AQR believes investors should brace themselves for a painful period ahead.
According to Dan Villalon, the firm’s principal and global co-head of the portfolio solutions group, the recent market slump is just the beginning of an anemic cycle for stocks and bonds. This is due in part to the public markets having been abnormally good when it comes to both returns and risk over the past decade. For example, the average annual Sharpe ratio of the traditional 60-40 stock and bond portfolio was three times more in the last ten years than it was from 1900 to 2011. The higher the Sharpe ratio — one measure of risk-adjusted returns — the better. “Only four percent of the time over the past 122 years have risk-adjusted returns for traditional allocations been so good,” according to Villalon.
“I think a lot of investors set their expectations, either formally or informally, in terms of what they’ve seen [in the past decade],” Villalon said at a roundtable this week. “But what I want to argue is the wonderful past…[has] set us up in a pretty bad place for the next 10 years.”
According to Villalon, there are three potential ways to ameliorate the pain for investors in the coming years: correctly identifying the best performing active managers, adding private assets, or diversifying existing portfolios. The last one has proved to be the most viable solution, he said.
To begin with, alpha — which generally refers to the outsized return that active managers generate over a benchmark — is hard to access at the scale needed by big investors, especially after fees. “It’s probably not a feasible solution for most investors,” he said. Active managers, however, are hoping to shine in the current market environment.
Villalon is also doubtful about whether private assets can truly help investors in a low-return environment. “One of the reasons that private equity returns looked superior to that of public equities was because private equity firms used to acquire companies relatively cheaply when compared to the valuation of the overall market,” he said. “But that valuation gap has been nearly eliminated since the start of the 2010s.” In addition, he argues that the seemingly low volatility in the private markets is nothing but an illusion. “When you look at these longer horizon measures of risks, private equity looks a lot like regular equity, and private credit looks a lot like regular credit.”
That leaves investors with the sole option of traditional diversification. According to AQR, some diversifiers, including style factors like trend, value, and momentum, can help investors in the worst market conditions. The trend factor, for example, outperformed the U.S. 60-40 portfolio in all of the 10 largest drawdowns from 1880 to 2021, according to AQR data. When different style factors are combined, the diversification benefit is even more pronounced.
The key to diversification — as AQR sees it — is to be able to buy stocks that are aligned with a certain style bet and short the ones that may be out of favor. “By going long and short, you are breaking free of market beta,” Villalon said. “In other words, you’ve built something that’s truly diversifying to traditional sources of returns.”