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AQR: Smart Beta Investments Leave Alpha on the Table

Investors are piling into factor-based investments for their simplicity and low fees. But a new academic paper authored by AQR researchers argues that sloppy implementation of these strategies is costing them returns.

Investors are rushing into factor-based investments, but a new academic paper authored by investment professionals from asset manager AQR argues that many money managers are not fully exploiting the investment opportunities.

Ronen Israel, principal and head of the global alternative premia group at AQR and one of three authors of the new paper, “Craftsmanship Alpha, an Application to Style Investing,” tells Institutional Investor that the way money managers implement factor-based or style-based investments is crucial to the success that investors will have with the strategies.

In an interview, Israel says the authors coined the term “craftsmanship alpha” to describe the returns available to investors when money managers skillfully construct portfolios to reflect the nuances of particular factors. Factors or styles refer to proven sources of returns in the market, such as value, low volatility, growth and momentum.

Funds targeting these characteristics are run by computer algorithms and are one of the fastest-growing fund categories in part because investors are seeking out transparent alternatives to expensive actively managed funds. Also called smart beta investments, the funds are often sophisticated alternatives to plain vanilla, and ultra-cheap, index portfolios, such as those tracking the Standard & Poor’s 500 stock index.

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“When people talk about alpha they are generally thinking about finding completely new ways to generate returns,” says Israel, who helped build AQR’s algorithmic trading capabilities. “But there is a tremendous amount of alpha that you can extract just by focusing on better implementation of a strategy. We think many investors are leaving alpha on the table,” he says.

Investors can better differentiate among multiple funds that target the same style by understanding a money manager’s implementation strategy.

“Our paper focuses on the craftsmanship required to build effective style portfolios. That is, the kind of decisions that happen after we have already agreed on the types of style portfolio that we want to build,” the report’s authors wrote.

As an example, value stocks are generally defined as being cheap as opposed to expensive and being a long-term investment. But a stock’s value characteristics can be measured based on different individual metrics, such as sales-to-price or earnings-to-price ratios, or a combination of multiple data points. Stocks can also be compared to others in the same industry or to ones in different sectors.

A factor-based fund can also combine value stocks with other styles and have a multiple factor approach within the same portfolio. These design choices matter, according to the study, whose other authors are Adrienne Ross, a vice president at AQR, and Sarah Jiang, AQR managing director.

“By focusing on craftsmanship, you can capture more of the return that you are seeking,” says Israel.

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