AQR offers numerous mutual funds. However, they are widely known for their low volatility funds which we utilize for many of our clients— mostly the Equity Market Neutral Fund and the Long/Short Equity Fund.
In addition to the information and resources provided on our website, we felt it would be helpful to provide a simple explanation of how these funds work and why we like them.
The Market Neutral Fund is a hedged equity fund with a target beta of zero.
This fund has both long and short positions in global equities. The fund sells short approximately the same amount of positions they buy long striving to capture returns on both strategies (long and short). This parity between long and short positions is what creates a beta that is close to zero. This is why the fund is described as a “market neutral” fund.
Because the beta is near zero, this strategy experiences volatility similar to an intermediate bond portfolio. As such, we have integrated this strategy into the fixed income allocations for many of our clients.
AQR’s approach to determine what stocks should be bought long and sold short is based on their own quantitative ranking system. AQR ranks their large universe of equity positions (most attractive to least attractive) based on a data screen of three main factors— valuation, momentum and quality of issuer. Most of the weight (approximately 80%) is based on valuation and momentum.
We have examined the returns of the Market Neutral strategies for the last 16 years and discovered the following:
- Consistent positive monthly returns – Of the approximately 200 monthly returns we reviewed, over 64% were positive.
- Narrow range of monthly returns and volatility – We also found that 79% of the time, monthly returns fell between 2% and -2%.
- Average monthly return – The average monthly return has been approximately 0.50% per month (approximately 6% annually).
- Tends to do well in negative markets – Since 2001, the S&P 500 has experienced 3 years of negative returns, and 2 years of “flat” returns. See the chart below for the performance of the Equity Market Neutral Fund for these same years.
|Year||S&P 500 Return (%)||Market Neutral Return (%)|
We believe this fund may be the best risk/reward fund currently available. To completely understand the fund, you must first understand the Market Neutral Fund. The Long/Short Equity Fund is essentially the Market Neutral Fund, but with an added 50% overlay of a global stock market index (MSCI World Index). Thus, the performance of the Long/Short Equity Fund will be equal to the performance of the Market Neutral Fund plus the performance of 50% of the MSCI World Index.
The strategy is long/short, meaning that you should expect to participate in both the upside and downside of equity market returns. This fund will move in tandem, but to a lesser degree, and can serve as a long-time diversifier. For example, if the MSCI World Index is up 25% for the year and the Equity Market Neutral Fund is up 5.5%, the Long/Short Equity Fund would return 18% for the year (12.5% from 50% exposure to MSCI World Index + 5.5% from Equity Market Neutral). Thus, capturing 72% of the market returns with 50% of the risk.
There are scenarios where the Long/Short Equity Fund can also outperform the market. For example, let’s assume the Market Neutral is up 5.5% for the year and the MSCI World Index is up 10% for the year. The Long/Short Equity Fund would be up 10.5% for the year (5% + 5.5%). Thus, the Long/Short Equity would outperform the market in years in which the MSCI World Index earns less than 11% with 50% of the risk and volatility.
Investors who have concerns about the current levels of the equity markets and feel a sell off is imminent should find great comfort in establishing a position in the Long/Short Equity Fund. Let’s assume the MSCI World Index is down 30% for the year. We will also assume that the Equity Market Neutral is up 5%. The Long/Short Equity Fund will be down 10% (-15% + 5%).
In conclusion, the strategy is designed to have a risk level that is approximately half of the global equity markets. Over an extended period of 5-10 years, we expect this strategy to return somewhere near the return of the global equity market, while minimizing losses in a bear market.
To build a well-diversified portfolio, an investor has to look beyond any single country’s stock market and take a global approach.
While models can be useful for gaining insights that can help us make good decisions, they are simplifications of reality. Investors who are evaluating investment strategies can benefit from understanding that the reality of markets cannot be fully explained by a model alone.