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AQR C A P I T A L
M A N A G E M E N T
Clifford Asness
Managing and Founding Principal
AQR Capital Management, LLC
Hedge Funds, Hedge Fund Beta,
and the Future for Both
AQR C A P I T A L
M A N A G E M E N TAQR C A P I T A L
M A N A G E M E N T 1
An Alternative Future
Seven years ago, I wrote a paper about hedge
funds in general (and ten years ago about
whether they actually hedge)
I was smart enough to present the pros and
cons of hedge fund investing
AQR C A P I T A L
M A N A G E M E N TAQR C A P I T A L
M A N A G E M E N T 2
An Alternative Future
Seven years ago, I wrote a paper about hedge
funds in general (and ten years ago about
whether they actually hedge)
I was smart enough to present the pros and
cons of hedge fund investing, i.e., I hedged
AQR C A P I T A L
M A N A G E M E N TAQR C A P I T A L
M A N A G E M E N T 3
An Alternative Future
Seven years ago, I wrote a paper about hedge
funds in general (and ten years ago about
whether they actually hedge)
I was smart enough to present the pros and
cons of hedge fund investing, i.e., I hedged
The basic conclusion was that something like
index funds and hedge funds represent the
future, but not yet…
AQR C A P I T A L
M A N A G E M E N TAQR C A P I T A L
M A N A G E M E N T 4
Sources of Portfolio Returns
Dynamic
Returns
Market Returns
Skill
• Active strategies (“alpha”)
• Unique to certain managers
• Cynics and believers disagree on
its existence
• Pure value
• Pure momentum
• Arbitrage strategies
• Many agree on return premium
• Global equities
• Global bonds
• Commodities
• Most agree on
return premium
WHAT
HEDGE
FUNDS
SAY
WHAT
HEDGE
FUNDS
DO
AQR C A P I T A L
M A N A G E M E N TAQR C A P I T A L
M A N A G E M E N T 5
Two Definitions of Hedge Funds
A strategy that:
Trades relatively liquid assets
Seeks to make positive
average returns over time
Provides diversification versus
traditional stock and bonds
markets
Investment pools that are:
Unconstrained
Unregulated
High fees
Illiquid
Non-transparent
Supposed to make money all
the time
Run for rich people in Geneva
by rich people in Greenwich
A Compensation Structure
Source: “An Alternative Future”. Diversification does not eliminate the risk of experiencing investment losses.
A Portfolio Tool
AQR C A P I T A L
M A N A G E M E N TAQR C A P I T A L
M A N A G E M E N T 6
Hedge Fund Styles
Event Driven
Convertible Arbitrage
Global Macro
Fixed Income
Arbitrage
Equity Market Neutral
Long/Short Equity
Dedicated Short Bias
Emerging Markets
Managed Futures
AQR C A P I T A L
M A N A G E M E N TAQR C A P I T A L
M A N A G E M E N T
5%
6%
7%
8%
9%
10%
2% 4% 6% 8% 10% 12% 14% 16%
Retu
rn
Volatility
Stocks & Bonds
Stocks, Bonds & Hedge Funds
7
Hedge Funds: The Good News
1. Hedge funds offer a diversifying, positive expected return
2. This can improve almost any portfolio’s risk-adjusted return
100% Bonds
100% Hedge Funds
100% Stocks
Note: We believe index results are exaggerated by illiquidity and survivorship bias,
but are in the right direction
Realized Efficient Frontier
Jan 1994 – June 2011
Source: Hedge Funds: DJ CS Total Hedge Fund Index, Stocks: S&P 500, Bonds: Barclays Capital Aggregate. For illustration only. Past performance is not an indication of future results.
Diversification does not eliminate the risk of experiencing investment losses.
AQR C A P I T A L
M A N A G E M E N TAQR C A P I T A L
M A N A G E M E N T 8
Growth of Hedge Fund Assets
Source: Hedge Fund Research Inc.
$0
$200
$400
$600
$800
$1,000
$1,200
$1,400
$1,600
$1,800
$2,000
$2,200
Hedge Fund Industry AUM (Jan 1990 – Jun 2011, billions)
AQR C A P I T A L
M A N A G E M E N TAQR C A P I T A L
M A N A G E M E N T 9
1. Lags in Mark to Market [Illiquidity]
2. Correlation
3. Momentum Strategies
4. Survivorship Bias
5. Option Writing
6. Performance Fee Option Maximization
7. Taxes
8. Spotty Historical Track Record
9. Hot Money
10. High-Water Mark Abuse
11. Structured / Levered / Guaranteed Products
12. Crowded Strategies
The “Dark Sides” of Hedge Funds (2004)
Source: “An Alternative Future”
AQR C A P I T A L
M A N A G E M E N TAQR C A P I T A L
M A N A G E M E N T 10
Hedge funds have high and increasing levels of passive
market exposure
High & Rising Correlations
Source: Dow Jones Credit Suisse Hedge Fund Index (data from January 1994 – June 2011) and HFRI Hedge Fund Index (data from January 1990 – June 2011). Past performance is not an
indication of future results.
Popular Hedge Fund Indices’ Correlations with MSCI World
(Rolling quarterly hedge fund index returns through August 2011)
Since
Inception
10Yrs
7Yrs
5Yrs
3Yrs
Dow Jones Credit Suisse
Hedge Fund Index 0.66 0.86 0.90 0.90 0.92
HFRI Hedge Fund Index 0.82 0.94 0.94 0.95 0.96
AQR C A P I T A L
M A N A G E M E N TAQR C A P I T A L
M A N A G E M E N T 11
Illiquidity Still a Big Problem
Source: HFRI Hedge Fund Index. For illustrative purposes only.
5-Year Rolling Regression of HFRI on S&P 500 and Lagged Quarter Graph Below is T-stat on Lagged Quarter
0.0
1.0
2.0
3.0
4.0
5.0
1995 1997 1999 2001 2003 2005 2007 2009 2011
T-Stat
AQR C A P I T A L
M A N A G E M E N TAQR C A P I T A L
M A N A G E M E N T 12
What Happened in 2008?
1. Spectacular Asset Growth
2. Scaling Up Non-Scalable Strategies
Load up on beta (no longer “alternative”)
Load up on leverage (no longer “investment”)
Reduce liquidity (no longer “marketable”)
3. A Series of Unfortunate Events
Market Crisis (prices fall = bad for beta)
Financing Crisis (capital evaporates = bad for leverage)
Liquidity Crisis (everyone sells = bad for liquidity)
AQR C A P I T A L
M A N A G E M E N TAQR C A P I T A L
M A N A G E M E N T 13
Still, Not Too Bad…
Credit Crisis (Jul. 2007 – Mar. 2009)
Cumulative Return
Last 10 Years (Jul. 2001 – Jun. 2011)
Annualized Return
S&P 500 -45% -2%
MSCI World -48% 4%
Hedge Funds* -19 to -15% +4 to +7%
Hedge Funds outperformed equities in the credit crisis, but if you went into the crisis
thinking hedge funds were “uncorrelated”, you had to be somewhat disappointed.
* To proxy for the range of hedge fund returns, we use the maximum/minimum of the HFR Fund of Funds Index and the Dow Jones Credit Suisse Hedge Fund Index. For illustrative
purposes only. Past performance is not an indication of future results.
AQR C A P I T A L
M A N A G E M E N TAQR C A P I T A L
M A N A G E M E N T 14
Is There Still an Alternative Future?
Hedge Funds have a role in asset allocation if they:
1. Offer positive expected returns
2. Are uncorrelated (or at least low correlation) to
markets, especially equities
3. Are relatively liquid (if not please call them
something else)
Can this be done?
AQR C A P I T A L
M A N A G E M E N TAQR C A P I T A L
M A N A G E M E N T 15
Time
ALPHA
ALPHA
HEDGE FUND
BETA
NON-
TRADITIONAL
BETA
TRADITIONAL
BETA
ALPHA
TRADITIONAL
BETA
ALPHA
NON-
TRADITIONAL
BETA
TRADITIONAL
BETA
Prior to Equity
Indices
‒ Returns viewed as
alpha
Traditional
Beta introduced
Examples:
– S&P 500 Index
– Barclays Aggregate
Non-Traditional
Beta introduced
Examples:
– Commodity Indices
– Real Estate
Hedge Fund
Beta introduced
Examples:
– Merger Arbitrage
– Convertible Arbitrage
How Alpha Becomes Beta
AQR C A P I T A L
M A N A G E M E N TAQR C A P I T A L
M A N A G E M E N T 16
Why Might Alternative Returns Exist?
Liquidity Needs
• Companies need financing on good terms (convertible arbitrage)
• Supply and demand for capital not always balanced (carry trades)
Risk Aversion
• Investors don’t want to wait for mergers to close (merger arbitrage)
• General aversion to short stocks (short bias)
Suboptimal Investor Behavior
• Slow reaction to news, tendency to sell winners (managed futures)
• Avoid investments with bad news / poor results (value)
Manager Expertise
• Some people may be able to predict the future better than others
• Manager “craftsmanship”
AQR C A P I T A L
M A N A G E M E N TAQR C A P I T A L
M A N A G E M E N T 17
Hedge Fund Beta
We think investors can access many hedge fund
strategies through hedge fund betas
Hedge Fund Beta is the set of risks shared by hedge fund
managers pursuing similar strategies
It can be invested in directly at low cost vs. hedge funds
Potential Advantages of investing in Hedge Fund Beta
• Diversified
• Economically Intuitive
• Lower Cost / Liquid
• Transparent
• Alternative
• Can be run hedged
Diversification does not eliminate the risk of experiencing investment losses.
AQR C A P I T A L
M A N A G E M E N TAQR C A P I T A L
M A N A G E M E N T 18
Hedge Fund Beta Everywhere
Event Driven
Convertible Arbitrage
Global Macro
Fixed Income
Arbitrage
Equity Market Neutral
Long/Short Equity
Dedicated Short Bias
Emerging Markets
Managed Futures
AQR C A P I T A L
M A N A G E M E N TAQR C A P I T A L
M A N A G E M E N T 19
HF Beta ≠ Replication
Hedge Fund
Beta
Hedge Fund
Replication
Primary
Objective:
Maximize diversifying
returns
High R2 to hedge fund
indices
Strategy
Construction: Bottom-up Top-down
Investment
Approach:
Dynamic strategies using
current information
Regression using prior
returns
Building
Blocks: Individual securities Broad indices
Traditional
Beta
Exposure:
Tactical and kept at
modest levels Potentially large
Diversification does not eliminate the risk of experiencing investment losses.
AQR C A P I T A L
M A N A G E M E N TAQR C A P I T A L
M A N A G E M E N T 20
Drawing the Right Lessons
Some lessons from the crisis for hedge fund investors:
• Know where returns come from (alpha, hedge fund
beta, market beta)
• Be conscious of fees for each return source
• Build a portfolio based on this separation
Hopefully these steps pave the way to a brighter alternative
future for all of us
AQR C A P I T A L
M A N A G E M E N TAQR C A P I T A L
M A N A G E M E N T 21
Disclosures
The information set forth herein has been obtained or derived from sources believed by AQR Capital Management, LLC (“AQR”) to be reliable.
However, AQR does not make any representation or warranty, express or implied, as to the information’s accuracy or completeness, nor does
AQR recommend that the attached information serve as the basis of any investment decision. This document has been provided to you solely for
information purposes and does not constitute an offer or solicitation of an offer, or any advice or recommendation, to purchase any securities or
other financial instruments, and may not be construed as such. This document is intended exclusively for the use of the person to whom it has
been delivered by AQR, and it is not to be reproduced or redistributed to any other person. This document is subject to further review and revision.
There are many risks associated with convertible securities including but not limited to liquidity risk, equity risk, interest rate risk, and credit risk of
the underlying bond. Convertible bond securities may be considered illiquid securities, which cannot be sold or disposed of in the ordinary course
of business at approximately the prices at which they are valued. Difficulty in selling securities may also result in a loss or may be costly to the
portfolio. There is a risk of substantial loss associated with trading commodities, futures, options, derivatives and other financial instruments.
Before trading, investors should carefully consider their financial position and risk tolerance to determine if the proposed trading style is
appropriate. Investors should realize that when trading futures, commodities, options, derivatives and other financial instruments one could lose
the full balance of their account. It is also possible to lose more than the initial deposit when trading derivatives or using leverage. All funds
committed to such a trading strategy should be purely risk capital.