing, this finance professional takes a light-handed approach, recognizing that his kids' interests lie more in words than numbers. Despite not forecasting any of them becoming financial quant geeks, he's open to the idea and continues to share information with them in a way that's age-appropriate.
Navigating setbacks and criticisms: Embrace challenges and criticism, learn from them, and stay true to your ideas. Perseverance and support from family and mentors are key to overcoming obstacles.
Setbacks and criticisms are inevitable in the world of finance and academia, but they can lead to growth and opportunities. The speaker shares his experience of going through rough patches in his career, including the infamous quant quake, and how his family and mentors supported him through it all. He also talks about the importance of being open to feedback and revisions, as demonstrated by his experience with having the title of his paper changed due to a common misconception. Ultimately, the speaker emphasizes the value of perseverance and staying true to one's ideas, even when faced with challenges or criticism.
The value of intellectual honesty and open-mindedness in investing: Consider all viewpoints and evidence, even if they don't align with personal beliefs, and prioritize intellectual honesty and open-mindedness in investing for a collaborative and inclusive investment industry.
Learning from this conversation with Patrick O'Shaughnessy and his guest, Eugene Fama, is the importance of intellectual honesty and the value of open-mindedness in investing. Despite Fama not being a huge fan of momentum investing, he was supportive of a paper on the topic and allowed it to be incorporated into his firm DFA's investment process. This demonstrates the importance of considering all viewpoints and evidence, even if they don't align with one's personal beliefs. It also highlights the significance of having a collaborative and inclusive culture in the investment industry. Additionally, the conversation underscores the value of learning and staying informed through reading and engaging in intellectual discussions. Overall, this conversation serves as a reminder to remain open-minded, stay curious, and prioritize intellectual honesty in our personal and professional pursuits.
