Asness Meets ‘Grim Reaper’ Before Fund Rebounds From 50% Loss
Clifford Asness, who runs AQR Capital Management LLC, one of the world’s biggest hedge funds, says fellow fund managers gouge their clients by charging exorbitant fees for just tracking the markets. He also takes a dim view of the administration of President Barack Obama, calling his economic team “Cossacks on a shtetl,” a reference to the Russian cavalrymen who sacked Jewish villages in Eastern Europe in the 19th century.
The hedge fund manager -- who is both a University of Chicago Ph.D. and a Marvel comic book collector -- is well known for his impolitic outbursts, Bloomberg Markets magazine reports in its November issue.
“What kind of coward doesn’t share his views?” asks Asness, 43, as he paces his office overlooking Long Island Sound in Greenwich, Connecticut. “I believe strongly that the world is going on the wrong course.”
Asness went the wrong way three years ago. From the start of 2007 through year-end 2008, AQR’s flagship Absolute Return fund fell more than 50 percent -- the kind of drawdown that’s often a death warrant for a fund. Firmwide assets tumbled to $17.2 billion in March 2009 from a peak of $39.1 billion in September 2007, according to AQR investors.
“I heard the Valkyries circling,” quips Asness, who says he identifies with action heroes like Captain America and Spider- Man. “I saw the grim reaper at my door.”
AQR survived. It did so by launching a campaign of diplomacy with its clients and offering a host of new funds and strategies. Asness’s funds have recovered smartly. Though the Absolute Return fund’s assets were down to $1.6 billion as of Aug. 31 from a peak of $4 billion, the fund rose 38 percent in 2009 and more than 10 percent through mid-September of this year, investors say.
As a quantitative investment firm, AQR uses algorithms and computerized models to trade stocks, bonds, currencies and commodities. Many quant funds got hit hard in 2007 and then again in the 2008 market crash.
“AQR has to fight against this current that’s going against them,” says Daniel Celeghin, a partner at Casey, Quirk & Associates LLC, a consulting firm in Darien, Connecticut. “They are one of the few quant firms that have managed to come back.”
AQR’s $1 billion Delta fund, opened in late 2008, returned 19.3 percent in 2009, an investor says -- beating Hedge Fund Research Inc.’s Fund of Funds Composite Index, which returned 11.5 percent. The fund was up 3.9 percent in 2010 through August versus a 0.3 percent loss for the HFRI index.
One version of AQR Global Risk Premium, a $3.9 billion asset allocation fund -- meaning it divides its investments across myriad markets -- surged 21.2 percent in 2009 and was up 17.2 percent this year through August, according to investors.
AQR has also been building a family of mutual funds for retail investors since 2008, with total assets in September of $2.3 billion. Three of them focus on momentum investing -- exploiting the tendency of securities to continue in their most recent trajectories. One invests in futures, and another bets on various kinds of arbitrage. Two trade foreign stocks. The latest, an asset allocation fund based on the Global Risk Premium fund’s strategy, rolled out October 1.
The firm markets the funds, which use quantitative models, through financial advisers.
Year to date through August, AQR has added $5.8 billion to its assets, which totaled $26.8 billion by the end of that month, according to investors. “It’s extraordinary to have had that kind of drawdown and then see them pull in their belts and come back so strongly,” says Tom Healey, founder of private investment firm Healey Development LLC, which invests with AQR.
Still, longtime investors in AQR suffered. The devastation of 2007 and 2008 gave the Absolute Return fund a negative record from its 1998 inception to its nadir in the market crash, according to a former employee. AQR declined to provide any fund returns for this article.
In early August 2007, AQR and some other quants found their programs had directed them into many of the same losing stock positions -- briefly costing them billions as markets short- circuited. Most funds quickly bounced back, only to plunge again in 2008 when stock, bond and commodity prices collapsed.
Research firm Lipper Inc., which tracks quant funds, says their number fell to 240 in July from 374 at the end of 2005. From the start of 2005 through June 2010, investment firms actively trading U.S. equities using quantitative strategies had a cumulative return of minus 1.15 percent.
Those using fundamental techniques -- traditional stock picking based on companies’ prospects and share prices -- had a cumulative return of 9.51 percent, according to EVestment Alliance LLC, an Atlanta-based research firm.
The August 2007 quant rout unfolded over four days, probably after one or more firms tried to close out some of their positions, according to Andrew Lo, director of Massachusetts Institute of Technology’s Laboratory for Financial Engineering, who has studied the quant crash.
On Aug. 6, there was a rush to the exits. Stocks popular with quants collapsed as they sold, while those they were betting against soared as managers scrambled to cover short positions. On Aug. 10, markets rebounded. AQR Absolute Return, which had a peak-to-trough loss of 13 percent in August, finished the month down only 3.4 percent because it stuck with its positions.
The calamity of 2008 was far more wide ranging and enduring. The collapse of mortgage-related assets brought down the stock, bond and commodity markets globally. Absolute Return fell about 40 percent, according to investors. Now, Asness is working overtime to win back investors and make sure his algorithms perform.
One reason some of AQR’s funds attract investors is their low fees. The Delta fund offers investors an arrangement in which they pay a 1 percent management fee plus 10 percent of any profits it earns, versus the 2 percent and 20 percent typical of hedge funds. The fee rises or falls depending on how closely the fund tracks its benchmark.
AQR mutual funds charge as little as 0.49 percent, on a par with some of those offered by low-cost Vanguard Group Inc. Vanguard founder John Bogle says he’s impressed.
“He’s proved his point that he can do it at a reasonable cost,” says Bogle, who’s a fan of AQR research. “If I were a betting person, I’d bet he gives competitive returns.”
Asness’s low fees, positive performance and powers of persuasion have reassured investors.
“His ability to communicate in front of trustees is phenomenal,” says Jeff Scott, chief investment officer of the $36 billion Alaska Permanent Fund Corp., which invested $500 million with AQR in January, now spread among Absolute Return, Delta and Global Risk Premium. “These are people who are trying to solve our problems and not just raise money.”
On an August morning, Asness walks to his sun-dappled office windowsill and picks up a Captain America action figure. The hedge-fund mogul owns a panoply of action heroes, from the Hulk to the Silver Surfer, and the comic books that spawned them.
“I like to think of it as a much, much more affordable version of a money manager collecting art,” he says.
Though the wisecracks never stop, Asness is at the same time a demanding boss, two former employees say. One recalls being questioned about profit-loss updates on Thanksgiving.
And Asness admits to a temper: He’s knocked his ViewSonic computer monitor to the floor on three occasions, though it never broke.
“Either they’re building good computer screens or my punch isn’t what it used to be,” he says.
Grad School Ambiance
Asness calls the decor at AQR -- with its wood-paneled walls and spare furnishings -- “Goldman Sachs circa 1997.” In tone, however, the research process hums more like a finance graduate school.
“We try and run it like an applied academic seminar,” Asness says. “If you can get savage capitalists to rationally act like a team, then you have a beautiful thing.”
AQR’s trading is mostly automated, so there is little of the shouting and tumult that characterize some hedge funds. Partners, traders and analysts sit on a trading floor in a dozen rows, with some senior researchers taking the windowed offices. Academics are invited to give talks on subjects ranging from behavioral finance to accounting rules.
A Plethora of Funds
AQR manages some 65 funds of various stripes, and often tailors core strategies to meet client needs -- using more or less leverage, for example. The firm has adapted its models to trade in everything from the Polish zloty to Japanese bonds, to oil, gold and wheat. Asness says the myriad strategies and markets provide the extra safety that comes with spreading one’s bets.
Example: AQR uses its models to run traditional long-only funds, seeking to beat a benchmark by a few percentage points while limiting risk.
“We really believe in diversification of all kinds,” Asness says, adding that it especially helped during the meat grinder of 2008. “It did make it a lot easier to stay the course.”
Even as he works to outsmart volatile markets, Asness continues offering opinions on everything from Broadway musicals to overhauling U.S. health care. Asness performs across all media, writing opinion pieces for newspapers and magazines, talking on television shows and at conferences and contributing to websites.
“It’s almost like he can’t help himself,” says Theodore Aronson of Philadelphia quant firm Aronson + Johnson + Ortiz. “He’s afraid of no one and is not capable of telling a lie. It’s not the usual pablum.”
Asness sounds off most frequently in e-mail blasts to a personal network of friends, family and investors. One sarcastic example, from March, concerned a U.S. Senate move to create a federal office to predict financial crises.
“This is definitely going to work,” he wrote. “No more bubbles. These geniuses will get it right. Promise. And all for a government salary.”
Asness admits to a superhero complex. His favorite Marvel comic book character is Captain America, who gains strength with the help of a secret serum and whose shield can be used as an indestructible weapon. Asness has an image of the shield tattooed on his left arm.
“His super-villains are intellectual dishonesty and ignorance,” says Jonathan Beinner, a managing director at Goldman Sachs Group Inc. and a former classmate of Asness. “When someone offers an opinion that Cliff feels is incorrect or dishonest, whether it be related to investments, politics or pizza, he feels it is his duty to stand up, even if it’s not in his best interest.”
In August, Asness was complaining about Obama’s health- care law, which he calls socialized medicine, the increased powers Congress gave financial regulators and the tendency of commentators to blame banks alone for the crisis.
“Everyone dropped the ball on this; the public acted like frigging idiots,” he says. “There were sins of individuals, sins of banks, sins of government.”
Asness’s views are not always predictable. He has praised Tea Party activists, blogging in March, “Your aggressive stand for freedom and small government has inspired the country.” At the same time, he endorses the American Civil Liberties Union’s campaigns to guard civil liberties.
With AQR in comeback mode, Asness is in good humor as he bites into a piece of spicy tuna roll sushi one August afternoon at AQR’s offices. Around a conference room table are two of the three other founding AQR partners. David Kabiller, 47, a former Northwestern University tennis champion, heads client relations and favors Tom Ford blazers.
John Liew, 43, is a former Asness classmate at the University of Chicago Graduate School of Business, where they both earned Ph.D.s in finance. He heads AQR’s global asset allocation team.
The fourth founding partner, Robert Krail, also a University of Chicago alum, is on medical leave.
AQR was buttressed by some key decisions during 2007 and 2008, Asness says. For example, the firm didn’t panic and pull the plug on its models. “We believed in the models,” Asness says. While that punished AQR in the sell-off, it left the firm positioned for the rebound beginning in March 2009.
“It’s riding a statistical beast,” he says. “Having a lodestone to come back to helps.”
AQR has tried to keep its investors loyal by keeping them well informed of its strategies for battling the market turmoil.
“Clients want to hear from us,” Kabiller says. “People have a negative view of a black box.”
No New Restrictions
The firm didn’t impose new restrictions on investor redemptions, as many funds did.
The firm did make some changes. Now, a big stock sell-off will automatically trigger systems that reduce leverage at various thresholds, cut back on risk and raise cash.
Like many quant firms, AQR is grounded in the efficient market hypothesis, or EMH, promulgated by professor Eugene Fama of the University of Chicago, who was Asness’s Ph.D. thesis adviser. Fama, 71, and his adherents say that the stock market is effective at digesting the available information about an asset and setting the right price for it.
EMH lost a lot of its luster in the sell-off, when the Standard & Poor’s 500 Index fell 57 percent in 18 months. “From a macro perspective, the market has been woefully lacking in trying to figure out what the valuation of an asset should be,” says Justin Fox, author of “The Myth of the Rational Market” (HarperBusiness, 2009).
“People had an idea that the market was effective at sussing things out. That’s been discredited.”
Not Perfectly Efficient
Asness doesn’t believe any market is perfectly efficient.
“We aren’t believers in the extreme form of the efficient market hypothesis and shouldn’t have to defend it,” Asness says. “EMH says ‘prices reflect all information,’ and I think the tech crash and the real-estate bubble culminating in 2008 were real blows to that idea.”
AQR’s business, in fact, is to find inefficiencies in the markets and profit from them. AQR researchers examine variables that over time generate higher returns, or premiums. Fama and Kenneth French, who now teaches at Dartmouth College, in 1992 published research showing that stocks with high book values relative to their prices outperformed those with low book values. The difference between the two is known as the value premium. The book value of a company is its net worth.
The same research found that small-capitalization stocks outperformed large caps.
Quants such as those at AQR have found ways to apply the value premium to different markets and asset classes, like currencies and bonds -- or even whole countries. Asness and colleagues might add up the market valuation of stocks in France and Germany, compare them with the earnings or book values of the listed companies and conclude that one of the countries’ stocks are undervalued.
Another variable that generates a premium is momentum -- the tendency of a stock’s price to continue upward if it is rising and downward if it’s falling. Asness, in his 1994 Ph.D. dissertation, was among the first to show the existence of a premium tied to momentum, Fama says.
The value and momentum premiums drive more than half of AQR’s returns, Asness says. Another model AQR uses asserts that the stocks of companies that are reducing their share count tend to outperform those of companies increasing it.
“We think they all make money more often than not,” Asness says.
Born in the borough of Queens, New York, Asness may have inherited his entrepreneurial streak from his mother, Carol, who ran a medical education firm. His father, Barry, was an assistant district attorney in Manhattan. Asness’s younger brother Bradley would follow in their father’s footsteps; he took up law and is now general counsel at AQR.
“He’s 6 foot 2, has all his blond hair, and I am bitter,” Asness deadpans.
Cliff Asness is 5 foot 10 inches (1.8 meters) tall and weighs 200 pounds (90 kilograms). He is bald with a graying beard.
“I had a mediocre record in high school,” Asness says. “I was desperately trying to get girls interested in geeks.”
His destiny, according to the 1984 yearbook: “Rich.”
Summa Cum Laude
“I believed in diversification even then,” he says.
The future hedge fund mogul made his presence felt on campus.
“He was the king of the geeks,” says Beinner, a dorm mate in Asness’s freshman year who’s now chief investment officer of Goldman Sachs Asset Management’s fixed-income unit. “Cliff just had a following. People were always asking him questions when he was hanging around the computer lab.”
“He would run regression analyses for me,” says Lo, referring to the process used to find relationships between variables for the purpose of predicting future values. “Given his background in computer programming and finance, he was perfect.”
Lo wrote Asness a recommendation to the University of Chicago Graduate School of Business, now the Booth School of Business, and soon he was off to America’s citadel of free- market thinking.
Asness became one of Fama’s favorites.
“Cliff was among the smartest students to pass through,” Fama says. In 1990, Asness became the efficient-markets guru’s teaching assistant, putting him on track for an academic career.
“I thought he had the potential to make an excellent professor,” Fama says.
A summer job at Goldman Sachs, engineered with help from Beinner, sent Asness in a different direction. In 1992, he signed on for a one-year research job. In 1993 and 1994, the Ph.D. candidate found himself struggling to complete a 150-page thesis while logging 80-hour weeks for Goldman. In 1994, the investment bank hired him to build a quant research department.
$1 Million Classroom
Although they’re friends, Fama says he remains irked that Asness didn’t pursue an academic career.
“We invested a lot of time and effort in Cliff,” he says. Asness donated $1 million to name a classroom after Fama. “He should name another,” Fama says.
At Goldman, Asness recruited future AQR partners Liew and Krail, two former classmates from the University of Chicago who worked at Trout Trading Co. In addition to building trading models, the Quantitative Research Group crunched numbers and drew charts to help guide the bank’s traditional stock pickers and other managers. Asness also started what was then a small hedge fund for Goldman called Global Alpha -- which would grow to $11 billion in assets by 2007.
Under Asness, Global Alpha scored gains of 111 percent in 1996 and 42 percent in 1997. He grew frustrated with his other duties.
“We thought it was crazy that they wouldn’t let us focus on investing alone,” Asness says.
Two Sets of Twins
Asness, Liew, Krail and Kabiller, who had worked in Goldman’s pension services group, decamped to start AQR in 1998. In 1999, Asness married Laurel Fraser, a former Christie’s International salesperson, who before they dated had been his executive assistant at Goldman. They are parents of two sets of twins, born 18 months apart.
AQR started with $1 billion, Asness says. It began trading in August 1998 -- when the bubble in Internet and other technology stocks was in full bloom. AQR followed its models, betting against expensive stocks and buying cheap ones. That meant Absolute Return hemorrhaged money until the market turned against tech in March 2000.
“We began with $1 billion and through hard work and acumen turned that into $400 million,” Asness jokes.
The founders toured the world, trying to persuade investors that the tide would turn. In 2000, Asness penned a paper called “Bubble Logic,” in which he picked apart the arguments supporting sky-high technology stock valuations.
“When fallacies rule the land, somebody has to point out the naked emperor,” he wrote.
In March 2000, the market turned and Absolute Return began making money. The fund finished 2000 up 16.7 percent, investors say. The Nasdaq Composite Index lost 77.9 percent of its value between March 2000 and October 2002. From there, AQR flourished, with assets rising to $12 billion in 2004, when the firm moved to Greenwich.
A key lesson of 1998 to 2000 was replayed less than 10 years later.
“No strategy is so good that it can’t have a bad year or more,” Asness says. “You’ve got to guess at worst cases: No model will tell you that. My rule of thumb is double the worst that you have ever seen.”
The firm has also redoubled its effort to develop new strategies for boosting returns and improve existing ones. John Cochrane, the AQR Capital Management Professor of Finance at the University of Chicago, says many quants just mine past data and extrapolate returns.
“AQR is really analytical,” he says. “They put a lot of academic research to work -- and they create a lot of academic research.”
The Delta fund is one result. Drawing on years of analysis, the fund is based on the notion that some of the investing techniques used by hedge funds, such as merger and convertible bond arbitrage, aren’t as sophisticated as they’re cracked up to be.
Merger arb hedge funds typically buy the stock of acquisition targets and sell short that of acquirers. Convertible arbitrage often involves buying a convertible bond and shorting the corresponding stock, locking in the yield.
AQR’s research showed that with the right formulas programmed in, the buying and selling of stocks and bonds for merger and convertible bond arbitrage could be automated. And that’s what the Delta fund is: a kind of systematic hedge fund using multiple strategies.
“It’s sexy in a wonkish sort of way,” Asness says.
The Global Risk Premium fund is another example. Research showed that pension funds that use traditional, balanced asset allocation formulas -- say, 60 percent stocks and 40 percent bonds -- are actually unbalanced in terms of risk. That’s because stocks, which are much more volatile, may account for 85 to 90 percent of such a portfolio’s risk.
The Risk Premium fund puts money to work in a variety of asset classes -- stocks, bonds, commodities and others -- to spread risk more evenly. The amount of volatility a pension investor wants in order to get to a desired return is adjusted with leverage.
Asness and colleagues say they’re tweaking formulas at the fortified Absolute Return fund so that it can return to its former prominence in the firm.
“AQR believes in preserving capital by managing risk,” says the Alaska Permanent Fund’s Scott, who’s targeting returns of 5 percentage points above inflation going forward. “The returns are working, but the bigger picture is working too. What we found with Cliff is, he rolls up his sleeves and teaches us.”
Around the developed world, expectations for future investment returns have withered following the financial crisis and the drawn-out recession. Asness realizes that AQR won’t soon return to the fat margins of pre-crash days.
“The whole industry is less lucrative than it used to be,” he says.
How will AQR define its own success in an era of tempered hopes? More assets? Higher profits? Asness -- father of four, self-declared family man -- gives an answer he knows will get him in trouble at home.
“Two words,” he says, pausing for effect with a smile. “Trophy wife.”
There goes the bigmouth again.
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