altii: Mr. Asness, how long will the zero interest-rate policy of the central banks last?
Asness: I believe it will last a little longer than it should. If you think about central banks, they walk the line between taking liquidity and low interest rates away too soon and killing a nascent recovery, or taking liquidity and low interest rates away too late and getting inflation. Whether or not their policies are successful in reaching their goals, I think central banks are far more scared about lack of recovery than inflation. But this doesn’t matter much to how we trade.

altii: Institutional investors are suffering with billions of fixed income investments and even lowering interest rates in their portfolios. What is your recommendation for them? Where to invest?
Asness: We would agree that bond investors are facing historically-low expected returns. Unfortunately, stock markets alone aren’t likely to solve investor problems – stocks today are less expensive than bonds, but that doesn’t mean stocks are cheap.

altii: But?
Asness: We don’t think there’s a single, simple answer for institutional portfolios, but we do think that cost-effectively diversifying a portfolio across more sources of returns is a good start. The type of diversification matters – we generally recommend to diversify by risk, not capital. So instead of thinking only about how much of your money to invest in a given asset class or strategy, we recommend also thinking about how much of your risk should go into it.

altii: Do you mean Risk Parity?
Asness: Yes, an increasingly popular way of investing along these lines is Risk Parity, but this notion of diversification by risk can also work in other asset classes, like hedge funds for example. We manage strategies that apply this “equal risk” framework across classic hedge fund styles, and other strategies that use it across long/short style premia, including for example value and momentum.

altii: We see new heights in equity indices but without any euphoria. A good thing?
Asness: New heights on their own don’t matter as much to me as how they compare to fundamentals, such as earnings. While I am interested in current prices, it’s expected returns that I’m more interested in, and prices relative to earnings do a better job than prices standalone for predicting long-term returns. The high prices of many equity markets today relative to earnings means that expected long-term returns are lower than they were at the beginning of the year, so as a value investor, these new heights aren’t a good thing.

altii: A lot of investors are interested in Real Assets – from Real Estate to wind parks and agriculture. Is this a new boom or even a bubble or a valid alternative to fixed income cash flows?
Asness: We don’t manage strategies like these, so I don’t have a good answer.

altii: What have the participants of the financial industry learned from the crisis since Lehman and the subprimes?
Asness: I think one of the lasting takeaways has been a renewed focus on risk management. This extends across investing – managers are more focused on their risk monitoring, operations and relationships with trading and investors are more focused on the drivers of risks in their portfolios. I also think the definition of who a “long-term investor” is has changed.

altii: In which way?
Asness: Before the crisis, a long-term investor was roughly defined as somebody who could tolerate more risk than the average investor and who could provide liquidity in a crisis. The problem with this definition, as we saw in the crisis, is that these investors were double-counting their ability to take risk. As we entered the crisis, portfolios of both the shorter-term investors and the longer-term investors were becoming riskier. Both were taking more risk than they were designed to take, which made it much harder for anybody, even the “long-term investor,” to take advantage of low prices in the market. Post-crisis, I think long-term investors – and investment managers – are more aware of their risk tolerance not just on average, but when times get tough – that taking more risk on average and simultaneously providing liquidity draw from the same budget for pain.

altii: Is further regulation a way to avoid the things we have seen in the past?
Asness: Possibly, but certainly not the regulation we have enacted.

altii: You are offering a wide range of Hedge Funds and other alternative products. Which products and strategies have convinced you most in the last years?
Asness: As a statistician, it takes more than a few years for me to be convinced of anything, but we have started some new strategies based on some old ideas that I’m excited about. One is a strategy that takes a few themes or “styles” that have rewarded investors over the long term and seeks to systematically capture them globally and across asset classes. These styles are value, momentum, carry and defensive; and we seek to capture them through both longs and shorts, and while hedging out exposure to equity markets.

altii: What is the reason behind?
Asness: We think that stock and bond markets are offering investors historically-low expected returns today, so any new sources of returns are especially valuable. I like the styles underlying our strategy because 1) they have been well-research and documented – and not just by us, 2) there are a host of sensible explanations for why they work and should continue to work, and 3) they have worked well in just about every asset class we look at.

altii: You have offered Risk Parity (RP) products at a very early stage. In Germany there are only a few RP products from various asset managers on offer. But there is also clear criticism being voiced in the media that RP only works/worked in an environment with lowering interest rates. Do you agree?
Asness: Risk Parity tends to work particularly well with falling interest rates, but it doesn’t rely on falling rates to work well. Risk parity is more than just bonds – it’s about diversifying across multiple asset classes and markets. Because of this, you don’t need a move – up or down – in any single asset class for risk parity to perform reasonably well.
Studies supporting risk parity that focus only on the past 30 years are inherently biased, given falling bond yields. But it was not just bonds that benefited from the fall in yields since 1980 or so; equity yields have also fallen dramatically and equities have a very long duration. Indeed, all long-only assets have gotten major windfall gains from the secular decline in real yields; this effect is just most transparent in bonds.
Regardless, we can evaluate risk parity across a longer sample, one where the starting and ending yields are comparable. There are two such periods in the data, one starting in 1926 and another after the second world war, each includes interest rates making a “round trip”. In both cases, we find risk parity has a long-term edge over less-diversified portfolios.
But beyond these studies, real-world risk parity portfolios are not just stocks and bonds – they also contain inflation-sensitive assets such as commodities and inflation-linked bonds. This matters because there are scenarios where stocks and bonds may perform relatively poorly.

altii: Can you give an example?
Asness: The inflationary 1970s are a classic example. Over this decade-long period of rising yields, risk parity still outperforms 60/40 in backtests. How come? Bonds suffered, but it was not a good time for stocks either. Equities tend not to like rising inflation or rising yields. There was one asset class that thrived during rising inflation – commodities – which explains risk parity’s outperformance in that period.
Still, while we think risk parity is a better starting place for asset allocation, we think it’s just moderately better. There will be times when the traditional approach wins – for instance, when equities deliver substantially higher risk-adjusted returns than all other asset classes – but we think risk parity will win more often than not.

altii: In your presentation in Frankfurt you are going to speak about typical mistakes in portfolio construction. Maybe you can give us some hints here: Which are they?
Asness: We think that, generally speaking, institutional portfolios are not diversified enough. That isn’t to say there aren’t enough moving parts in institutional portfolios – in fact, we usually think there are too many moving parts –, but it is to say that a lot of what’s in there doesn’t matter as much as it should.

altii: How does a well-diversified portfolio looks like?
Asness: A well-diversified portfolio is where everything matters, but nothing matters too much, and risk parity is a decent starting point for portfolio construction. Granted, there’s nothing magical about “parity” – investors can add additional value through tactical tilts, but these should be modest.
Beyond risk parity, there are various useful and diversifying strategies pursued by hedge funds, but these are too often packaged with a long equity bias and sold at exorbitant fees. I’ll talk about what these strategies are and what I think the future for alternatives investors might look like.


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Vita
Clifford Asness, Ph.D., is the Managing and Founding principal at AQR Capital Management. Prior he was at Goldman, Sachs & Co. as a Managing Director and Director of Quantitative Research for the Asset Management Division. Cliff Asness received a B.S. in Economics from the Wharton School and a B.S. in Engineering from the Moore School of Electrical Engineering, both graduating summa cum laude at the University of Pennsylvania. He received an M.B.A. with high honors and a Ph.D. in Finance from the University of Chicago.

AQR Capital Management, NY
is a global asset management firm that is systematic and disciplined in applying analytical research to diversified strategies ranging from traditional benchmark-oriented long-only funds to absolute-return alternative approaches tailored to clients’ risk profiles. The firm’s first product was a hedge fund – one of the first to voluntarily register with the Securities and Exchange Commission. As of March 31, 2013, AQR manages $79.5 billion. More than $10.5 billion of that is in our mutual funds business, started in 2009. In 2011, AQR announced the formation of a reinsurance group to develop investment strategies that have low correlation with traditional markets and hedge funds.
AQR is based in Greenwich, Connecticut, with offices in Chicago, London and Sydney, and employs more than 300 people. AQR clients include institutional investors, such as pension funds, insurance companies, endowments, foundations and sovereign wealth funds, as well as registered investment advisors.