AQR CAPITAL I. Equity Premium: Evidence - ICPM … · 10/3/2012 3 AQR CAPITAL MANAGEMENT Value and Momentum Tilts Can Also Help in Timing Earning the equity premium together with

10/3/2012

1

AQR C A P I T A LM A N A G E M E N TAQR C A P I T A LM A N A G E M E N T

AQR Capital Management, LLC | Two Greenwich Plaza, Third Floor | Greenwich, CT 06830 | T: 203.742.3600 | F: 203.742.3100 | www.aqr.com

AQR C A P I T A LM A N A G E M E N T

AQR Capital Management, LLC | Two Greenwich Plaza, Third Floor | Greenwich, CT 06830 | T: 203.742.3600 | F: 203.742.3100 | www.aqr.com

AQR C A P I T A LM A N A G E M E N T

The information set forth herein has been obtained or derived from sources believed by AQR Capital Management, LLC (“AQR”) to be reliable. However, AQR does not make any representation or warranty,express or implied, as to the information’s accuracy or completeness, nor does AQR recommend that the attached information serve as the basis of any investment decision. This document has been provided toyou solely for information purposes and does not constitute an offer or solicitation of an offer, or any advice or recommendation, to purchase any securities or other financial instruments, and may not beconstrued as such. This document is intended exclusively for the use of the person to whom it has been delivered by AQR Capital Management, LLC, and it is not to be reproduced or redistributed to any otherperson. This document is subject to further review and revision. AQR hereby disclaims any duty to provide any updates or changes to the analyses contained in this presentation.

In Search of the True Equity Premium – And Looking Beyond It

Antti Ilmanen

AQR Capital Management

ICPM Discussion Forum, London

October 3, 2012


Outline

I. Equity premium: Historical evidence and Prospective analysis

II. Better ways to earn equity premium: Defensive equity, including value and momentum tilts through stock selection or timing.

III. Why do most institutions choose to depend on the equity premium? All mainstream investment models imply very high equity market dependence. Reasons: Not justified by M-V efficiency but by conventionality, leverage aversion, etc.

IV. Beyond the equity premium: More aggressive diversification through risk parity investing and alternative beta premia.

2


I. Equity Premium: Evidence

Long-run world equity premium over cash is 4.4% – geometric mean in DMS (2012) for 1900-2011• The equity premium over bonds is 3.5% and the real return is 5.4%. Comparable U.S. figures are

0.6-0.8% higher. Comparable arithmetic premia are 1.0-1.5% higher. No costs are deducted. In recent decades, the realized equity-bond premium has been flat to negative

3

Sources: AQR, Ibbotson Associates (Morningstar).

Ex-post Rolling 20-Year Compound Average Equity Premium in the U.S., 1945 - 2011

-4%

0%

4%

8%

12%

16%

1945

1950

1955

1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

2010

Equity Premium Over Cash Equity Premium Over Bonds


-4%

0%

4%

8%

12%

16%

1909 1919 1929 1939 1949 1959 1969 1979 1989 1999 2009

Ex-ante Real Return on Equity Market Ex-ante Real Tsy Bond YieldEx-ante Real Tsy Bill Rate (1953-) Ex-ante Equity-Bond Premium

Equity Premium Prospectively

Forward-looking real returns are below historical average but equity premia over FI areabove average. Simple measures (‘Shiller’ E10/P and DDM) point to ca. 4% expectedreal return on U.S. equities, compared to -0.5% real yields for bonds and -2% for cash.

4

Ex-ante Real Return Estimates on Major U.S. Asset Classes, 1900 - 2012

Sources: Bloomberg, Robert Shiller’s website, Ibbotson Associates (Morningstar), Kozicki-Tinsley (2006), Federal Reserve Bank of Philadelphia, Blue Chip Economic Indicators, Consensus Economics. Stocks are represented by the Standard&Poor’s 500 Index since 1957, and bonds are represented by long-dated Treasuries.

10/3/2012

2


Outline





5


II. Better Ways to Earn the Equity Premium ?

Defensive equity tilt: Similar return with less risk

Earning equity premium while tilting stock selection toward value and momentum

Timing equity market exposure with value and momentum signals

Admit: only the market-cap weighted index is macro-consistent (doable by everyone)

6


Defensive Equity Tilt: Similar Return With Less Risk

Source: AQR. Performance based on AQR models of hypothetical portfolios. These are not the returns of an actual portfolio and are for illustrative purposes only. Please see important disclosures in the Appendix relating to hypothetical performance and risks.

Cumulative Total Returns on U.S. Equities, 1927-2011

7

Most speculative assets within each asset class give disappointing long-run returns. Levering up their low-risk peers offers much better returns.

Leverage aversion and lottery preferences appear to be main the explanations Compound Average Return 9.57% vs 9.45%, Vol 13.9% vs 18.9%, SR 0.48 vs 0.39 (Def vs Mkt)

1

5

50

500

1927 1937 1947 1957 1967 1977 1987 1997 2007

Cum

ulat

ive

Ret

urns

Low-Beta 30%

U.S. Equity Market


Value and Momentum Tilts Help in Stock Selection Earning the equity premium together with helpful stock selection tilts can improve market-cap

weighted portfolio‘s performance. In a long-only context, correlation with the market is high (0.96).

Example: Combine one third each in “Market“ (the U.S. market-cap portfolio), “Value“ (top 30% of value-weighted Book/Market-sorted stocks), and “Momentum“ (top 30% of value-weighted 2-to-12-month Momentum-sorted stocks) portfolios. The combo‘s compound average return for 1927-2011 is 12.2% (before costs), exceeding the Market‘s 9.5%. (The combo‘s information ratio is 0.68 and its Sharpe ratio of 0.49 exceeds the Market‘s 0.39.)

8

Source: Ken French’s website. Full market universe, no size sorting (unlike HML and UMD factors). Performance based on hypothetical portfolios. These are not the returns of an actual portfolio and are for illustrative purposes only. Please see important disclosures in the Appendix relating to hypothetical performance and risks.

Cumulative Total Returns on U.S. Equities With Stock Selection Tilts, 1927-2011

0.4

4

40

400

4000

1927 1937 1947 1957 1967 1977 1987 1997 2007

Cum

ulat

ive

Retu

rns

Market with Value & Momentum Stock Selection Tilts

U.S. Equity Market

Outperformance

10/3/2012

3


Value and Momentum Tilts Can Also Help in Timing Earning the equity premium together with helpful market timing tilts can improve the “buy&hold“

portfolio‘s performance (but the risk is concentrated and difficult to maintain through adversity).

Example: Scaling the S&P equity index position size based on the inverted Shiller P/E ratio andpast-year real stock market momentum boosts the timed portfolio‘s compound average return for1926-2011 to 11.3% (before costs), exceeding the S&P‘s 9.8%. (The timed portfolio‘s informationratio is 0.32 and its Sharpe ratio of 0.47 exceeds S&P‘s 0.40.)

9

Source: Morningstar/SBBI, Robert Shiller website. Performance based on AQR models of hypothetical portfolios. These are not the returns of an actual portfolio and are for illustrative purposes only. Please see important disclosures in the Appendix relating to hypothetical performance and risks.

Cumulative Total Returns on U.S. Equities with Market Timing Tilts, 1926-2011

0.4

4

40

400

4000

1926 1936 1946 1956 1966 1976 1986 1996 2006

Cum

ulat

ive

Retu

rns

Market with Value& Momentum Timing Tilts

U.S. Equity Market

Outperformance


Outline





10


0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1.0

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

Global 60/40

Endowment Proxy

Hedge Fund Index

11

III. Why Do Institutions Overrely On The Equity Premium?

*For illustration purposes only and based on AQR backtest. Please see important risk disclosures in the Appendix.The Global 60/40 portfolio consists of the MSCI World Index and the Barclays Global Aggregate Index (Hedged to USD). The Endowment Proxy consists of S&P 500 (8%), MSCI ACWI ex-US(7%), MSCI EMG (5%), BarCap Global Agg hedged to USD (11%) , BarCap Global HY hedged to USD (4%), HFR (26%) as absolute return proxy, Russell 2500 Value as PE proxy (17%) and FTSEEPRA/NAREIT and S&P GSCI (11% each) as two real asset proxies. The Hedge Fund Index is the HFR fund-weighted index. Chart above shows 36-month rolling correlations.

36-Month Correlation to MSCI World

High Market Directionality: Correlations With Global Equities Often Exceed 0.9

Cor

rela

tions


Risk in Most Portfolios is Largely Driven by One Source –Stock Market Direction

Equity risk usually dominates what many investors consider a traditionally diversified portfolio

Concentration is more apparent when portfolio allocations are measured by risk and not by dollars

12

By Capital By Risk

Traditional Allocation

Hedge Funds

Nominal Interest Rate Risk

Inflation Risk

Credit/Default Risk

Public and Private Equity

Charts are for illustrative purposes only. Based on AQR volatility and correlation estimates. Please see risk disclosures in the Appendix. The Hedge Fund Risk is attributed across the four other risk categories,we have allocated 80% of the risk to equities and 20% of the risk to Credit/Default Risk.

10/3/2012

4


Typical ‘Alternatives‘ Diversification Has Not Worked Well

Alternatives have not helped much to diversify away the directionality of 60/40

Better risk-balanced portfolios and style/factor diversification offer more hope

13

GET ME OUTTA HERE!

Sources: The 60/40 portfolio consists of 60% MSCI World (developed equity markets) index, 40% Barclays Global Aggregate fixed-income index, currency-hedged to USD. The Alternatives-4 is a composite of hedge funds (DJ CS index), commodity futures (SP GSCI index), direct real estate (NCREIF transaction-based index), and private equity (Cambridge Associates private equity index). Diversification does not eliminate the risk of experiencing investment losses.

Quarterly Returns of 60/40 and Alternatives, 1997-2012


Major Investment Models…and Another Way

14

Wide Harvesting Approach

For illustrative purposes only.

All these mainstream models have equity market correlation of 0.8 or more


Embedded Belief In Traditional Portfolios Is This…

FOR INVESTMENT PROFESSIONAL USE ONLY

Shar

pe R

atio

15

Stocks Bonds Commodities

Not based on actual data. This is for illustrative purposes only.

Equity domination would be justified if equity premium offered a uniquely high Sharpe ratio (e.g. CAPM) Otherwise, better risk-balanced set of return sources would likely improve portfolio‘s risk-adjusted return

A stylized chart, for illustrative purposes only.


…While The Empirical Experience Is This

Shar

pe R

atio

s

1971 2011*

* These are the realized Sharpe Ratios based on monthly returns in excess of the 3 month T-bill returns for the MSCI World Index (stocks), the Barclays US Aggregate Government Bond Index (bonds), and theS&P GSCI Index (commodities). We begin in 1971, as that is when all three data series are available. The Equal Risk Weight Strategy is a simulated portfolio based on the MSCI World Index, the Barclays USAggregate Government Index, and the S&P GSCI Index, representing exposures to equities, bonds, and commodities, respectively. This simulated portfolio targets an equal amount of volatility from each assetclass every month. Please see important risk disclosures in the Appendix.

Similar long-term risk adjusted returns implies that a balanced risk allocation is a good strategic allocation

Besides these long-only market premia there are many long-short alternative beta premia with comparable or higher Sharpe ratios and appealingly low correlations with market premia

16

10/3/2012

5


17

Why Don‘t More Investors Escape Concentrated Equity Risk?

Market portfolio is directional, so the average investor‘s portfolio must be as well • Many “alternatives“ – private equity and hedge funds – do not reduce directionality

because their equity market correlation exceeds 80%

Can mean-variance analysis justify these portfolio choices? • Only if investors expect equity market risk to be uniquely well rewarded among

return sources, in contrast to empirical evidence

The answers must be found elsewhere:• Unconventionality – cf Keynes quote about the safety of failing conventionally • Aversion to the three dirty words in finance: Leverage, Shorting, Derivatives• Uncertainty about sustainability, reinforced by theoretical and empirical debates• Capacity and cost concerns


Only Equities Can Be Forgiven a Few Bad Years…Or A Decade

• To sum up, investors may have several reasons to over-rely on stocks – best theory, longest empirical evidence, high capacity, embedded leverage, and conventionality.

• These features enhance investors’ patience when the inevitable bad patch occurs, in contrast to less conventional ways of losing money where investors lack time consistency.

18

CAPM

Everyone‘s Doing It...

Capacity

2:1 Debt : Equity


Outline





19


IV. Beyond the Equity Premium

• We believe equity premium is the most reliable source of long-run returns. However, relying heavily on any single source of risk is inefficient, even if everyone does it.

• Our prescription is to diversify more aggressively: Cost-effectively harvest multiple return sources such as long-only market premia and long-short alternative beta premia.

• To us, this approach gives the most realistic way to achieve 5% real returns in a low-return world, for those willing to utilize the three dirty words in finance (L,S,D).

• Not easy – and not everyone can do it • Others may have more faith in illiquid assets, discretionary manager magic, or market

timing. We think these approaches can have a modest role in a portfolio, but the core should be beta-oriented (albeit not single beta!).

20

10/3/2012

6


Our Prescription: The Three Rs

21

Recipe for Long-Run Investment Success

Identify attractive return sources (market risk premia and alternative beta premia) and harvest them cost-effectively

Risk Premiums

Diversify by risk, but be mindful of cost, capacity and confidenceRisk Allocation

Seek to ensure long-term success through risk managementRisk Control


22

Risk Parity Gives Better Diversification

*Charts are for illustrative purposes only. Exposures are subject to change without notice. Please see important risk disclosures in the Appendix.

Traditional Portfolio Risk Parity Portfolio

Risk Allocation

Risk-balanced combination of several long-only market risk premia avoids equity risk concentration

Equity Risk

Interest Rate Risk

Inflation Risk

Credit/Default Risk


23

Alternative Beta Premia – Here Viewed Through Styles

Style tilts are deviations from market-weighted benchmarks based on certain characteristics or risk exposures

Alternative beta premia (or hedge fund premia, smart betas, exotic betas, dynamic betas) are comparable dynamic long-short strategies in liquid asset classes

Alternative beta premia can potentially improve portfolio returns and its diversification

Which styles show most consistent long-run rewards across contexts? • Value – overweight assets with low valuations• Carry – overweight assets with high income• Trend / Momentum – overweight assets with high recent returns• Low Risk – overweight assets with low beta or low volatility

Diversification does not eliminate the risk of investment losses.


24

Styles With the Most Pervasive Success

Sources: Asness etal. (2011), Frazzini-Pedersen (2011), Ilmanen (2011), Moskowitz etal. (2011). Sample periods from 1972/75 to 2009/11. SEE MORE EVIDENCE IN THE APPENDIX.

fffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffffff

For Each of These Styles, Assets with ‘High’ Characteristics Have Outperformed Peers With ‘Low’ Charactersitics in Diverse Contexts

10/3/2012

7


High Costs

And It Is Not Just About Smart Return Sources

25

What Investors Seek

What They Miss

Source: Penrose, Colorado Chamber of Commerce. http://www.penrosechamber.com/LocalInformation/History.aspx

Portfolio Concentration

Expected Return

Poor Risk Management

Pay Attention To Every Step Of The Investment Process


26

DisclosuresThe information set forth herein has been obtained or derived from sources believed by AQR Capital Management, LLC (“AQR”) to be reliable. However, AQR does not makeany representation or warranty, express or implied, as to the information’s accuracy or completeness, nor does AQR recommend that the attached information serve as the basisof any investment decision. This document has been provided to you in response to an unsolicited specific request and does not constitute an offer or solicitation of an offer, orany advice or recommendation, to purchase any securities or other financial instruments, and may not be construed as such. This document is intended exclusively for the use ofthe person to whom it has been delivered by AQR Capital Management, LLC, and it is not to be reproduced or redistributed to any other person. This document is subject tofurther review and revision. For one-on-one presentation use only.Gross performance results do not reflect the deduction of investment advisory fees, which would reduce an investor’s actual return. For example, assume that $1 million isinvested in an account with the Firm, and this account achieves a 10% compounded annualized return, gross of fees, for five years. At the end of five years that account wouldgrow to $1,610,510 before the deduction of management fees. Assuming management fees of 1.00% per year are deducted monthly from the account, the value of the account atthe end of five years would be $1,532,886 and the annualized rate of return would be 8.92%. For a ten-year period, the ending dollar values before and after fees would be$2,593,742 and $2,349,739, respectively. AQR’s asset based fees may range up to 2.85% of assets under management, and are generally billed monthly or quarterly at thecommencement of the calendar month or quarter during which AQR will perform the services to which the fees relate. Where applicable, performance fees are generally equalto 20% of net realized and unrealized profits each year, after restoration of any losses carried forward from prior years. In addition, AQR funds incur expenses (including start-up, legal, accounting, audit, administrative and regulatory expenses) and may have redemption or withdrawal charges up to 2% based on gross redemption or withdrawalproceeds. Please refer to the Fund’s Private Offering Memoranda and AQR’s ADV Part 2A for more information on fees. Consultants supplied with gross results are to use thisdata in accordance with SEC, CFTC, NFA or the applicable jurisdiction’s guidelines.Hypothetical performance results (e.g., quantitative backtests) have many inherent limitations, some of which, but not all, are described herein. No representation is being madethat any fund or account will or is likely to achieve profits or losses similar to those shown herein. In fact, there are frequently sharp differences between hypotheticalperformance results and the actual results subsequently realized by any particular trading program. One of the limitations of hypothetical performance results is that they aregenerally prepared with the benefit of hindsight. In addition, hypothetical trading does not involve financial risk, and no hypothetical trading record can completely account forthe impact of financial risk in actual trading. For example, the ability to withstand losses or adhere to a particular trading program in spite of trading losses are material pointswhich can adversely affect actual trading results. The hypothetical performance results contained herein represent the application of the quantitative models as currently in effecton the date first written above and there can be no assurance that the models will remain the same in the future or that an application of the current models in the future willproduce similar results because the relevant market and economic conditions that prevailed during the hypothetical performance period will not necessarily recur. There arenumerous other factors related to the markets in general or to the implementation of any specific trading program which cannot be fully accounted for in the preparation ofhypothetical performance results, all of which can adversely affect actual trading results. Discounting factors may be applied to reduce suspected anomalies. This backtest’sreturn, for this period, will vary depending on the date it is run. Hypothetical performance results are presented for illustrative purposes only.

There is a risk of substantial loss associated with trading commodities, futures, options, derivatives and other financial instruments. Before trading, investors should carefullyconsider their financial position and risk tolerance to determine if the proposed trading style is appropriate. Investors should realize that when trading futures, commodities,options, derivatives and other financial instruments one could lose the full balance of their account. It is also possible to lose more than the initial deposit when tradingderivatives or using leverage. All funds committed to such a trading strategy should be purely risk capital.

Diversification does not eliminate the risk of experiencing investment losses.

AQR Capital Management (Europe) LLP, a UK limited liability partnership, is authorized by the UK Financial Services Authority (“FSA”) for General Insurance IntermediaryPermissions; an Arranging, Introducing and Advising.


Appendix

27

Additional Slides


Challenge 1: CPI + 5% Is Harder to Reach

28

Sources: Bloomberg, Robert Shiller’s website, Ibbotson Associates (Morningstar), Kozicki-Tinsley (2006), Federal Reserve Bank ofPhiladelphia, Blue Chip Economic Indicators, Consensus Economics. Stocks are represented by the Standard&Poor’s 500 Index since 1957, and bonds are represented by long-dated Treasuries.

Ex-ante Real Yield of 60/40 Stocks/Bondsand T-Bills, 1900-2012

5% REAL

10/3/2012

8


Varied Investor Responses To This Challenge

29

Equity PremiumMore Equities

Illiquidity PremiumMore Illiquid Assets

Strategy Underlying Belief

Magic of AlphaMore Hedge Funds

Idea DiversificationHarvesting Multiple Return Sources

Traditional, 60/40

Endowment Model

Future ?

Investment ‘Model’


30

Challenge 2: Most Portfolios Are Highly Equity-Directional

The Cube: Asset Class, Strategy Style and Risk Factor Perspectives to Investing

Many Institutional Portfolios Imply a Lopsided Cube


What Can Investors Do?

31

Accept the equity risk domination (and accept suboptimal risk-adjusted portfolio returns)• Investors may have several reasons to over-rely on stocks

OR look harder for diversifying return sources. Possibilities (can choose many):• Illiquid alternatives: Often come with high beta, partly concealed by return smoothing• Hedge funds: Hope they cover costs and deliver α. Overweight CTAs and Macro (less equity β).• Government bonds: Still safe havens but very low prospective returns• Tail insurance or tail hedging: We prefer the latter as it is less expensive• Contrarian timing: One suitable approach for long-horizon investors;. Simple but not easy.• Risk parity: Less equity market concentration among long-only market risk premia• Alternative beta premia: Extend risk parity to dynamic long-short strategies

The latter often require leverage, derivatives and shorting – or delegating those activities. Many investors prefer the embedded leverage in equities,

real estate, PE and hedge funds, etc.

Diversification does not eliminate the risk of experiencing investment losses.


Weighing 60/40 vs Risk Parity

RISK PARITY

60/40

Sharpe RatioRisk Concentration

LeveragePeer Risk

32

10/3/2012

9


Backtested Performance of Diversified Market Risk Premia and Alternative Beta Premia

33

Source: AQR Capital Management, Barclays Capital, MSCI Barra, Standard&Poor’s. Notes: Simulated returns between January 1991 and April 2012. “Market Premia + Alternative Beta Premia” is a 70/30%risk-weighted portfolio of diversified risk parity strategies (long-only market risk premia in several asset classes) and hedge fund premium strategies (long-short strategies often used by hedge funds to capturealternative beta premia). “Market + Alternative Beta Premia with Tail Hedge Overlay” is a 63/27/10% risk-weighted portfolio of diversified risk parity strategies (market premia), hedge fund premiumstrategies (alternative beta premia), and opportunistic tail hedges, respectively. The backtested returns in the first two columns are calculated net of a 1.5% fixed management fee. The backtested composites of“Market Premia”, “Alternative Beta Premia”, and “Opportunistic Tail Hedges” are shown gross of fees but net of estimated transaction costs. Please see important disclosures in the appendix.

Market Premia + Alternativ

e Beta Premia

Backtest

Market + Alternative Beta Premia

with Tail Hedge

OverlayBacktest

US 60/40

Stocks /Bonds

Market Premia25% vol

AlternativeBeta

Premia12% vol

Opportunistic Tail Hedges

15% vol

USStock:S&P500

USBond:BarCap Agg

Cash

Annual Return 16.6% 19.9% 8.7% 35.8% 16.0% 8.5% 10.0% 6.8% 3.4%

Annual Volatility 9.3% 10.7% 9.3% 23.9% 9.0% 16.5% 15.0% 3.7% 0.6%

Sharpe Ratio 1.41 1.55 0.57 1.35 1.40 0.31 0.44 0.90 0.00

Correl. w.MSCI World 0.65 0.57 0.91 0.68 0.21 -0.60 0.93 0.07 0.00

Max Drawdown -22.9% -19.7% -32.5% -57.7% -15.0% -35.5% -50.9% -3.8% 0.0%


4.7%

3.0% 3.0%2.3%

4.7%

4.3% 4.3%

2.8%

1.3% 1.3%

1.3%

0.5%

0%

2%

4%

6%

8%

10%

Ex-Post RequiredReturn

Ex-Post SuppliedReturn

Average Ex-Ante Return(1900-2009)

Ex-Ante Return Now?

9.6%

Excess Equity Return

6.4% ?

9.1%9.6%

BondReturn

CPI

D/P

CPICPI

D/P

dP/E

RG = Real Growth of EPS,DPSD/P = Dividend YieldCPI = InflationdP/E = Repricing Gains

RG

D/P+

RG

RG

Prospective Equity Returns Are Leaner Than Past

In 2012 (as in 2009 below), 4% real return is a decent conditional forecast for real equity returns – actuallyimplying a high equity-bond premium, given negative real yields on Treasuries and cash.

Investor and academic views on equity premium have edged lower since 2000

Don’t need “new normal” or threats from develeraging, debts/deficits, demographics to expect lean future returns

Decomposing U.S. Stock Market Returns, 1900-2009

In the last column, “D/P+” adds 75bp of net buyback yield to the market D/PSource: Ilmanen (2011).

34


Why Assume So Slow EPS Growth?

According to the Dividend Discount Model, assuming unchanged valuations, stock market’s ex-ante realreturn is D/P + trend real cash flow growth.

Sum could be only 3% (2% + 1%), though buyback adjustments and growth optimism often point higher.

A Fact: Long-run real EPS (and DPS) growth has averaged ca. 1% p.a., clearly lagging real GDP growth(see Arnott-Bernstein (2002) and Cornell (2010); MSCI Barra (2010) for international evidence).

Cumulative Real Growth of U.S. Output and per-share Earnings and Dividends, 1900-2009

Source: Ilmanen (2011).

35

1

10

100

1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000

Rea

l Gro

wth

, Jan

190

0 =

3lo

g sc

ale

GDPGDP per CapitaEarnings per ShareDividends per Share


36

Return Predictability Evidence on Equity Premium

Cheap starting valuations imply attractive yields and maybe mean-reversion potential• However, mean reversion tendencies are overstated in in-sample analysis, including below, and simulated

results from trading rules are often less impressive than the graphs below suggest

Market timing is not easy (low predictability, concentrated bet, career risk) even if it has less bad name.

• Investors who try to time markets should at least use multiple predictors – and be humble !

Valuation Ratios Have Predicted Subsequent Multi-year Equity Market Returns in the U.S.(1900 – 2009)

Source: Robert Shiller’s website.

0

2

4

6

8

10

12

14

16

18

1 2 3 4 5

S&P

futu

re re

al re

turn

(% p

.a.)

Five subsets sorted by initial smoothed real earnings yield

1yr ahead 5yrs ahead

-15%

-5%

5%

15%

25%

35%

45%

0%

5%

10%

15%

20%

25%

1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000

Next-5yr R

eal Equity Return

Rea

l E10

/P

Smoothed Real Earnings Yield (lhs)

Next 5-Year Real Equity Market Return (rhs)

Correlation = 48%

10/3/2012

10


Rewards Within FI Markets: Term and Credit Dimensions

Long-run rewards for duration or credit risk-taking within bond markets have been more consistent for small risks than for the most speculative risks

Best rewards for short-dated duration extensions and “fallen angel“ credits

37

Realized Long-Run Term Premia Are Positive Only At Short Maturities

Realized Credit Premia Are Highest For Fallen Angels, Decline Beyond BB

Sources: Ilmanen (2011), Bloomberg, Bank of America Merrill Lynch, Barclays Capital, Center for Research in Security Prices, Citigroup, Ibbotson Associates (Morningstar).

8.0 8.2 8.59.1

10.710.0

8.2

0%

2%

4%

6%

8%

10%

12%

Treasuries AAA/AA

Credit

A Credit BBB

Credit

BB Credit B Credit CCC

Credit *

1990-2009 1973-2009* Using B returns

pre-1985

IG HY

5.15.8 6.0 6.3 6.5

6.3

6.2

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

Tsy0-3mo Tsy6-9mo Tsy1-3y Tsy3-5y Tsy5-7y Tsy7-10 Tsy 10y+

1990-2009 1952-2009


38

Source: AQR Capital Management. Simulated trading strategies gross of trading costs and fees. For illustrative purposes only. The returns above do not represent the return of an actual fund or AQR product.

Value Works Everywhere (Over the Long Run)

Historically, value stocks (with low multiples) have outperformed the marketand growth stocks (with high multiples) over decades in all markets studied

Value also works in country/sector selection and in other asset classes

Both behavioral and risk-based explanations; both may contribute

100

1,000

10,000

Log s

cale

(Ja

n '75=

1000)

US Non-US

Value-vs-Growth Cumulative Outperformance 1926-2009 (US) / 1975-2009 (non-US)

Source: Kenneth French’s website. For U.S. stocks (blue line since 1926, “US”), value (growth) stocks are defined by high (low) book-to-market ratios. For the international stocks (green line since 1975, “nonUS” or 20 other countries), value and growth stocks are defined by a composite of four valuation ratios (book-to-market, earnings-to-price, dividend-to-price, cash flow-to-price).


Carry Everywhere

In the long run, carry-seeking works in virtually every asset class or context

Stronger performance in cross-country strategies than within-country

Carry strategies are clearly risky; rare large losses concentrate in “bad times”

39

Cumulative Excess Returns of Carry-Seeking Strategies in Four Asset Contexts, 1993-2009

Sources: Ilmanen (2011), Bloomberg, Barclays Capital, Citigroup, J.P.Morgan

0

100

200

300

400

500

600

700

FX G10 FX Emg FI G10 Credits



Trend/Momentum Everywhere Trend-following strategies tend to work well at intermediate horizons (1-12 month)

Over longer (1-5yr) horizons, reversals tend to dominate perhaps because investors extrapolate multi-year growth or returns

Similar momentum-oriented strategies also work across stocks

40

Cumulative Excess Returns of Trend-Following Strategies in Four Asset Contexts, 1993-2009

Sources: Ilmanen (2011), Bloomberg.

0

100

200

300

400

500

600

Cmdty Futures Equity Indices Bond/Rate Futures Foreign Exchange


10/3/2012

11


Illiquidity Premia: Nebulous

Source: Harvesting Illiquidity Premiums presentation by Professor Andrew Ang, Oslo, November 2011

41

Four Ways To Capture Illiquidity Premia

Depo

PE

VC

FoF

HF Timber

Glob.Infrastr.

Glob.Reits

RealEst.

CMD

Emg.FI

HY

Glob.Govt US FI

Small EqEmg.Eq.

Glob. Eq.

3

5

7

9

11

13

15

17

0 1 2 3 4 5 6Illiquidity Estimate

Com

poun

d A

nnua

l Ret

urn

(GM

)

Scatterplotting Average Returns 1990-2009on Subjective Illiquidity Estimates

Source: Ilmanen (2011). Note: Positive slope may also reflect various biases and other risk premia.

Do not take illiquidity premia for granted. At best they are time-varying, at most negligible due to the demand from mark-to-market avoiders.


* Strategies are subject to change at any time without notice. Please see important disclosures in Appendix.

Complementary Perspective on Alternative Beta Premia: Hedge Fund Risk Premia

Equity Oriented Strategies

Seek to take advantage of market inefficiencies that cause specific stocks to be under- or over-priced.

Arbitrage Strategies

Seek to capture relative mispricing between two related assets – e.g. convertible arbitrage or merger arbitrage..

Macro Strategies

Profit from dislocations in global equity, bond, currency and commodity markets, including those driven by investors’ behavioral biases.

EQUITY STRATEGIESMACRO STRATEGIES

ARBITRAGE STRATEGIES

- Dedicated Short Bias- Equity Market Neutral- Long/Short Equity- Emerging Markets (Equity)

- Global Macro- Managed Futures

- Emerging Markets (Macro)

- Convertible Arbitrage- Event Driven

- Fixed Income Relative Value

EQUITY STRATEGIESMACRO STRATEGIES

ARBITRAGE STRATEGIES

- Dedicated Short Bias- Equity Market Neutral- Long/Short Equity- Emerging Markets (Equity)

- Global Macro- Managed Futures

- Emerging Markets (Macro)

- Convertible Arbitrage- Event Driven

- Fixed Income Relative Value

42


Capacity: Being a Giant Fund is a Mixed Blessing

Large size brings some diseconomies of scale

Harder to deviate from market-cap weights

Large footprint makes liquidity-demanding strategies (e.g. momentum andvolatility targeting) and high-turnover strategies especially hard

Hard to use leverage when AUM already so large

Activity in niche markets will not move the needle

03 October 2012 43


Capacity: What Can Giants Do?

Despite being more constrained than a smaller fund, the direction should be clear:Move toward the generic goal of better risk-balance than in market-cap or 60/40 orEndowment portfolios.

Among various stock selection styles, the most naturally fitting ones are Defensive(Low Beta and Quality) and Value as they enable capacity and patient execution.Even liquidity-demanding Trend-following deserves a small role, given theirdiversification and tail-hedging characteristics.

Macro strategies offer more capacity than security selection. ContrarianGTAA/timing may offer the best capacity besides being well-suited to the Giants’relatively stable risk aversion. Humble tactical risk-taking should be a small butpositive part of the long-run risk budget.

03 October 2012 44

Documents

AQR CAPITAL I. Equity Premium: Evidence - ICPM … · 10/3/2012 3 AQR CAPITAL MANAGEMENT Value and Momentum Tilts Can Also Help in Timing Earning the equity premium together with