Ignore AQR, You Must Hedge Your Portfolio
The pioneering quant investment fund, founded by Cliff Asness, is grossly wrong in underestimating tail risks
It is not news that as a result of the market bursts, many gurus who predicted said stock market crash come to light, as well as an infinity of books that seem to be the panacea for investment. And that is just what Cliff proclaimed back in March 2020 when Covid had hit the S&P500 by 20%.
Asness states in a paper called ‘Portfolio Protection? It’s a Long (Term) Story… ’ that those investors who systematically hedge their portfolios lose money in the long term against the index for the payment of the Premium in the purchase of options. In contrast, risk-mitigating and diversifying strategies such as defensive equities, risk parity, alternative risk rewards, and trend-following have more consistently added value over the horizons that matter most, as well as on average.
And it is precisely in the latter that Cliff is wrong and that is those typical investment portfolios suffer from too much asset-class diversification and not enough risk diversification.
Furthermore, AQR has tried to substantiate this claim through various backtests. In the one shown below, the quant fund tries to demonstrate to us that in the short term a portfolio created by PUTs 10 — 20% OTM has a better performance than the rest of the styles, while in the long term (> 5 years ) have a negative return against a portfolio consisting of 60% stocks and 40% bonds.
What AQR does not take into account is that ‘black swans’ or those events that occur at more than 5 sigmas: 1) cannot be predicted by backtesting, since by definition they are events that cannot be predicted; 2) are more prevalent than modern financial models dictate.
On the other hand, the main objective of Hedge Funds is to make money, this is greater the more money they have under management, and that only happens when they argue very complex investment strategies with a high Sharpe Ratio, and this serves to justify their management fees, despite the fact that indices have even bigger CAGR than their funds …
Black-Swan Events Hedge
First of all, the events that Cliff proposes are not events that focus on the tails of the distribution, in fact, drops of 10–20% are common every 3–5 years. In addition, this type of coverage is static, not dynamic, so it is assumed that the entire Premium is lost if the options do not materialize. As detailed in this article, the returns with much more OTM options are much higher than what the study made by the Hedge Fund proposes.
On the other hand, the strategies proposed by Asness have high leverage, while those like the one shown above, only exposed between 20–30% of the portfolio with a possible ‘infinite’ upside and, most importantly, have a large amount of cash when the market is cheaper.
Although, as mentioned above, black swans cannot be predicted, the monetary policies being carried out by the main central banks, where almost half of the dollars in circulation have been printed as of 2016, seems totally necessary to have a type of hedge against any event that may occur.
These policies will lead us to an inflationary environment, in fact, if we continue at this rate of growth of the CPI we will be able to reach levels not seen in the last 40 years. In this environment, long-term bonds are the ones that can suffer the most.
So, do you prefer to have a maximum drawdown of 20% with a possible “infinite” raise, or have total exposure to unpredictable events?
This article is for informational purposes only, it should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.