Lessons from Cliff Asness

A full biography on Cliff Asness would be a couple of pages long since he is so accomplished, but here is my shortened version in the event you do not know his background already:

Cliff is a Founder, Managing Principal and Chief Investment Officer at AQR Capital Management. Prior to co-founding AQR, he was a Managing Director and Director of Quantitative Research for the Asset Management Division of Goldman, Sachs. Cliff received a B.S. in economics from the Wharton School and a B.S. in engineering from the Moore School of Electrical Engineering at the University of Pennsylvania. He received an M.B.A. and a Ph.D. in finance from the University of Chicago.

Learning about the approaches of investors like Cliff helps me in my daily work even though what I do in my work is very different. Cliff is trying to identify statistical factors that can generate a persistent positive disparity of return across large numbers of stocks in an environment where there is extensive historical data. What Cliff is doing is both important and valuable. The growth of AQR’s assets under management reflects that clients are very pleased with financial outcomes.

Richard Zeckhauser describes what people like me do at work in this way:

“[We must] identify good investments when the level of uncertainty is well beyond that considered in traditional models of finance. Many of the investments considered here are one-time only, implying that past data will be a poor guide.”… Many unknowables are idiosyncratic or personal, affecting only individuals or handfuls of people, such as: Will the Vietnamese government let me sell my insurance product on a widespread basis? Will my friend’s new software program capture the public fancy or, if not, might it succeed in a completely different application?”

I work in in situations where both the identity of possible future states of the world as well as their probabilities are usually unknown and unknowable. When I am able to make decisions based on statistical factors I am a very happy person. Unfortunately, that is rare enough that I must focus on creating an investment process that does not depend on using statistical factors.

As an aside, I am currently considering changing the name of my investment process to “margin of safety investing.” I may start saying that “Apple is a margin of safety stock” rather than “Apple is a value stock.” Trying to convince people that Apple can be a “value stock” seems increasingly futile given how often people hear the term “value investing” used to describe a highly diversified statistical factor investing process. Cliff likes to tease me when I quote Charlie Munger so I will do it just once in this post:

“The idea of a margin of safety, a Graham precept, will never be obsolete. The idea of making the market your servant will never be obsolete. The idea of being objective and dispassionate will never be obsolete. I don’t want to own bad businesses run by people I don’t like and say, ‘no matter how horrible this is to watch, it will bounce by 25%.’ I’m not temperamentally attracted to it.”

After See’s Candy Munger and Buffett started defining a “bargain” based on the quality of the business. Because I inevitably make some mistakes and my luck will also be bad sometimes, I incorporate a margin of safety into my investing process. I use this approach in my personal investing and in my work. As an example, for me Apple is currently a “margin of safety” stock. Apple is a bargain reflecting a margin of safety even though it is not statistically cheap.

A substantial part of my personal portfolio is invested in a low cost diversified portfolio of index funds. I also own individual stocks like Apple that I selected based on the “margin of safety” approach recommended by Munger. Picking stocks and working in an actual operating business is more fun for me though. But I have enough money in index funds that I have an additional margin of safety. I could live well just on the value of the indexed assets if I was required to do so in the highly unlikely event that all my stock picks went to zero. As I have written many times on this blog, most people should not be picking stocks even for part of their portfolio since they are what Warren Buffett calls “know nothing investors” and should instead buy a low cost diversified portfolio of index funds.

That’s enough about what Cliff and I do differently, the material that follows is about his investment style. Set out below are the quotes arranged as dozen topics you usually find on this blog. Cliff is so articulate that I will let him speak for himself:

“Hedge funds are investment pools that are relatively unconstrained in what they do. They are relatively unregulated (for now), charge very high fees, will not necessarily give you your money back when you want it, and will generally not tell you what they do. They are supposed to make money all the time, and when they fail at this, their investors redeem and go to someone else who has recently been making money. Every three or four years they deliver a one-in-a-hundred year flood. They are generally run for rich people in Geneva, Switzerland, by rich people in Greenwich, Connecticut.” “I am a defender of many things financial but we probably have too many people in finance. We need active management but whether you are getting a good deal is a separate question. Index [investing] is raising a competitive force. On average fees have been too high.”

“If I ever get an economic law named after me I want it to be ‘there is no investment product so good gross, that there isn’t a fee that could make it bad net.” “The rules are quite simple: Diversify. Rebalance. Keep costs low. There aren’t many others. But no one writes that book because it’s three pages.” “Global diversification to us is about the chance that it turns out that your country is the world’s basket case.”

“A momentum investing strategy is the rather insane proposition that you can buy a portfolio of what’s been going up for the last 6 to 12 months, sell a portfolio of what’s been going down for the last 6 to 12 months, and you beat the market. Unfortunately for the case of sanity, that seems to be true.” “I still think I give a lot more credence to efficient markets than many on my side of the table. But behavioral effects, living through things like the technology bubble, the GFC, have pushed me more toward the middle. There are small inefficiencies often and very rarely there are large inefficiencies. But people overuse the word “bubble.” They use it for things they don’t like. They say “it’s in a bubble” when they really mean “I think it’s a bad bet as I think it’s overpriced.” I believe bubbles happen but much less often than many claim.”

“I’m in a business where if 52 percent of the days I’m right, I’m doing pretty well over the long-term. That’s not so easy to live with on a daily basis. When I say a strategy works, I kind of mean six or seven out of 10 years or just a little more than half the days. If your car worked like this, you’d fire your mechanic.” “It’s riding a statistical beast which can make it hard to live with. Having a guiding star to come back to, like long-term evidence in lots of places and an intuitive economic story, helps a lot.”

“Why doesn’t everyone do it? Why doesn’t all this stuff go away?” Any of these things, value, momentum, there are other things — quality investing, low-risk investing. Ironically I think they remain attractive as they’re in a sweet spot. Good enough to really help a portfolio long-term, but not so good that they aren’t a rough ride sometimes, sometimes very rough. That makes it hard for many to stick with and thus very hard to arbitrage away. It’s possible one day they do go away but there’s no evidence we’re near that point.”

“I tend to be on the cynical side when it comes to stock-picking particularly when you have to discern the skill of external managers.” “I’ve been a long-term cynic, not that all stock-picking doesn’t work, but to invest with active stock-pickers, you not only have to believe that it works, you have to believe you can figure out who has the skill beforehand.”

“I used to think that being great at investing long-term was about genius. Don’t get me wrong, genius is still good, but more and more I think it’s about doing something reasonable, that makes sense, and then sticking to it sticking to it like grim death through the tough times.” “If you have a three year period where something doesn’t work, it ages you a decade. You face an immense pressure to change your models, you have bosses and clients who lose faith, and I cannot really convey the amount of discipline you need.”

“Predicting the future is harder than misremembering the past.” “You’ve got to guess at worst cases: No model will tell you that. I’m fond of pointing out the obvious – that the worst case wasn’t the worst case until it happened, so you can’t always assume the worst case going forward is the worst we’ve ever seen. One rule of thumb is double the worst that you have ever seen. Though, I should say that’s more of a guideline than a rule, as if you do that with the global financial crisis you’re assuming caves and canned goods!” “Momentum itself…has negative skewness. The geeks call that a bad left tail. Nassim Taleb would call it a black swan event. It has standard deviations you’re not supposed to see. Big events. These bad events have tended to be more, maybe this is luck, but they have tended to mostly occur in strong markets, not in weak markets. We don’t ever like bad events, but worry less about ones that occur when the rest of a client’s portfolio is doing well.”

“Valuation of markets is a disastrous short-term market timing tool and a super weak strategy over all but the longest horizons.” “One of my peeves is people overuse the word bubble. I am not a pure efficient marketer that believes it should never be used. It should be reserved, not for saying ‘something is more expensive than I would like it to be’, but for saying ‘there is no possible scenario where this can work out’.” “‘Getting out now’ is a very extreme action yet oddly often how people think about market timing (an approach to timing that we label binary, immodest and asymmetric). If, on the other hand, investors wonder whether they should own somewhat fewer stocks and bonds than usual right now — well, that’s a much harder and much more interesting question. Overall, for those who think market timing is infeasible, we give hope using basic value and momentum type measures. But the hope is thin – it’s still a really tough strategy. We like to say ‘if market timing is a sin we recommend you only sin a little!’ At the other extreme, some observers oversell market timing as easy and reliable. It ain’t.” “More expensive markets do lead to lower long-term expected returns even if that doesn’t make them easy to time.” “Both stocks and bonds [offer today] lower expected returns than normal and the combo is actually pretty bad versus history.”

“Three dirty words of finance are leverage derivatives and shorting.” “Of course, we think in many cases those are pretty useful things! But you have to know what you’re getting into.”

“Every time someone says, ‘There is a lot of cash on the sidelines,’ a tiny part of my soul dies. There are no sidelines. Those saying this seem to envision a seller of stocks moving her money to cash and awaiting a chance to return. But they always ignore that this seller sold to somebody, who presumably moved a precisely equal amount of cash off the sidelines.”

“One of the hard things you find out in many fields but I found out in empirical finance is there might be the multiple good explanations for something but they’re not mutually exclusive.” “At academic seminars, this idea that there could be multiple explanations, is something I push at times because there’ll always be two people who want to win. For example, somebody has an over reaction story, and somebody has an under reaction story. Somebody says it is risk, somebody says it is behavioral. But in truth it could be both! And, just to make our lives really hard, the mix of what’s more important doesn’t have to be the same at all points in time.”

End Notes

http://www.afr.com/business/banking-and-finance/hedge-funds/aqrs-cliff-asness-and-the-quest-for-truth-in-the-madness-of-financial-markets-20160916-grhqtn

https://nexchange.com/article/16428

https://www.aqr.com/Insights/Perspectives

https://www.aqr.com/-/media/AQR/Documents/Insights/White-Papers/Market-Timing-Sin-a-Little.pdf

https://www.aqr.com/Insights/Research/White-Papers/Market-Timing-Sin-a-Little

http://www.morningstar.com/videos/756837/asness-firmly-in-the-middle-on-efficient-markets-h.html

https://www.google.com/amp/s/amp.ft.com/content/b39b0918-887f-11e5-9f8c-a8d619fa707c

https://www.institutionalinvestor.com/article/b14z9ymqt85t6k/market-timing-is-back-in-the-hunt-for-investors

https://www.institutionalinvestor.com/article/b16v960w13q832/aqr-machines-aren’t-to-blame-for-market-sell-off

https://www.cfapubs.org/doi/pdf/10.2469/faj.v70.n1.2

https://www.google.com/amp/s/amp.businessinsider.com/financial-advisor-insights-june-25-2014-6