RIA advisors looking to add low-correlated assets at low cost to client portfolios could do well to consider three no-load alternative mutual funds from AQR, or Applied Quantitative Research, an investment management firm based in Greenwich that manages $30 billion in assets. Although many funds have launched recently in the alternative space, very few have delivered the risk-adjusted returns that AQR's Diversified Arb Fund has, and none have been managed by award-winning hedge fund managers like AQR’s Risk Parity Fund. AQR also offers a Managed Futures Strategy Fund, that’s worth a look.
Founded in 1998 by Goldman Sachs alums, AQR has long catered to the institutional market, but it is lately making more of a push to court financial advisors—particularly RIAs. The firm hired new staff members this year to bring their advisor solutions group team up to 10 and it plans to continue hiring as the client base expands. The firm’s alternative funds were launched in 2009 and 2010, but more new funds are likely to follow.
AQR is courting advisors with educational offers as well, including its annual “AQR University” program. This year’s program, for 150 advisors, takes place in Silicon Valley on June 27th, featuring keynote speaker Condoleezza Rice, whose foreign policy commentary will provide the “lightest” speech of the day, sandwiched as it is between talks on “Understanding Multi-Strategy Alternatives” and “Does Risk Parity offer Better Beta?” AQR also offers white papers and quarterly conference calls and makes portfolio managers available to current and prospective clients.
The firm’s products are complicated beasts—part enhanced index fund, part quantitative strategy, and part multi-alternative asset investment vehicles. While understanding and explaining these products to clients may seem daunting, their unique approach makes it well worth the advisor’s time to do so. AQR acknowledges the Efficient Market Hypothesis in its approach and attempts to exceed relevant benchmarks with diversification, rigorous risk management, insights derived from voluminous academic research, and cutting edge trading technology.
A Closer Look
The AQR diversified Arbitrage Fund is a multi strategy event driven portfolio, similar to event driven hedge funds and has delivered extremely favorable risk adjusted return since inception. The fund engages in merger arb, convertible arbitrage, dual class arbitrage, and other arb strategies like short duration credit and closed end fund arbitrage. The fund builds both on insights from academics like Harvard professors, hiring Professor Mark Mitchell and a raft of others from elite research universities, as well as investment professionals, to exploit multiple and uncorrelated sources of return.
“We have been doing arbitrage for 11 years, building on the research of Dr. Mark Mitchell, who built a database of every deal since 1963”, says David Kabiller, a co-founder and Principal at AQR. “When you demystify merger arb, it is an insurance business. In any insurance game, you win by diversifying and managing risk. We use quantitative insights to estimate downside risk and control exposure. The dual class share strategy is largely mean reversion, while the credit arbitrage exploits anomalies within the credit market,” says Kabiller. He notes that short dated, higher risk corporate paper is usually underpriced, due to a phenomena called ‘market segmentation:’ there are no natural buyers for this paper, since high yield funds seek longer dated exposures and buyers of short term debt like money market funds cannot hold low rated debt.
The fund utilizes leverage but largely as a function of long and short positions—its long exposure was 115.2 percent at quarter end, while short exposure was 76.9 percent. This hedged portfolio has low correlation to market indices and impressive risk-adjusted performance. “The Diversified Arb fund targets 4 percent annual volatility and has delivered a 2.5 Sharpe ratio since inception, far outpacing the S&P 500’s 0.3 Sharpe ratio over the same time,” notes Kabiller. And this return stream will diversify equity and debt portfolios. “The fund has had a -0.01 beta to the S&P 500 and a -0.08 percent correlation to the index, giving investors returns and diversification benefits,” says Daniel Schwartz, an associate in AQR’s Advisor Solution Group.
Both the targeted volatility and observed risk characteristics of the fund are closer to a low duration bond portfolio than an equity product, allowing advisors to use the fund for low risk portfolios and diversification benefits in riskier portfolios. The fund is also worth considering as an alternative to 60/40 balanced funds, delivering lower volatility and offering uncorrelated equity and debt exposure in a more risk controlled manner than long only balanced funds. “These risk premiums are return factors that most portfolios do not have access to,” notes Kabiller. Arbitrage focused mutual funds like the Merger Fund (MERFX) and multi class alternative funds and managed futures funds like the Permanent Portfolio (PRPFX) have been around for some time. But AQR's arb product expands beyond merger arb into multiple arbitrage strategies like convertible arbitrage, closed end fund trading, and dual class arbitrage, and Managed Futures and Risk Parity offers a quantum leap by combining multi asset with sophisticated quantitatively-driven risk management. The fund has $1.5 billion in assets, and like AQR’s other advisor products, has two share classes, one with a 12b-1 fee and one without.
The Managed Futures Strategy Fund also attempts to deliver uncorrelated returns, targeting a mix of commodity, currency, equity and fixed income futures and drawing on AQR’s background in price momentum strategies. “Our work has demonstrated that returns accrue to value and momentum in multiple asset classes. Managed futures with a price momentum base and a rigorous risk management profile can deliver attractive risk adjusted returns with low correlation to equity indices,” explains Kabiller. The fund targets a 10 percent annual volatility, well below the S&P 500’s 17 percent. Returns since inception have been modest, but the observed risk has been reasonable as well, making this fund a good choice for advisors seeking multi asset alternative products to enhance diversification.
The Risk Parity Fund is the most elegant and audacious of AQR’s advisor offerings. The fund is based on a compelling insight- most multi asset funds allocate based on dollar amounts. As the name implies, the managers of the Risk Parity fund attempt to keep risk from each asset class roughly equal, allocating to over 80 index futures based on observed and expected risk from each asset class. “This is Finance 101: people use dollar allocations, like the canonical 60/40 balanced fund. If you translate that into risk units, 90 percent of the risk is coming from the equity allocation. Risk Parity looks across all asset classes and seeks to take similar risks in each,” says Kabiller.
In other words, balanced funds are hardly balanced at all. The fund has gross exposure of 259 percent of assets, but through its risk management approaches, which include rigorous draw down control, keeps volatility consistent with a 10 percent annual target. The institutional version of this product was down 10-12 percent in the 2008 financial crisis.
This product has won multiple industry accolades in its institutional version, including “Non US Equity Manager of the Year” from Institutional Investor, and “Hedge Fund Innovator of the Year” from AiCIO {Asset International for Chief Investment Officers}. The the mutual fund’s observed beta has been 0.57 relative to the S&P 500, and with exposures to equities, debt commodities and currencies, this fund has myriad uses in a portfolio. Advisors can use it as a core holding and view it as a multi-asset core holding, or add it as a multi asset alternative satellite product to enhance diversification. It can also be used as a quasi life-cycle fund, given the breadth of its exposure.
