Cliff Asness from AQR: The Impact of Stories, Behaviour and Risk (EP.93)

Episode Summary

Executive Summary: Cliff Asness, founder of AQR Capital Management, discusses market efficiency, value investing challenges, and factor-based strategies. He explains that despite recent poor performance, value remains attractive due to extreme valuation spreads. Asness contrasts his views with his PhD advisor Eugene Fama, advocates for 'sinning a little' at extremes, and shares insights on communicating with clients during drawdowns, the importance of education for staying invested, and his hockey-inspired paper on pulling the goalie early as an analogy for contrarian investing.

Main Topics: Market Efficiency Spectrum (Priority: 5/5): Asness discusses how his views differ from Eugene Fama's, positioning himself as a 'minor heretic' who believes markets are somewhat more inefficient than his former advisor, shaped by experiences like the tech bubble, GFC, and recent value struggles. Value Investing Challenges and Opportunities (Priority: 5/5): Asness defends value investing during its prolonged underperformance, arguing that extreme valuation spreads (second only to 2000) make the current environment attractive, and that recent losses are consistent with behavioral explanations rather than structural breakdown. Factor Implementation and Complementarity (Priority: 4/5): Discussion of how AQR uses multiple factors (value, momentum, profitability, low risk) together, and how the failure of complementary factors in recent years alongside widening value spreads signals irrationality rather than factor decay. Client Communication and Staying Power (Priority: 4/5): Asness emphasizes that education, empathy, and proven track records are critical for helping investors stick with strategies during inevitable tough periods, noting that clients with longer tenure handle drawdowns better than newer ones. Size Factor Skepticism (Priority: 3/5): AQR does not explicitly trade size, as Asness believes the small-cap premium is fully explained by higher beta without alpha, though value works better within small caps. Hockey Goalie Pulling as Investing Analogy (Priority: 3/5): Asness's popular paper on pulling the goalie 5-6 minutes early when down by one, and 11 minutes when down by two, serves as a metaphor for doing what is statistically rational but socially difficult in investing. 60/40 Portfolio and Alpha in Modern Markets (Priority: 4/5): Asness argues 60/40 is not dead (it has performed well recently) but is likely to deliver lower forward returns given high stock valuations and low bond yields. He believes alpha opportunities remain because information access does not eliminate behavioral biases.

Key Arguments: Market efficiency is a spectrum, not binary; Fama acknowledges markets are likely not perfectly efficient. Value works for both risk-based and behavioral reasons; recent underperformance is likely behavioral and extreme valuation spreads signal opportunity. Sinning 'a little' at extremes (market timing/style timing) can be appropriate if done modestly, unlike pure market timing. Multiple factors should be used together; momentum helps in environments where value fails for irrational reasons. Small-cap premium is fully explained by higher beta; no alpha exists for pure size, though value works better within small caps. Alpha is not necessarily harder to find; democratized information does not prevent irrational crowd behavior. Communication and education are critical for sticking with strategies during tough times, which is essential for capturing long-term returns. Pulling the goalie earlier than conventional wisdom is analogous to making rational but unpopular investment decisions. 60/40 is a decent default but can be improved through tilts to value, momentum, low beta, and international diversification. Clients with longer tenure handle drawdowns better; new clients and employees struggle more with recent poor performance. AQR restricts mutual fund distribution to financial advisors to improve investor discipline and retention.

Data Points: AUM: $186 billion - AQR's assets under management as stated by hosts at the start of the episode. Sharp ratio: 0.4 - Asness states the long-term Sharpe ratio of the stock market is approximately 0.4, and that a good value factor has a similar Sharpe ratio. Duration of value underperformance: ~10 years - Asness refers to the last 8-10 years as a period of poor value performance, similar to the tech bubble. Goal pull time (down one): 5-5.5 minutes - Asness's model suggests pulling the goalie with 5-6 minutes left in the game when down by one goal. Goal pull time (down two): 11 minutes - When down by two goals, the model recommends pulling the goalie with about 11 minutes remaining. Firm age: ~25 years - AQR has been operating since the late 1990s, as Asness references having 'done this live for 25 years.' Time since Rangers' last Cup: 26 years - Asness laments the New York Rangers' Stanley Cup drought from 1994, which is now 26 years (at time of recording). Two sets of twins age gap: 18 months - Asness mentions his two sets of twins were born 18 months apart, humorously calling family planning a 'failure of risk control.'

Pivotal Quotes: "If you walk up to a crazy mob with pitchforks and torches and give it all the information in the world, it will still look at you, call you a witch, and burn you." — Cliff Asness: Arguing that democratized information does not prevent irrational market behavior, used here to refute claims that alpha must be harder to find because information is widely available. "Your mind cannot be so open that your brains fall out." — Cliff Asness: Commenting on the need to keep an open mind about whether factors might be broken or the world has changed, while still maintaining intellectual discipline and not dismissing evidence without good reason. "The number one thing for success is to have an investment process that will deliver over the long term. But a good investment process without good communication is not actually that useful." — Cliff Asness: Emphasizing that while the investment process is primary, communication is essential for clients to stick with it through inevitable tough periods, making both critical.

Implications: Listeners should understand that factor investing requires patience through multi-year drawdowns; current extreme value spreads suggest high expected returns, but staying power is critical. Asset allocators should consider diversifying across factors and managers, avoid abandoning strategies at lows, and recognize that 60/40 may offer lower forward returns.