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MA, HAO (140313)NTARANGWI, FRIDAH (140155)SAHIN, CIGDEM (140499)SENAWIDJAYA, NELVILIA (140924)ZENG, SIDA (140942)HEDGE FUNDS AND INVESTMENT MANAGEMENT REGULATION 1

1Company Profile[1998] Established in by former Goldman Sachs workers: Clifford Asness, David Kabiller, Robert Krail, and John Liew and headquartered in Greenwich, Connecticut[2014] Over 411 employees[Dec. 2014] Approximately $122.2 billion assets under management, including assets managed by CNH Partners, an affiliate of AQRHedge fund strategies focus on pure absolute return alpha, and often involved taking both long and short positions in securities and using financial derivativesFirst hedge-fund managers to voluntarily register at its inception with the Securities and Exchange Commission (SEC)In addition to traditional strategies, in 2004, the firm formed a partnership with CNH partners, expanding their alternative offering to include convertible arbitrage and merger strategies[2009] AQR became one of the first investment managers offering alternative strategies in mutual fund formatOperates mainly in equity market

AQRInstitutional Investment VehicleTraditional Investment StrategiesTotal ReturnRegistered FundsAlternative Investment StrategiesInvestment VehiclesEquityAbsolute Return Facts

Feb. 2015 |StrenghtsHigh qualified financial advisor channelImpressive historical performance track record for hedge fundsReliable strong strategic partnershipsExtensive experience in implementing momentum strategies Increase in competitivenessWeaknessesRetail mutual funds limits Open end - liquidity riskStricter reporting and compensation requirementsHigher transaction costsHigher volatility risks: common stock risk, counter party risks, derivative risks, etc.2

FundsLarge-cap International (AIMOX)Large-cap U.S. (AMOMX) Small-cap U.S. (ASMOX)AMOMXASMOXAIMOXRegulationMinimum InvestmentLiquidityShort sellingFeesReturn correlations to marketHorizonStrategyBenchmark(Un)LeverageTargeted investorObjectiveReplicate returns indexActively manage portfolio to generate active returnsTarget InvestorsRetail & Institutio-nalLong TermMutual fundsStrongDirectional*Long or shortHigh Beat the market (index funds match the market)UnleveragedInstitutional and/or retailLow Open-endMax. 30%Fixed by SECHedge fundsLowDirectional; Arbitrage** & Spread***Long and/or shortLowAbsolute return with low volatilityLeveraged Wealthy investorsMin. $500,000/$1mQuarterly; lock-in periodUnlimited2/20 (bargain)AQR Momentum FundStrong DirectionalLongLowAbsolute return with low volatilityUnleveragedInstitutional & retail (2010)/Institutional & wealthy investors (2014)Min. $5000 (2010)/ min. $5m (2014)Open-endMax. 30%Fixed by SEC

Feb. 2015 |2Mutual Funds & Hedge Funds* A directional strategy is any trading or investment strategy that entails taking a net long or short position in a market. It is betting on the direction the overall market is going to move in. ** Arbitrage is a trading strategy which involves the purchase and resale of an asset to exploit short-term price differences between markets in order to make a profit.*** A strategy that involves a position in one or more options so that the cost of buying an option is funded entirely or in part by selling another option in the same underlying. Also called spreading.3

3Momentum StrategyMomentumDefinitionInvestment strategiesBuying outperforming stocks Selling underperformed stocksProfit: the tendency of the outperforming stocks to continue outperform in the near futureIntuitionAssociated with inefficiency in markets; driven by investor behavior: Slow reaction to new information; Asymmetric responses to winning; and losing investments (disposition effect)The "bandwagon effectImplicationAll strategies: higher risk-adjusted returns by adding momentum to their portfoliosQuality: momentum provides better performanceValue : momentum be an effective complementValue & Quality: momentum as an alternative to their growth allocationLarge-cap internationalSmall-cap U.S. Large-cap U.S. Large 1000 international stocksNext largest 2000 U.S. stocks Largest 1000 U.S. stocks MOMENTUM INDEXLong-only momentum indexMomentum IndexLong-onlyRebalanced quarterlyStocks with reasonable market cap and liquidity only as open-endRanking based on performance during t-12 until t-2Value-weighted index (by each firm in the portfolio by market cap)

Feb. 2015 |Top third ranking Intuition of Momentum due to investor behavior1. Under-reactionInvestors may be slow to react to new informationDifferent receive news from different sources, and react to news over different time horizons and in different waysAnchoring and adjustment is a behavioral phenomenon in which individuals update their views only partially when faced with new informationaccepting its full impact.2. Disposition effectInvestors tend to sell winning investments prematurely to lock in gains, and hold on to losing investments too long in the hope of breaking even When good news is announced, the price of an asset does not immediately rise to its value because of premature selling. Similarly, when bad news is announced, the price falls less because investors are reluctant to sell3. Bandwagon effect (also called over-reaction)Short-term traders may use recent performance as a signal to buy or sellLonger-term investors look to recent performance to confirm their convictionsThe interaction between these investors can create price run-ups or -downs that can persist for many months until correction

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4Challenging IssuesPrincipleRebalancing frequency should be based on the primary objective of fund(= Actively manage portfolio to generate active returns)Frequent rebalancing => higher turnovers => higher transaction costs => lower net returns

Rebalance quarterlyKorajczyk and Sadka (2004) : most profitable strategy for equal-weighted long positions in winners and short positions in losers is J=11/S=1/K=3**

Tradeoff

Optimal frequencyOptimal rebalancing period will be obtained when the difference between return spread and transaction costs reaches its maximum valueTheoretical Formula:Return Spread of Rebalancing Transaction Costs due to Rebalancing***

SolutionExcessive rate of return of fund 4.44% (Exhibit 3) Transaction costs >1.11% (4.44%/4), the quarterly rebalancing will harm the return of fund.Grundy and Martin (2001): at round-trip transactions costs of 1.5%, the profits on a momentum strategy become statistically insignificant

Feb. 2015 |RebalanceMore Frequent RebalancingPros - Less tracking errorsCons - High transaction costsCriteraIt is necessary to justify a trade if the transaction brings more return than transaction costs it generatesCertain gap in rank should not be the criterion, unless it is more feasible to implement

ScenarioMomentum strategy: based on past returnsHybrid strategy: based on return forecast

Theoretical FormulaReturn Difference of Two Stocks Transaction Costs due to Rebalancing

ExampleAQR is holding the stocks of XYZ company which ranks 350th in the Russell index this quarterMeanwhile ABC company, not yet in the portfolio, ranks 333rd now. If the difference in the returns of the two companies is higher than transaction costs, then AQR can justify the tradeBoundary Stocks** (ignoring price impacts; transaction costs) (J=length of the period over which past returns are calculated; S=period of time before implementing a trading strategy; K=length of time the position is held)***where Return Spread= Return after rebalance Return before rebalance5

Tradeoff between price impact and the tracking error damageIf we sell the stocks with poor performance immediately , it will have a price impact on the stocksHowever, if we dont sell the stocks quickly, we will probably suffer losses from the ongoing decline of stock pricesCompanyAQRs ExposureAverage Daily Trading VolumeExposure/ADTVSectorSector Weight in PortfolioMoodys Corp.2.891.7001.250.690231%Financials6.3%Walt Disney Co.14.832.3987.131.630208%Consumer Discretionary12.6%Schlumberger Limited15.721.2749.960.300158%Energy11.2%Actavis PLC3.281.4082.605.690126%Health Care14.1%Microsoft35.896.54835.837.100100%Information technology31.3%Dow Chemical Co.9.308.1009.625.96097%Materials4.4%Level 3 Communications Inc.2.070.9292.314.44089%Telecommunication Services0.4%Boeing Co.2.089.0324.806.65043%Industrials13.6%American Electric Power Co.. Inc.1.023.3162.729.03037%Utilities1.0%Coca-Cola Enterprises. Inc.1.052.35214.570.2007%Consumer Staples4.5%Theoretical Trade-off FormulasMin (price impact loss + losses from tracking error)The break-even point of funds size is important

Empirical studyKorajczyk and Sadka (2004): Taking price impact costs into consideration, 11/1/3 momentum strategy will perform better using value weights rather than equal weightsValue-weighting is concentrated in more liquid stocks than equal-weightingSpecifically, the zero- break-even point is 200 million dollars for the 11/1/3 EW strategy, while it is more than 2 billion dollars for an 11/1/3 VW strategy

Solution11/1/3 Value-Weighted strategy instead of Equal-Weighted strategy to reduce the price impact and to help the fund reach a larger sizeFor example, the following selling period could be one option for stocks with different exposure/ADTV ratiosExposure/ADTVRecommended Selling PeriodE/A