AQR is an asset manager overseeing around $100 billion, with its long-short strategy managing approximately $2 billion. Over the last 10 years, it has delivered an annualized return of around 10% and is rated five stars by Morningstar. Let’s understand what’s inside the world’s best long-short strategy.
Firstly, the approach is idiosyncratic and uses a selection process on both the long and short sides, meaning that individual stocks are both bought and sold. Hence, the strategy is exposed to idiosyncratic risk. Second, the strategy incorporates Beta and seeks to maintain a strategic beta of around 0.5, which means it carries a market bias. Third, the fund factsheet does not articulate the leverage. I don’t know the reason why. Maybe because the share class of $50M or $5M can understand the implicit leverage of 2:1. But there is also a share class of $2,500 intended for the small retail individual investor. I guess for this individual, the fund does not want to bother explaining the implicit leverage. If you can invest in a long-short with $2,500, it’s assumed you are smart enough to understand these details.
Keeping the above specifications in mind, let’s perform a back-of-the-envelope calculation of alpha from the perspective of an investor interested in this strategy. If we assume an average leverage of 2:1, the annualized returns are not 10.8% but effectively 5.4%. And with a Beta of 0.5 (the fund’s long-term strategic target) and benchmark returns at 6.1% for the last 10 years, the alpha calculation is around 2.35%:
Alpha = 5.4% - 0.5*(6.1%) = 5.4% - 3.05% = 2.35%.
So, after 10 years of performance and now with nearly $2B in assets and annual management fees up to 5%, the investor ends up with an underwhelming outperformance. And with the 1 Year T-bill rate at 4.237%, one wonders the purpose of this strategy, its differentiation, its utility in an asset owner’s or individual investor’s portfolio. I am happy to be convinced otherwise. Any upcoming market volatility could dampen these net alpha returns even further and potentially nudge them into negative territory—just as has occurred on previous occasions when the drawdown of the long-short exceeded that of the benchmark.
In conclusion, if the world’s best is generating such numbers, one can safely assume that we are in the Stone Age of financial innovation on both the long and short sides. It’s surprising that if the fund is a top star fund with a significant reputation, it would bury the leverage information in the fund factsheet and not be more upfront about drawdown comparisons.
Machine-driven long-short strategies, which can move beyond idiosyncratic risk (using short and long baskets), remain non-leveraged, and deliver above 3% alpha, should ideally see money flowing away from AQR’s long-short strategy and into these alternatives. The threshold for brilliance in long-short is very low.