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AQR: Plain Old Diversification Still Investors’ Best Bet

Strategies like selling equities when valuations are high or buying put options have not historically worked out as well as simply holding uncorrelated assets, the quantitative investment firm found.

Attempts to re-position portfolios ahead of the next big market crash are “likely to disappoint,” according to a recent paper from AQR.

The alternative investment firm co-founded by Cliff Asness said strategies such as selling equities when valuations are high or buying put options to hedge against equity risk have historically fared poorly compared with diversification. 

The paper compared a range of asset classes and diversified portfolios, from a simple 60/40 mix of stocks and bonds to multi-asset strategies like risk parity. It also examined the hypothetical performance of defensive investments such as put options.

Puts — contracts investors buy to lock in the sell price of securities that they believe will decline in value — on average lost money between 1986 and 2017, according to the paper. In fact, AQR’s hypothetical portfolio of put options was the only strategy featured in the study to deliver a negative average return, falling 4.2 percent annually during the 31-year period.

Even during equity market drawdowns, puts were outperformed by every other defensive strategy analyzed in the study except for gold, which performed slightly worse on average. 

“Even though put options are an explicit hedge, they are not a silver bullet — their returns vary by drawdown, and the protection that they provide is far from guaranteed,” AQR said in the paper. “In contrast, the ‘indirect hedges’ — such as defensive equity, defensive trend, and global macro — appear to have delivered better performance on average and when most needed.”

Other investments that fared better than put options on average were a hypothetical trend-following strategy and a hypothetical multi-asset, multi-factor strategy that AQR described as “styles.”

The styles strategy, in fact, had the highest average return during both downturns and throughout the market cycle, earning 9.2 percent annually between 1986 and 2017. However, the multi-factor strategy also displayed the highest performance dispersion during drawdown conditions, leading to a negative median return.

[II Deep Dive: Cliff Asness: Stick With Liquid Alts]

The Standard & Poor’s 500 stock index, meanwhile, earned an average of 7.5 percent annually between 1986 and 2017, despite falling by at least 10 percent on six separate occasions. That result did not change when the years analyzed were expanded to the period between February 1, 1926 and December 31, 2017, which had eleven bear markets including the Great Depression.

During that nearly 91-year period, AQR said that markets tended to go up even when prices were very high — meaning that investors who attempted to time the market based on market valuations could have missed out on a “great deal” of return over the long term.

“The data does not support the conventional wisdom that expensive markets can help to time crashes,” AQR concluded. “As with everything in investing, there is no perfect solution to addressing the risk of large equity market drawdowns. However, we find using nearly a century of data that diversification is probably (still) investors’ best bet.”

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