Cliff Asness on Celebrating 25 Years With AQR

Episode Summary

Executive Summary: Cliff Asness, co-founder of AQR Capital Management, discusses his journey from academia to founding a $100B+ quant hedge fund. He covers the importance of luck and serendipity in success, the evolution of AQR's strategies from value and momentum to tax-aware investing, and the challenges value investing faced during the 2010s due to cheap money and tech bubbles. Asness also critiques the private equity industry for masking volatility and expresses cautious optimism about value's prospects in the current macroeconomic environment.

Main Topics: Career Origin and the Role of Luck (Priority: 4/5): Asness recounts his transition from a PhD in finance at University of Chicago to Goldman Sachs, then to PIMCO, and finally co-founding AQR. He emphasizes the serendipitous events that shaped his path, including a memorable sushi interview at PIMCO. Founding AQR and Early Challenges (Priority: 5/5): The launch of AQR with an aggressive hedge fund strategy in August 1998 coincided with the LTCM crisis. Asness shares how the firm suffered a 35% drawdown in its first 18 months but survived by diversifying its quantitative approach across asset classes and factors. Expansion of Strategies: From Value to Multi-Factor (Priority: 5/5): Asness explains how AQR grew from pure value and momentum to include quality, low-risk, and tax-aware investing. He emphasizes the importance of out-of-sample testing and diversification across factors and geographies. The Decade of Value Underperformance (2010s) (Priority: 5/5): Asness provides a detailed analysis of why value struggled for most of the 2010s, attributing it to fundamental deterioration in cheap companies rather than a mere bubble. He contrasts this with the 2019-2020 bubble period where value suffered due to mania rather than fundamentals. Tax-Aware Investing and Asset Location (Priority: 4/5): Asness challenges conventional wisdom by arguing that separating active management into a long-short portfolio plus an index fund can be highly tax-efficient, especially when holding periods average one year. He advocates for placing such strategies in taxable accounts to utilize tax-loss harvesting. Current Market Regime and Value's Outlook (Priority: 5/5): Asness discusses the impact of higher interest rates and inflation on value investing. While he acknowledges that cheap money fueled growth stock manias, he believes the current environment could be favorable for value, especially as the cheap-vs-expensive spread remains elevated (85% of dot-com levels). Critique of Private Equity (Priority: 4/5): Asness strongly criticizes the private equity industry for masking volatility and marking assets at unrealistic prices. He argues that investors are drawn to PE for its lack of mark-to-market reporting rather than genuine opportunity, predicting potential turbulence when these assets are repriced.

Key Arguments: Value investing suffered in the 2010s due to fundamental underperformance of cheap companies, not just market inefficiency; by 2017, cheap stocks were not actually cheap relative to their fundamentals. The 2019-2020 growth stock mania was a bubble where value lost due to irrational exuberance, not fundamentals; this is distinct from the 2010-2018 period. Tax-aware investing can be more effective by separating active bets into long-short portfolios, allowing investors to harvest tax losses and convert short-term gains into long-term gains, especially with average one-year holding periods. Private equity often attracts capital because it hides volatility, not because it offers superior returns; this creates systemic risk when underlying assets need to be marked to market. The era of central banks facing no trade-offs (low inflation, ability to cut rates freely) is likely over, which could structurally favor value investing over growth. Factor timing is difficult, but investors should 'sin a little' by overweighting factors when they reach extreme cheapness, as value did in late 2019 (though Asness admits he should have listened to his own advice more aggressively).

Data Points: AUM of AQR: over $100 billion - Specializing in quantitative analytics, value investing, and various other strategies. Number of children and their birth spacing: two sets of twins, 18 months apart (four children in 18 months) - Asness describes this as a 'gross failure of risk control.' Initial hedge fund launch size: $1 billion - Believed to be the largest single-strategy hedge fund launch up to that point (1998). Drawdown in first 18 months: 35% - Aggressive hedge fund product with 23% target volatility; the drawdown occurred during the LTCM crisis and dot-com bubble. Years value underperformed (pure price-to-fundamental factor): 2010 through 2018 (roughly 8 years) - Asness notes that the value factor had a terrible run, but AQR's multi-factor approach still performed well due to momentum, quality, and low-risk factors. Current spread between cheap and expensive stocks relative to dot-com bubble: 85% - The value spread has narrowed from dot-com extremes but remains elevated, implying potential opportunity. Rise in 30-year real interest rates: 200 basis points - Stock markets have largely shrugged off this rise, which Asness finds concerning.

Pivotal Quotes: "if something's a winner in three months and we think the price has just gotten stupid, the alpha models will dominate the tax [model]. It's not a pure tax product." — Cliff Asness: Explaining the trade-off between alpha generation and tax optimization in their tax-aware strategies. "We had a very strong start prior to trading. We left [Goldman]. It took us about nine months to, we didn't take a thing out of Goldman. We were building and rebuilding. We had a roadshow. We made it, what I think is, I've been saying for years, was an era, and it was an era." — Cliff Asness: Reflecting on the timing and conditions of AQR's launch and the early success of raising $1 billion. "I think it's going to be a long time till the central banks in the world face a world with no trade-offs. And the spread between cheap and expensive, kind of my North Star, I'm sad to tell people it is no longer wider than the dot-com bubble. It's about 85% of it, though. So we've had a massive comeback. But this is the salesiest thing I will tell this audience. I have laughed at people on Wall Street since I was 26 for the following phrase, but I think. We're in the third inning of this thing." — Cliff Asness: Discussing the current macroeconomic regime and his bullish outlook for value investing despite the narrowing of the value spread.

Implications: For investors, Asness suggests a multi-factor approach (not just value) is crucial, especially in a higher-rate environment. Tax-aware strategies should be reconsidered for taxable accounts. Private equity's opacity may lead to corrections. Value's 'third inning' implies potential gains but requires patience and diversification. Central banks' loss of policy flexibility could structurally favor value over growth.