Cliff Asness co-founded AQR Capital Management. As portfolio manager of the AQR Managed Futures Strategy Fund (AQMIX), he tells us what this fund is all about, why it’s ranked at the top for “absolute return” funds, and how it offers diversification.
1. At its core, what does this fund do and how does it do it?
The fund attempts to identify and profit from trends in many global markets across four major asset classes: commodities, currencies, equities, and fixed income. At a basic level, managed futures is a strategy that trades futures contracts long and short across a very broad range of instruments. One of my colleagues likes to use the visual of Eddie Murphy screaming in the futures pit in the movie “Trading Places” to describe the strategy, even though that’s a fairly misleading visual of how futures are traded in today’s electronic marketplace, and we don’t have access to Clarence Beeks.
Managed futures is a strategy that has been around pretty much as long as futures markets have been around. Historically, it’s been a strategy pursued primarily by futures traders and in the last 10-20 years by hedge funds. The trading strategy employed by most managed futures funds boils down to some type of trend-following strategy, which is also known as momentum investing. Simply put, momentum investing is buying securities that are improving and selling securities that are deteriorating. There has been a mountain of research since the early 1990s showing that momentum “works”–meaning that price momentum has significant predictive power. Beyond this empirical evidence, there has also been considerable behavioural finance research to explain why trends tend to persist. I’ll mention three key reasons:
1. Anchoring and adjustment. This refers to the observation that people adjust their expectations more gradually than they should. This initial underreaction to news gives the trend follower an opportunity to buy at a price before the price has fully adjusted.
2. Central banks. These institutions like stable exchange rates and interest rates, and that causes them to generally trade against price moves. As they make what should happen instantly happen slowly over an extended period, you can seek to profit from the initial trend.
3. People tend to chase performance. We don’t need to look any further than our own industry to see this. Mutual funds that have had strong performance tend to attract strong asset inflows. Once an initial trend develops, the trend can persist simply from the buying or selling pressure coming from performance-chasing. This herding activity can often lead to prices even moving past fundamental value, creating longer-lasting trends.
In this fund, we look at trends over two different time horizons and try to determine when things have gone too far. We look over 1. short-term trends, 2. long-term trends, and 3. at whether or not a trend has become overextended. It’s important to know whether a trend has become overextended, either in the short term potentially because of large flow imbalances or during a longer time period such as when bubbles evolve, as it means the trend has a higher probability of reversing. We use all three categories of trend signals to form an aggregate view on each of the more than 50 assets we trade in the fund.
2. What makes it superior to the many other “absolute return” funds that have launched in the past year?
“Superior” is too strong a word. It can be tough to assess whether a managed futures fund is better than an equity market neutral fund or a global macro fund as each can provide diversification from traditional asset allocation in different ways. As a category, managed futures has historically shown a tendency to do well in strong up markets and strong down markets. The downside is that they tend to do only so-so or even lose money in markets that go sideways or are “trendless.” In the recent 2008 bear market, managed futures hedge funds were one of the few asset classes to have positive returns on average, which is one of the reasons for the current interest in the category.
Within the managed futures category, there currently aren’t that many existing funds to compare our fund with, although we expect more to emerge as investors demand for these types of strategies grows. The current relevant comparison in the mutual fund space is against other managed futures funds that replicate indexes such as the S&P Diversified Trend Index or Commodity Trends Index. While these indexes certainly provide exposure to trend following which we think can be a benefit to any traditional asset allocation, there are some subtle points we believe we do better. To start, these indexes include far fewer instruments than our fund, for example they don’t include equities and have very little or no fixed-income exposure. In comparison, we actively trade many more instruments in many more markets as we have found that these trends occur everywhere, so why limit yourself to fewer markets? Another advantage comes from using several different trend and contrarian signals as opposed to using a single indicator. Both the long and short term really do matter to whether a trend is going to continue, and we really believe you can avoid some ugly reversals if you measure whether a trend is overextended.
The indexes also have more of a binary implementation. What I mean by this is that regardless of the conviction you may have of an asset’s trend continuing, the index invests the same amount whereas we are able to actively scale positions up and down based on our conviction in a trend. Additionally, we evaluate the portfolio daily and trade using portfolio optimization techniques to handle the appropriate trade-off between expected return, expected transaction costs, and risk.
Finally, as with most indexes, there is no method of risk control, but instead the amount of risk you take depends largely on the volatility level that the markets give you. We dynamically adjust our positions in each asset and the fund as a whole depending on our forecast of volatility for each instrument, generally taking smaller positions when the market has been acting more volatile. In addition, we have a drawdown control system, which aims to minimize the size of potential drawdowns when the market environment for the strategy has been poor, and an exposure control system to try to keep the fund from taking too concentrated of a bet or taking too much overall risk in one theme.
3. A sceptic may say that you’re bringing a fund like this to market after one of the worst market downturns. Can you speak about the timing of the fund’s launch and why it may have merit even if equity returns during the next decade are stronger than those of the past decade?
Well, if you are saying that we are responding to investor demand, then we’ll plead guilty as charged. Equities have underperformed for decades now, and investors are looking for other ways to make money that isn’t predominantly driven by economic growth. We are looking to offer an array of alternative investments as tools for investors to try to build more resilient portfolios. It’s also important to know that, historically, managed futures has done well in both bull and bear markets as my colleagues find in their cool paper that really demystifies the asset class.
That said, like any investment style, it won’t make money all the time, but we do think it can help investors reduce their overall portfolio risk which can enable them to ride out the tough times and reap potential rewards when the equity markets do ultimately recover. The reason to be in truly diversifying alternatives is exactly because you don’t know if or when equities will do well. By launching this fund we are not forecasting that equities continue to do poorly, rather we’re acknowledging that nobody knows which way the equity market is heading.
4. The trend of hedge fund managers launching mutual funds is a relatively new phenomenon. Can you explain why you made the decision to offer mutual funds and how they might differ from the hedge funds you manage?
Our decision to enter the mutual fund world has been a long time coming and a part of our strategic business initiative to diversify our business model; it’s not a response to any one event. For instance, we started this process well before the credit crisis. The typical hedge fund company can be very profitable with fees commonly set at 2&20 (2% management fee and 20% of net profits), but it can also be an unstable business. Since the start of AQR, echoing something we did at Goldman Sachs, our plan has always been to be an asset management firm, not just a hedge fund. So, we not only manage institutional absolute return funds but also institutional long-only funds and now mutual funds, as well. Compared with the institutional world where absolute-return hedge funds abound, there are very few alternative mutual funds available. We believe there is pent-up demand for low cost truly diversifying absolute-return funds in mutual fund format, and the response we have seen from advisors seems to validate our position.
One minor difference between a private fund and mutual funds is that certain rules for mutual funds limit the amount of commodities and fixed income one can invest in, so the amount of risk we target needs to be lower overall in the mutual fund. We target an average of 10% annualized volatility in the mutual fund. The other major difference between a private vehicle and a mutual fund is liquidity. Typically, a private hedge fund will have quarterly liquidity whereas a mutual fund is subject to daily liquidity.
5. Given the performance-based fee structure of hedge funds versus the more limited fee structure of mutual funds, how do you guard against the potential conflict of favouring the vehicle (hedge funds) that offers your firm the potential for larger revenues?
As a registered investment adviser registered with fiduciary responsibility to all our clients, we exercise due care that the investment opportunities are allocated fairly among all our client accounts. Our compliance team monitors that trade allocations comply with our policies on fair allocation.