LEVERAGE. DERIVATIVES. SHORTING. Transcript 10/18/2013 #1017

November 15, 2013

CONSUELO MACK:   This week on WealthTrack: A financial thought leader and money manager who says you are not totally diversified until the three dirty words of finance are in your portfolio. AQR Capital’s Cliff Asness explains what they are, next on Consuelo Mack WealthTrack.

Hello and welcome to this edition of WealthTrack, I’m Consuelo Mack. Get a comfortable seat, take out your note pads and be prepared for a graduate level seminar on investing, mostly in layman’s terms, but just in case I am providing some definitions. Our guest this week is a Financial Thought Leader with an academic and research bent. He is Clifford Asness, the managing and founding principal of AQR Capital Management. AQR stands for Applied Quantitative Research- Asness and several of his team mates are what are known as “quants.” I’ll define that in a moment.

Asness co-founded AQR in 1998.  The global investment management firm, which runs hedge funds, mutual funds and a diversified collection of investment strategies, has over $83 billion in assets under management, $11 billion of which is in mutual funds. Asness who has a PhD in finance from the University Of Chicago, has received several awards for numerous financial research papers, some of which we will have on our website. So what does a quant do? Here’s how the Financial Times puts it: “A quantitative analyst typically combines information and techniques from economic theory, accounting, statistics, computer programming, and information technology in order to identify the proper value for a financial instrument such as a stock, bond, derivative, or other security.”

That’s as deep as I want to go! Luckily Asness speaks plain English and was able to communicate on my level. And I started with the basics. Why he believes stocks are expensive and will not provide the 8% annualized returns most investors expect. He bases his lower forecasts on a valuation method devised by one of our favorite guests, Yale professor Robert Shiller’s CAPE ratio, which stands for “Cyclically-Adjusted Price-to-Earnings” ratio which is figured over ten-year periods instead of the typical P-E multiple based on current price and earnings.


CLIFF ASNESS:  It’s obvious that stocks have value, and you want to use a longer term period to evaluate them. Bob’s method, we’ve been using it for more than ten years. So we didn’t pick it, because it’s ten years. And it’s very useful to use the same method for a long time. Because it doesn’t let you cheat. And if you want to be a “perma-bear” or a “perma-bull”, one great way to do it is to keep moving your method around to whatever measure tells you what you like at that time, but we’ve been using the same method for a long time. It’s not the be-all, end-all. It’s not perfect, but the average for this number is going to be 15, 16, 17, something like that.


CONSUELO MACK:  This is the price earnings multiple. Right. It spreads over ten years. Right.


CLIFF ASNESS: It’s right now around 23, 24.


CONSUELO MACK:  So it’s relatively expensive, the market.


CLIFF ASNESS:  Relatively expensive.




CLIFF ASNESS:  And historically, if you’ll look at every ten-year period, and divide them into starting periods by this cape number, and then look at the average return in the next ten years, the average return has been zero over inflation, when starting from this level.


CONSUELO MACK:  You just said we’re’ talking about long-term now, even though… so you and I are looking at the current market, and by Bob Shiller’s price range ratio measure, it’s expensive. It’s 22 or 23. The average is 15. So that’s now. But so, you know, looking out, let’s say five to ten years, you still think that stock returns are going to be lower than they have been in the past.


CLIFF ASNESS:  I think they’re either going to be a little bit lower or a bunch lower.  If PEs stay high, they’ll be a little bit lower, because you won’t suffer that loss from mean reversion.  But you’re buying at a higher price and a lower yield.  And if they stay where they are instead of what historically has been a five, six, seven percent real return over inflation, I think more like a four percent return over inflation, inflation, you can argue what it is, but if that’s a two right now, and if it stays steady, we’re talking about a six instead of an eight.  If inflation goes up, I can get to an eight, but that’s not the fun way to get to an eight.  That doesn’t make anyone any happier.


CONSUELO MACK:   So why do I care?  So why is this so important to understand that the returns, the real returns, that’s “X inflation that you’re going to get from stocks, are lower than what you’ve expected?


CLIFF ASNESS:  You care about this for planning purposes.  If you’re an individual with a spreadsheet at home, which I believe every individual who knows how to use a spreadsheet has tucked somewhere of how much I have to save for retirement, one number you put into that spreadsheet is what am I going to earn on my nest egg.  If you are an institution, a pension fund, an endowment, and you have either obligations or you want to know what you can fund at a school that you’re the endowment for, you make an assumption on what you’re going to make on your investments.  If you’re assuming eight, and the true answer is six, you’re being too optimistic.


CONSUELO MACK:  So that’s one of the things how you can adjust, is that you can work longer, or you can save more, but hey, you’re a money manager, and you’re running hedge funds, and you’re running mutual funds.  You have another approach that you think that we can … where we can get higher returns, right?




CONSUELO MACK: So talk about, number one, how you think we should be adjusting our portfolio strategy away from an over reliance on stocks, which I think is dangerous, to other strategies?


CLIFF ASNESS:  Sure. Well, you are right. We do start out thinking investors over rely on stocks.  If you take your famous 60-40 investor … I’m not sure anyone on earth actually owns …


CONSUELO MACK: Right. 60% stocks- 40% bonds.


CLIFF ASNESS:  Thank you.


CONSUELO MACK: Right. The benchmark.


CLIFF ASNESS:  I’m not sure anyone on earth actually owns it, but we all use it as the canonical example. Bonds are also expensive these days. That’s the last thing you need someone to come here and explain.  They’re lower yielding than normal. So it’s actually a double whammy. But the typical portfolio, if that’s 60-40, it’s really a stock portfolio. Stocks drive the ups. Stocks drive the downs.  They drive the long-term risk.  They drive the long-term return. Bonds are diluting the return on stocks. So we think in a lot of ways people should be looking for other things other than just equities.


Let me step back and tell you how we at AQR view the world of investing. How do you turn a dollar today into more than a dollar tomorrow? We think of it as three ways. One is markets go up over time.  Even with my rather depressing talk early on, it’s still six percent a year, and you still want that in your portfolio. We’re not saying own none of that.  Another is alpha. You could be a complete efficient market cynic about it, you can believe you find it left and right, but it should be relatively unique.


CONSUELO MACK: What do you mean?


CLIFF ASNESS:  Meaning it’s a skills set one or a handful of managers possess, but I can’t explain it to … if I possess it, I can’t explain it to you in 30 seconds.  I can’t tell you here’s a simple strategy to pursue.  It’s very bespoke. It’s very customized.


CONSUELO MACK: Also, you know, as individual investors we can’t rely on it… History has shown, basically, that there are hot managers, and then they cool off, and there’s Dow’s work … …securities.


CLIFF ASNESS:  You’re exactly right. We do think there’s a middle ground between those two, of strategies that are known. And when I say a strategy, I mean if a hedge fund manager is doing it, it’s long this and short this.  If a traditional manager, and, you know, we do both, is doing it, it’s overweight this and underweight this.  But I’ll give you a bunch of examples. Academic research has taught us a lot.  Cheap things beat expensive things over time.  It was originally found for individual stocks, we and others have extended it to markets around the world, to bond markets, to currencies, to commodities. Momentum.


CONSUELO MACK: And, actually, Ben Graham could have told you that as well in the twenties, and did, but yes.


CLIFF ASNESS:  Sometimes I come clean before someone says that, and says I don’t claim to have discovered this, and I point out Ben Graham would roll over in his grave if I tried to pretend I or the academics in the eighties, when a lot of this was studied.


CONSUELO MACK: Right. But the study, it’s actually panned out.  It’s actually been proven to be a good strategy, is to buy cheap.


CLIFF ASNESS:   It has. And what I’m talking about is a little bit different than the Ben Graham approach, in that the Ben Graham approach, which a lot of people have practiced successfully, I’m certainly not putting down that approach, it’s much more of a systematic thing. If you go around the world and buy the 500 cheapest stocks on an average of ten of your favorite measures, and you come up with similar ones to me, price to earnings, sales, cash flow, whatever your favorites are, and sure, let’s pretend we’re hedge fund managers now. The 500 worst.  There’s been a fairly reliable, and when a statistician like me says “reliable,” I mean two out of three years.  If your mechanic said reliable like this, you’d fire your mechanic. But two out of three years is actually a fairly good investment.


CONSUELO MACK: It’s really good, right, in the investment world.


CLIFF ASNESS:  Where cheap has beaten expensive. That’s a little bit different, and that’s what was really studied in the eighties. Fama and French were among the first to study this. I added some to this literature. It’s grown over time. And that has held up. So value is one. Momentum is another.  And it feels like the opposite of value, right?


CONSUELO MACK: It certainly does. Because momentum, I think, is being short term.


CLIFF ASNESS:  And I would say it’s shorter term. The momentum that has been successful in both the academic literature and I think in real life, for at least the 20 years I’ve been looking at it, is more like six to twelve months momentum. It’s not super high frequency, to use a buzzword today.  It’s that things that have been going up over what I call the short to medium term tend to keep going.


CONSUELO MACK: Six to twelve months. That’s kind of your window for momentum. And actually, as we’re talking, when you look at the strategies that you employ, value is one, and momentum is another AQR as well.


CLIFF ASNESS:  And those, too often, disagree.  If you want to get full geek credentials, you refer to them as negatively correlated, but they often disagree, because something that has been going up a lot in the last year is often expensive.




CLIFF ASNESS:  But if the twelfth most expensive thing has finally started to give it up a bit. Maybe it was the most expensive thing a year ago. Maybe that guy is both expensive and has bad momentum. That’s a candidate for an underweight or a short, when these things agree. And AQR has contributed a lot to this, but this is not unique to us. This is giant literature on this. Two other very big things we believe in are defensive, high-quality, low beta, meaning low… you know, when the stock market doesn’t move very much. Other forms of quality are things like profitable companies. Systematically, in the same way, I will never talk about your favorite individual stock, but systematically, stocks that protect you have actually outperformed their risk level.


CONSUELO MACK: And don’t those overlap with value?


CLIFF ASNESS:  You know, the answer is, yes. And it is okay that things overlap. And you know what people like me do when we write papers on these things, we literally try to answer the question, is the overlap driving all of this, or is there anything new to this? And it turns out there is some overlap, but you really want both. Think of it this way. Every measure is imperfect.


CONSUELO MACK: So what is defensive then? I mean what makes an investment defensive?


CLIFF ASNESS:  A defensive stock… the simplest definition, you can broaden it, would be a low volatility, a stock that doesn’t bounce around much, or a low beta stock. It’s often referred to. When the market moves up, it moves up 80 percent as much, and moves down 80% as much.


CONSUELO MACK: So I don’t you talk stocks, but is there a classic example of a defensive stock?


CLIFF ASNESS:  Well, I will give you a classic example, and then I’ll shoot it down.  Is that okay?


CONSUELO MACK: Yes.  Certainly.


CLIFF ASNESS:  Most people think about industries when they think about this. They think about utilities as the classic example of defensive, and real cyclicals, or technology, is a classic example.  You know I’m always talking about papers we write. Oddly my first love is still writing these things. But myself and two colleagues have just written a paper saying that if you remove the industry bet entirely, meaning we take about 50 industries and buy the defensive half of that industry, it works better.


CONSUELO MACK: Oh. Interesting.


CLIFF ASNESS:  The industry bet is actually part of it, but you don’t need to make the industry bet. So can I come up with a one stock example? I will fail at that like I fail every time you ask me about it. But, in general, buying things that are cheap, buying things that have started to get better, and buying things that can protect you, which is related to cheap, you’re right, but not the same, the best asset in the world has all of those. And those are other things we look for at AQR. It’s not the be all, end all, but I’m giving you the biggies.


CONSUELO MACK: Right. So these are the big themes.  So one of the things that, when you and I had talked earlier, you talked about that it’s very important to diversify your portfolios, and these are strategies that enable you to diversify because momentum is not correlated with value, and whatever.


CLIFF ASNESS:  And when you do them in a long, short way, neither is correlated with the market.


CONSUELO MACK: So, you know, most of us, we hear long, short, and we think, okay, this is fine for Cliff Asness to talk about AQR Capital, but, you know, I’m just a regular guy or gal, and there’s no way that I can do long, short.  So what are the accessible diversifiers to the average person?


CLIFF ASNESS:  I think you want to go out there and look for funds that are constructing themselves in some way, where they’re taking out some of the market risk, and betting on something else. I’ve just very parochially given you the things I believe in. I don’t think I’ve figured out the whole world.  There are probably plenty of other examples. But finding a small, tiny tilt that’s mainly still equity market risk is probably not going to get the job done in a world where equity is going to return lower. Maybe it will be slightly better. But pretty much anything you believe in, so it can apply to any manager that is done in a fun form, and increasingly you can do this. You can create a hedged fund. And notice I said “hedged fund,” not hedge fund.


CONSUELO MACK: Right. Hedged.


CLIFF ASNESS:  Because I’m talking about regular old-fashioned mutual funds are perfectly viable for this. We joke at AQR, and it’s not just a joke, that there are three dirty words in finance.  George Carlin used to have seven you couldn’t say on T.V. As a side point, you now can say six of them. And I’ll leave that to the viewers’ imagination.


CONSUELO MACK: Three is a better number for television.


CLIFF ASNESS:  The three dirty words of finance are leverage, derivatives, and shorting. And it’s because they’re scary. And first let me say, they really are scary.


CONSUELO MACK: Yes. Leverage, having debt, is a disaster if you had too much of it during the financial crisis.


CLIFF ASNESS:  Absolutely. Shorting can get you in trouble, certainly, if you concentrated in an individual name. Derivatives, certainly, if you don’t understand what you’re doing. This will be a very general statement, but the worst use for these things… so it’s given them their worst name, if you ask me, is twofold. It’s levering, and often done with derivatives, and what not, a bad bet to try to make it into more money. And let me give you an example. If I sat here and told you stocks are going to return less than normal, which I did, someone can come along and say, “Well, I can fix that for you.” Let me make the math easy on myself.  On T.V. I can’t do math any better than someone who’s not a quant. Let’s say they’re half as good as normal.  Someone comes along and says I’ll just lever it two to one. First of all, they’re not wrong, they did return.  Your expected return has gone up, has doubled. The only problem is, of course, they’ve also doubled their risk, and that can be a total disaster.  The other dangerous use of these things is obfuscation, particularly in derivatives. I’m not a big regulation guy. That won’t surprise you. But I will give people advice that there’s no particularly great or pressing need for super complicated derivatives. But the basic ones …




CLIFF ASNESS:  Financial futures. Short selling an individual stock, which is not a derivative, but it’s my third dirty word. When these three things are used not to lever up a bad bet, to try to make as much money against the past, not to obfuscate a complicated bet, but to create a new return and risk, and I say both, it’s still a risk, that wasn’t there before. Long, cheap stocks, with good momentum and good quality characteristics that are defensive.  Short their opposite brethren.  And that’s not an arbitrage. You don’t make money all the time. But it’s a different risk than the stock market that we believe pays you to do far more often than it doesn’t. So when these techniques are used in moderation to diversify more, to make something that would not matter now matter a little bit, then we think they can be a force for good.


CONSUELO MACK: The typical diversifiers are, for instance, gold.  I mean cash is considered to be a diversifier, you know, limited partnerships. I mean there are REITs that are considered to be non-correlated. Are there other simpler tools that we should have or investments that we should have in our portfolios, if we can’t go kind of the more sophisticated route?


CLIFF ASNESS:   Sure. You’ve managed to name four of the many things I consider myself not an expert on.  But REITs are certainly a possibility. Real assets, in general, should get more play in a portfolio, and the stock market doesn’t have enough of them. I would buy a diversified portfolio of REITs. And that could be my expertise. I don’t have special expertise. I do think cash, even at zero, if you are… it becomes a timing situation. I do not think people should all run to cash. The risk premiums are still positive. But here is what I would prefer. Some people… I’ll set up a straw man that you didn’t ask me about. A lot of people ask me about should I buy “puts” now. Should I go buy insurance against this market that…


CONSUELO MACK: Right … a decline.


CLIFF ASNESS:  I think that is almost always a bad idea, unless your timing is superb. “Puts” are almost an option…


CONSUELO MACK: Well, they’re short term. Right. You can lose money on them, and they can be expensive.


CLIFF ASNESS:  They’re hugely expensive. You nailed it.


CONSUELO MACK: What about just gold as an insurance policy against disaster?


CLIFF ASNESS:  I would own a small amount in almost any portfolio, and not a large amount. But gold is true… it’s not a bad world. It’s a disastrous world insurance. So I would own a small amount of that. I’d own a small amount of REITs. But to be brutally honest, without access to those three dirty words, there’s not a whole lot you can do to escape from the stock market dominating your portfolio. It’s most of what’s out there.


CONSUELO MACK: Greatest risks in the market or risk in the market right now, Cliff?


CLIFF ASNESS:  The greatest risk in the market, which is certainly nothing I’m forecasting, is I think an expensive market is more subject to bolt from the blue bad news than a cheap market.


CONSUELO MACK:  One Investment for a long-term diversified portfolio. What would you have us all own some of?


CLIFF ASNESS:  I am going to be very counterintuitive, and this is not a forecast. I’m actually picking an expensive investment, one more expensive than stock.  I’m going to pick the bond market. And I don’t want anyone to listen to your show and go, “God, he loves bonds.”


CONSUELO MACK: He’s lost it.


CLIFF ASNESS:  Having said that people understate the power of diversification. Take the 1970s.  The 1970s was a disastrous period for bonds. A portfolio that took equal risks in stocks, bonds, and commodities, something like we might prefer, did better than all stocks, and it had way more bonds.


CONSUELO MACK: In the seventies?


CLIFF ASNESS:  In the seventies. One thing, commodities were strong, which helped, which in an inflationary period, which is when you’re really going to see your bond disaster, is not a certainty, but it’s not a bad bet, I think. Second, the power of diversification is that strong, that having three different horses, even if one doesn’t work… you know, if you commit to yourself to diversification, the glass is half empty way to view it, you’re always in the worst thing, but the glass half full way is you’re always in the best thing. It turned out to be commodities that decade.


If you look over the long term, we think balance risk, even when rates mildly rise, we look at periods from the forties to the eighties, it was a… you know your interest rate. They mildly rose, and then they shot up in the early eighties, and then they’ve been coming down ever since, until very recently. Even over that rising period, having a relatively equal amount of risk in bonds, not even dollars, work better than traditional approaches. So this is not a short-term forecast. I’m certainly not sitting here telling your viewers here’s an undervalued asset.


CONSUELO MACK: But don’t abandon bonds, and always have a portion in your portfolio.


CLIFF ASNESS:  Exactly. And I love it, because it’s counterintuitive, and it gives me a chance to beat to death what is almost always our most important theme, diversification beats timing.


CONSUELO MACK: Cliff, to get back to real basics, so we just mentioned three different asset classes: Diversification, commodities, stocks, bonds. So should those be the three foundations of our investment stool?


CLIFF ASNESS:  Well, the short answer is yes, but I always give the slightly longer answer. They are three biggies. But a few of the things that I give honorable mention to are inflation-protected bonds, which in some actions, some big movements, they look a lot like regular old government bonds, but you can easily imagine, and we’ve seen times where they behave quite differently. They are inflation protected, so if we ever hit a period of real inflation, they would have to act differently.


CONSUELO MACK: Which we will at some point …


CLIFF ASNESS:  Some point.


CONSUELO MACK:  …but right now they’re very unpopular, so this is probably a good time to buy them.


CLIFF ASNESS:  Sure.  It very well might be. Again, I avoid all attempts of you to trick me into timing something. I’m joking.


CONSUELO MACK: Except value. You do pay a lot of attention to value, so…


CLIFF ASNESS:  We do. We do. We do. We do.


CONSUELO MACK: And prices that you pay. Okay.


CLIFF ASNESS:   We do. But we always do. We don’t say now is the time.




CLIFF ASNESS:  So those are the three big legs of the stool, but inflation-protected bonds.  And then another thing I give honorable mention to, which I want to sneak in, is making sure you’re very global. And that’s another thing that might be unpopular now, particularly for U.S. investors, because the U.S. has done better than global portfolios, particularly this year. Speaking for myself, I have no idea, and I think the royal we of the world has very little idea in the short term, or the next year, which part of the world is going to do better. Global diversification protects you over the long term. We’ve written on this.


We wrote a paper that said, “Global diversification works,” with parenthesis, “eventually,” meaning it doesn’t do a great job in the short term.  If the world crashes, it’s going to affect everything.  But global diversification, to us, is much more about the chance that it turns out that your country, whatever country that is, is the Japan of the 1990s.  You are the world’s basket case.  Maybe that will be the poster child for a long time, because it happened recently. I don’t mean to pick on Japan, but when we go do the study, every country, to some degree, maybe not as bad as Japan was then, but to some degree, has been the Japan for a while, for long periods. So diversifying globally takes away the chance that you have all your eggs in the wrong basket.


CONSUELO MACK: Cliff, it is always a treat to have you on WealthTrack, so thank you so much for …


CLIFF ASNESS:  It’s always fun. Thank you.


CONSUELO MACK: …being with us, from AQR Capital Management.


At the close of every WealthTrack, we try to give you one suggestion to help you build and protect your wealth over the long term. This week’s Action Point is: Consider quants. Specifically, consider adding mutual funds to your portfolio run by a reputable and leading-edge  quantitative research and strategy firm.

We have had two masters of the art on WealthTrack over the years. One is this week’s guest, Cliff Asness. His firm, AQR Capital Management runs several mutual funds offering different strategies for portfolio diversification. The other is finance professor Andrew Lo, who heads up MIT’s Laboratory for Financial Engineering and is the Founder and Chief Investment Officer of AlphaSimplex Group, which runs several funds under the Natixis ASG name. In his words they are “designed to help investors achieve greater diversification than traditional stock and bond funds, while actively controlling risk and liquidity. Both firms are highly regarded by investment professionals.

Next week we have a special treat for you: A rare interview with legendary deep value investor, Martin Whitman, Founder of the Third Avenue Value Funds.  His motto is, buy safe and cheap!  If you wish to see past WealthTrack interviews, go to our website and check out our extra feature for personal insights from our guests as well as research and articles we find particularly compelling. Also feel free to connect with us on Facebook and Twitter. In the meantime, have a great weekend and make the week ahead a profitable and a productive one.

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