Sticking with liquid alternatives is painfully difficult after disappointing performance but, at least in some cases, should prove worthwhile, according to Cliff Asness, co-founder of AQR Capital Management.
“Recently, the quantitative factor-based liquid alts that we favor at AQR have had tough times,” Asness said in a blog post this month on the Greenwich, Connecticut-based hedge fund firm’s website. “I feel the pain and pull of irrationality as much as anyone,” he wrote in a longer paper cited in the post.
Asness, who says he’s not letting his emotions affect the way he runs AQR, wrote a defense of well-constructed liquid alts that can help investors diversify their portfolios and — eventually — reap long-term gains. The strategy, which should have low correlation to traditional assets, is particularly important now with stocks and bonds trading at expensive levels, according to the blog post.
“We acknowledge and, speaking even for myself, suffer from many of the difficulties that come with sticking with such strategies through tough times,” Asness wrote. “Of course, this difficulty is a big part of why we think the strategies work to begin with and are sustainable going forward.”
Within liquid alts, he says the main method of constructing truly uncorrelated investments is going long some assets and short those that are related, with reason to believe the longs will outperform the shorts on average.
“You do not want a liquid alt because you’re bearish on stocks or, more generally, traditional assets,” Asness wrote in the paper. “That kind of timing is difficult to do well.”
Investors who are convinced that traditional assets are heading for a steep drop should bet against those assets with a short position, according to the paper. Liquid alts should be viewed as a "diversifier" for a portfolio, not a hedge, he wrote.
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When liquid alt investments are struggling, Asness says explanations for their performance aren't as easily as for, say, a conventional stock picker who can point to three companies that had a few bad months. It can be harder to visualize what’s in a truly hedged liquid alt.
Using “equity market neutral” as an example, Asness explains that investors would own a very diversified set of assets characterized as cheaper, improving in price and fundamentals, and higher quality. And they’d also be short their opposites in the same portfolio, which changes over time.
“Losing unconventionally is hard,” he wrote in the paper, as tough times seem to appear out of nowhere. “This can add to frustration,” he said, as there is no root of the pain to be identified and then reversed.
“All you get to do is root for the process to go back to delivering what it has delivered historically,” he said in the the paper. “That’s what you want in a liquid alt, but we must acknowledge the additional difficulty this quality brings.”
It's been a strong period for “beta” since the 2008 financial crisis, and a weak one for systematic value investing, according to the paper. More diversified liquid alts, particularly those with a market-neutral stock selection, had not suffered until 2018, Asness wrote, saying that “factors” in equities this year have been unable to make up for value’s “multi-year slack.”
AQR is not making any radically changes to its investment process, even though this isn't exactly easy given the performance of liquid alts.
“Doing nothing, in this context, runs against every bias out there,” Asness wrote, “but we think is usually the right thing, particularly when done consciously after considering the evidence.”
He also wrote some words of encouragement for investors. “Embrace the suck!”