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Investing with Style

The Case for Style Investing

Antti Ilmanen, Ph.D.* December 2012

Principal Investors are bombarded by a variety of investment
Ronen Israel strategies and alternatives from an ever-growing
and increasingly complex financial industry, each
claiming to improve returns and reduce risk. Amid
Tobias J. Moskowitz, Ph.D. the clamor, academic and practitioner research has
Fama Family Professor of Finance sifted through the vast landscape and found four
Booth School of Business, University of Chicago intuitive investment strategies that, when applied
Research Associate effectively, have delivered positive long-term
National Bureau of Economic Research returns with low correlation across a multitude of
asset classes, markets, and time periods using very
liquid securities. These four investment styles are
Value, Momentum, Carry, and Defensive, which
form the core foundation in explaining the cross-
section of returns of most asset classes.

* Antti Ilmanen can be reached by email:

AQR Capital Management, LLC
We would like to thank Cliff Asness, April Frieda, Georgi Georgiev, Sarah Two Greenwich Plaza
Jiang, David Kabiller, Johnny Kang, John Liew, Thomas Maloney, and Greenwich, CT 06830
Mark Stein for helpful comments and suggestions, and Jennifer Buck for
design and layout. p: +1.203.742.3600
f: +1.203.742.3100
Investing with Style: The Case for Style Investing 1

In this paper, we will describe style investing, pay high fees for alpha end up paying exorbitant
discuss the intuition and evidence for the four fees for beta.1 In addition, even when alpha is
pervasive styles, and detail how to implement a identifiable and attainable, it is usually packaged
strategy that can access these premia to improve in illiquid vehicles with little transparency and
the risk and return characteristics of traditional very high fees. For example, hedge fund investors
portfolios. Despite a wealth of academic evidence have often paid too much and accepted
on style premia, an accessible investment vehicle unfriendly terms for strategies that are common
that delivers a very broad yet consistent set of and well-known.2
style returns (at reasonable terms) has not
existed. We seek to change that by offering a new While the definition and pursuit of alpha is
fund that provides investors with an intuitive, elusive and the generation of alpha is opaque,
transparent, and cost-effective approach to gain expensive, and not easily scalable, there are other
exposure to these pervasive investment styles. ways to seek returns that can significantly
improve investor portfolios. Putting semantics
aside, all an investor should care about is
Most existing portfolios, even seemingly receiving positive returns that are uncorrelated
diversified ones like the traditional 60% with what she currently owns. Regardless of
stocks/40% bonds, have excessive dependence on what you call them, these returns will look like
equity risk. This proved especially painful during alpha to the investor. In this article, we focus on
the 2008 global financial crisis. Further, most a proven set of strategies that can produce such
investors currently recognize that traditional returns, which we call styles. Style investing
sources of returns, such as stocks and bonds, may delivers long-term positive returns with little
not do as well as they have in the past. correlation to traditional asset classes. And, it
Consequently, investors have turned their achieves this in a more intuitive and cost-
attention to alternative sources of return, effective manner using liquid securities that allow
specifically those uncorrelated with traditional for more scalability.3 In essence, investing can be
assets. One way to achieve these returns is to seek made much simpler and more effective by
alpha. Alpha is a loaded word in Finance. In focusing on the core foundations of returns
theory, true alpha is the extra return achieved building blocks we call styles. Practically
beyond any known risks or systematic strategies speaking, if an investor is not already exposed to
and is unrelated to any of those strategies. It is style premia, it is alpha! But, it is identifiable
therefore often taken as a measure of unique alpha, not concealed amongst traditional betas,
managerial skill. and offered at significantly better terms.

Unfortunately, alpha is at best elusive and, more Think of a style as a disciplined and systematic
often than not, illusive. First, the definition of method of investing that produces unique long-
alpha is confusing and often misused. Academics term positive returns across markets and asset
and practitioners struggle to define true alpha
and debate its very existence. Second, even if we 1
Asness, Krail, and Liew (2001) and Asness (2004).
Berger, Crowell, Israel, and Kabiller (2012). Also see AQR Alternative
can agree on a definition, alpha is often cloaked Thinking (July 2012) which discusses other ways to label and classify
inside a broader portfolio that contains simple long-short strategies than style premia: alternative beta premia, exotic
betas, smart betas, and hedge fund risk premia.
market exposures (e.g., betas). Since a single fee 3
While there are other sources of returns that can be achieved through
illiquidity, providing insurance, and arbitrage trades, these are separate
is charged for the portfolio, investors willing to topics and strategies not considered here.
2 Investing with Style: The Case for Style Investing

classes, backed by scientific data. For years, (and later, commodities) as a powerful
academics and practitioners have been studying investment tool and more recently has been
markets, trying to identify persistent, systematic studied in equity indices, individual stocks, and
sources of return. Many attempts to identify options.9
additional return premia have turned out to lack
robustness, possibly the result of data mining (for Identifying robust return sources is the first
example, research claiming to find stock return ingredient of successful style premia investing,
predictability from sun spots, seasonal affective and finding consistent evidence in many markets
disorder, and moon phasesno kidding!). and asset classes achieves this aim. The second
However, sifting through the research and data key ingredient is diversifying across as many
has resulted in the identification of a set of classic styles and asset classes as possible, especially
long-short styles that deliver consistent long-term since the styles are uncorrelated, and sometimes
performance backed by sound economic negatively correlated, to each other. Finally,
reasoning across many unrelated asset classes, in proper long-short implementation of these styles
different markets, and in out-of-sample tests. provides for hedged returns that have low
They are value, momentum, carry, and correlations with traditional equity risk premia.
defensive. Historically, investors may have been exposed to
individual styles indirectly and, as we will argue,
Style investing has been most widely studied in inadequately through portfolios that simply add a
equity markets, with a classic example being the style tilt onto predominantly long equity-market
influential work of Eugene Fama and Kenneth risk exposure, but often disguised and priced as
French (1992, 1993), who describe the cross- alpha. Our approach is to provide pure,
section of U.S. stock returns through two main diversified exposure to all four styles
styles, in addition to the market equity-risk simultaneously in a transparent vehicle, designed
premium: value and size. Subsequent research to have low correlation to traditional risks and at
into stocks added two additional styles, namely a fair price. Our unique approach provides direct
5 6
momentum and low-beta or low-risk. Research exposure to all four styles, not one at a time, and
on value, momentum, and low-beta has been not commingled with traditional sources of risk.
extended to international stocks as well as to
other asset classes that include bonds, currencies, A skeptic might say there must be a catch. There
commodities, derivatives, and real estate, with is, of course, but it is a small one that can (and
similarly strong results. Size, on the other hand, must) be managed. In order to achieve proper risk
has not proven as robust, cant be easily applied balance and attain the high returns and low
across other asset classes such as currencies or correlation properties investors seek, style
commodities, and entails betting on illiquid investing requires the three dirty words in
securities, which is a feature we aim to avoid in financeleverage, short-selling, and derivatives.
constructing a liquid strategy. The last style, This is a consequence of three desires: market
carry, was first applied in currencies and bonds neutrality (or removing traditional betas), risk
(not dollar) diversification, and decently sized
Ilmanen (2011) provides an overview. expected returns. Leverage, shorting, and
Jegadeesh and Titman (1993) and Asness (1994).
Black (1972) and Frazzini and Pedersen (2011a). derivatives are necessary to achieve these
Asness, Moskowitz, and Pedersen (2012), Asness-Liew-Stevens
(1997), and Frazzini and Pedersen (2011a,b).
8 9
Israel and Moskowitz (2012). Koijen, Moskowitz, Pedersen, and Vrugt (2012).
Investing with Style: The Case for Style Investing 3

important objectives efficiently. Hence, putting implementation of the value style can be
together a portfolio of style premia requires straightforward. Take a set of stocks and sort
careful portfolio design decisions, proper them by some measure of fundamental value to
portfolio construction, effective implementation price. Go long or overweight the stocks that have
and cost control, as well as sound risk high fundamental value to price and short or
management. We discuss these below. underweight the ones that have low fundamental
value to price. By being explicitly long and short,
Value means buying assets that are cheap relative the resulting portfolio has very little correlation
to their fundamental value and selling expensive with the overall equity market, and when applied
across many assets, can capture the aggregate
Momentum involves buying assets that recently return to value investing while diversifying away
outperformed their peers and selling those that
recently underperformed. idiosyncratic security risk. The traditional choice
of value measure is the ratio of the book value of a
Carry implies buying high-yielding assets and selling
low-yielding assets. company relative to its price (B/P), but other

Defensive consists of buying low-risk, high-quality

measures can be used and applied
assets and selling high-risk, low-quality assets. simultaneously to form a more robust and reliable
view of a stocks value. For example, investors
can look at a variety of fundamentals beyond
In Part I, we describe the style premia in greater
book value, including earnings, cash flows, and
detail, followed by empirical evidence in Part II.
sales, relative to price. It is our view (and
In Part III we discuss how best to put the four
experience) that more measures provide for more
styles together into one cohesive portfolio.
robust portfolios.11
Finally, in Part IV we address the benefits of
adding style premia to a traditional portfolio.
Value can be applied beyond the original context
of stock selection to equity indices and other asset
Part I: What are Style Premia?
classes. In equity indices, an aggregate measure
We focus on the four classic styles: Value, of B/P for the entire market can be used to
Momentum, Carry, and Defensive. We first implement value investing. Extending the value
discuss the basis for each of these styles, concept to bonds, currencies, and commodities
including the underlying economic intuition requires using measures not derived from
behind them. Then, we present empirical accounting statements, but still retains the notion
evidence showing their long-term return, risks, of fundamentals to price.12 For bonds, a measure
and correlations. of real bond yields, defined as the yield of a 10-
year government bond index minus forecasted
Value investing is probably the best-known style, inflation for the next 12 months, is used. In the
especially in equities. The idea of buying case of currencies and commodities, a measure of
undervalued assets (and selling overvalued ones)
dates back to at least Benjamin Graham. For
almost 30 years, value investing in stocks has
been studied extensively in academia, most
prominently by Fama and French. 10 The (1996), Fama and French (2004), Fama and French (2008), Fama and
French (2012).
Israel and Moskowitz (2012).
10 12
Fama and French (1992), Fama and French (1993), Fama and French Asness, Moskowitz, and Pedersen (2012).
4 Investing with Style: The Case for Style Investing

the 5-year reversal in price, reflecting mean in this case price momentum. It has been shown
reversion, is related to value. In all cases, a that measures of fundamental momentum, such
systematic process that first sorts assets by these as earnings momentum, changes in profit
measures, going long the cheap (relative to margins, and changes in analysts forecasts for
fundamentals) assets and short the expensive stocks, are also useful in forming profitable
ones, is applied. portfolios. For both price and fundamentally
based momentum strategies, the evidence of
Academics still debate why the value premium strong risk-adjusted returns is pervasive across
exists. For example, there are explanations rooted time and markets.
in investor behavioral biases, such as excessive
extrapolation of growth trends, as well as risk- Similar to the debate about why value investing
based explanations like value assets having works, there is an active academic discussion
greater default risk. Both sets of theories are about why momentum is related to average
grounded in economic intuition with ample returns. This debate again rests on two possible
theoretical foundation. Given the economic explanations: risk-based and behavioral theories.
motivation and strong empirical evidence, value Risk-based stories posit that high-momentum
investing is clearly a persistent source of excess stocks are riskier and therefore command a
returns. higher discount rate. An example is high-
momentum stocks containing more growth
Momentum investing is an almost equally well- options in earnings that make them more
known style, supported by evidence that is as sensitive to aggregate shocks. In addition, strong
robust and pervasive as the evidence behind correlations among momentum stocks suggest
value investing. Momentum is the tendency of the presence of a common source of risk.
assets, in every market and asset class, to exhibit Behavioral theories, on the other hand, argue that
persistence in their relative performance for some under-reaction to new information due to
period of time. Since being documented in anchoring or inattention, and/or overreaction to
academia in the early 1990s among U.S. equities, price moves due to feedback trading (becoming
momentum has been studied extensively in a more confident in ones positions and beliefs
variety of contexts. The typical approach is to when they are supported) and investor herding
look at the past 12 months of returns for a may be prominent sources of momentum. In
universe of assets, going long the ones that have addition, the disposition effect, which is the
outperformed their peers and short the tendency for investors to sell winners too soon
underperformers. By being long and short, the and hold on to losers too long, may be a
resulting portfolio has little correlation to significant contributor to momentum.
traditional markets, and when applied across
many assets, captures the aggregate return to Carry is a well-known style particularly among
momentum while diversifying away idiosyncratic macro-economists and practitioners in currency
security risk. markets. At its core, carry is based on investing
(lending) in higher yielding markets or assets and
Similar to value investing, momentum investing financing the position by shorting (borrowing) in
does not need to be confined to a single measure, lower yielding markets or assets. A simplified
description of carry is the return an investor
DeBondt and Thaler (1985, 1987), Fama and French (1996), and
Asness, Moskowitz, and Pedersen (2012).
Investing with Style: The Case for Style Investing 5

would receive (net of financing) if market negative skewness and larger left tails,
conditions (e.g., prices) remain the same. A specifically in bad economic environments.
classic application is often found in currency However, and importantly, those risks tend to be
markets, where sorting countries by their short asset-class specific and are largely diversified
term (say, 3-month) lending rate, and going long away in a portfolio where carry is applied across
the countries with the highest rates and short the many asset classes.14 Hence, strong positive carry
markets with the lowest is a profitable strategy returns can be captured while mitigating (though
over several decades. Likewise, carry strategies in not avoiding) much of the occasional carry
fixed income and commodity futures, where crashes that occur in a particular asset class like
backwardation or contango are exploited across currencies. The concept of carry, applied more
various commodities, have also been profitable broadly across other asset classes besides
over time. For stocks, the carry earned is the traditional currency trades, is a clear example of
expected dividend yield. Thus, in the case of how style investing, when applied universally,
equities, carry is closely related to value, but the can generate more attractive risk and return
two measures are not identical. Moreover, carry is characteristics.
quite different than value in other asset classes.
Defensive, or low beta/low risk, strategies have
The economic intuition behind carry is balancing experienced a resurgence in recent years. The
out supply and demand for capital across initial motivation for defensive strategies dates
markets. High interest rates can signal an excess back to Fischer Black, who in 1972 saw that the
demand for capital not met by local savings; low security market line (the line linking beta to
interest rates suggest an excess supply of capital. average returns) was too flat, relative to what
Traditional economic theory would argue, in the theory (the Capital Asset Pricing Model, or
case of currencies, for example, that the rate CAPM) would predict. In other words, high-risk
differentials would be offset by currency assets didnt offer high-enough returns relative to
appreciation or depreciation, such that the return low-risk assets. Subsequent research has shown
an investor would experience would be the same that this phenomenon can be extended to many
across currency markets. The evidence is that a different markets and asset classes beyond
currency carry strategy not only can collect the stocks. In the case of stocks, we sort by
yield differential, but has often captured some forecasted betas and go long the stocks with the
capital gains from currency appreciation as well. lowest betas and short the ones with the highest
This is perhaps caused by the presence of non- betas. By applying some leverage to the lower-
profit-seeking market participants, such as beta stocks to equalize the long portfolios beta
central banks, who introduce inefficiencies to with the short side, a portfolio retains its market
currency markets and interest rates, due to other neutrality, while capturing the fact that the lower-
more political motives. beta stocks offer a better risk-adjusted return than
the higher-beta stocks. By being diversified across
The strategy is certainly not without risk, as there many assets, we capture the defensive return
can be sharp periodic unwinds when capital flees premium while diversifying away idiosyncratic
for low-yielding safe havens. The positive security risk. Extending the low- vs. high-risk
performance over the long term could be
compensation for investing in a strategy with Koijen, Moskowitz, Pedersen, and Vrugt (2012), and Ilmanen (2011,
chapters 13 and 22).
Black (1972) and Frazzini and Pedersen (2011a,b).
6 Investing with Style: The Case for Style Investing

concept more broadly, we also can go beyond classes and for other styles we similarly use
beta to include more fundamental measures of several intuitive measures for robustness.
riskor conversely qualityby seeking high
profitability,16 low leverage, and stable earnings We create a large universe of securities to
among stocks, or by favoring short-duration maximize diversification benefits. In the case of
assets in fixed income. stocks and industries, we use approximately 1,500
stocks across the major developed equity markets,
There are a number of competing theories for weighting each market by its relative liquidity
why lower-risk assets may offer higher risk- and breadth as follows: U.S. 50%, Japan 20%,
adjusted returns. We believe the most compelling Europe ex-U.K. 20%, and U.K. 10%. We also
reason resides in the fact that leverage needs to apply the four styles to 21 equity index futures, six
be applied to lower-risk assets to raise the overall bond futures, five interest rate futures, 19
risk and return expectations. Since most investors currencies, and eight commodity futures. For
are leverage-averse or leverage-constrained, they capacity and cost reasons, we focus exclusively on
typically choose to hold the higher-risk assets, liquid assets, leaving out illiquid segments of
thereby lowering the prospective returns for those traditional assets (e.g., small-cap stocks, non-
assets.17 As a result, an investor who is willing to government bonds and other illiquid fixed
take the other side of that trade and hold the income, and emerging-market equities and
levered, lower-risk asset may be well-rewarded in commodities beyond the most liquid six to eight
the long run. markets in each group).

Part II: Empirical Evidence of Style Premia Equity country allocation and currency allocation
are separately conducted in developed markets
To provide empirical evidence of the style
(75%) and emerging markets (25%), motivated by
premia, we create composites of the four styles by
their relative liquidity/capacity. Similarly, we
applying long-short strategies across seven
weight long-dated government bonds three times
different asset classes (or contexts): individual
more than short-dated interest-rate futures to
stocks globally, industries,19 country equity
avoid using excess leverage. Overall, 60% of total
indices, government bond indices, interest rate
risk is equity-related20 (stocks, industries, and
futures, currencies, and commodities. In each
equity indexes) and 40% of risk is in other asset
case we develop a set of measures that robustly
classes (fixed income, currencies, and
define the style in a straightforward manner. For
commodities) based on the risk decomposition
example, in the case of stocks, we use five well-
that follows:
known measures of value: book-to-price,
earnings-to-price, forecasted earnings-to-price, Stocks (32%) and industries (8%)
cash flow-to-price, and sales-to-enterprise value
(an adjusted measure of price). In other asset
Country equity index futures (20%)

Country bond futures (11%) and interest-rate

16 futures (4%)
Novy-Marx (2012).
Asness, Frazzini, and Pedersen (2012).
Frazzini, Kabiller, and Pedersen (2012) show that Warren Buffett is one
extraordinarily successful example of such an investor. Note: equity-related risk does not mean long equity market exposure. In
We deploy strategies in stocks and industries separately because of a this case 60% of the risk is in long-short styles that use some form of
wealth of evidence showing distinct predictability among industries equities, either from individual stocks, industries, or equity index futures,
separate from individual stocks (Asness, Porter, and Stevens (2000), but the exposure is equity-neutral (non-directional) in the sense that
Moskowitz and Grinblatt (1999)). equity risk is taken equally on the long and short sides.
Investing with Style: The Case for Style Investing 7

Currencies (15%) Exhibit 1: Style Premia Simulations

1990 2012
Commodity futures (10%)
Annual Excess Return 9.0% 11.5% 13.7% 9.3%
where balanced long-short strategies are deployed Volatility 10.0% 10.0% 10.0% 10.0%

within each category. These choices are based on Sharpe Ratio 0.90 1.15 1.37 0.93
Correlation to Equities 0.03 -0.03 0.22 -0.13
careful portfolio analysis that balances the
Correlation to 60% Equities/
0.03 -0.01 0.22 -0.11
correlations among the assets and styles along 40% Bonds

with capacity and liquidity considerations, all Equity Tail Return 6.5% 9.7% -2.8% 11.2%
Skew -0.37 0.02 -0.33 -0.29
designed to achieve the highest and most reliable
Kurtosis 0.43 0.57 0.69 0.10
return-to-risk ratio while helping diversify Auto-correlation 0.20 0.13 0.14 0.04
traditional portfolios. The factors or Source: AQR. Correlations are measured against the MSCI World equity
index and the Barclays Global Aggregate bond index. Equity tail return is
characteristics we select to identify each style in the styles annualized average return in the worst 10% of months for
each asset class range from very simple single global equities. Please see the Appendix for important disclosures.

factors like momentum that uses the past 12-

month return (for stocks, skipping the most Exhibit 2 presents the Sharpe ratios of the styles
recent months return), to more complicated broken out by asset class.21 The Sharpe ratios
composites of multiple factors that vary across largely range from 0.3 to 0.9, with only one being
assets (e.g., value, which uses a composite of slightly negative (value for commodities). As the
several accounting ratios to price in equities, real table shows, there is pervasive evidence across
bond yields for fixed income, and mean reversion many asset classes of the efficacy of these four
estimates for currencies and commodities). The styles.
measures used are always intuitive and attempt
Exhibit 2: Style Premia Sharpe Ratios
to achieve what we believe are the purest and
by Asset Class
strongest signals of each style, while maintaining 1990 2012
transparency and clarity. In general, our design
Stock Selection 0.82 0.97 0.95
choices favor simplicity. Industry Selection 0.07 0.92 0.40
Equity Country Selection 0.61 0.48 0.33

Exhibit 1 presents the performance results of Bonds Country Selection 0.40 0.02 0.90 0.09
Interest Rate Futures 0.69 0.89 0.65
simulations of the diversified style premia
Currencies 0.34 0.63 0.79
portfolios, highlighting the positive risk-adjusted
Commodities -0.09 0.81 0.82
returns (Sharpe ratios ranging from 0.9 to 1.4) Composite 0.90 1.15 1.37 0.93
and ability to diversify away from equity- Source: AQR.
directional risk (correlations to global equities
ranging from approximately -0.1 to 0.2). (Here
Exhibit 3 plots the cumulative gains of each style
and throughout the paper we use monthly returns
composite over time. We plot the time series from
from January 1990 to June 2012.) All strategies
are scaled to 10% annual volatility for ease of
comparison. Each style is a composite measure of The six empty cells in the matrix are due to either extreme overlap with
other strategies or difficulty in applying the style concept to some
various indicators of that style, applied across the securities. For example, the empty cells for carry strategies in equities
could be filled with dividend yield strategies, but because these strategies
seven asset classes or contexts we consider. are so similar to equity value strategies, we decided to exclude them. The
lack of defensive strategies for interest rate futures, currencies, and
commodities is because it is difficult to apply the low-beta or quality
concepts in these markets. However, we are pursuing further research
into both topics.
8 Investing with Style: The Case for Style Investing

1990 to 2012, but evidence on the efficacy of these as the styles annualized average performance in
styles in many markets goes back much further the worst 10% of months for global equities. This
(e.g., 1926 in U.S. stocks, 1970 in commodities). risk measure captures an investments correlation
with extremely bad times, when investors may
Exhibit 3: Style Premia Growth
of $1 in Log Terms care about performance the most, and therefore
1990 2012 drives risk premia according to financial theory.
Exhibit 5, which sorts asset class styles by the tail
risk measure, shows that the currency carry
premium is particularly risky. However, the tail
returns of the other styles and asset classes
oscillate above and below zero, which suggests
that a broad composite of style premia diversify
away the tail returns of each style in each asset
class and provide for long-term market neutrality.

Exhibit 5: Tail Return of Style Premia

Value Momentum Carry Defensive
by Asset Class
Source: AQR. 1990 2012
Exhibit 4 presents the correlations of the various 5%

style premia to each other. Note, that the styles 0%

provide a tremendous amount of diversification
with each other in addition to a portfolio of
traditional assets as presented in Exhibit 1. In -20%
particular, the correlation between value and
momentum is -0.6, indicating the two styles are
powerful diversifiers of each other while still both Tail Return Avg Return

having long-term positive risk-adjusted returns. Source: AQR.

The other correlations are very close to zero, with

the most positive correlation between momentum Part III: Keys to Building a Style Premia Portfolio
and carry of only 0.21.
Although the notion of style premia is
Exhibit 4: Style Premia Correlations straightforward, there is a tremendous amount of
1990 2012 judgment and experience required to properly
VALUE MOMENTUM CARRY DEFENSIVE implement a style premia portfolio in order to
VALUE 1.00
efficiently harvest returns and manage risk.
MOMENTUM -0.60 1.00
CARRY -0.08 0.21 1.00
DEFENSIVE 0.02 0.12 -0.03 1.00 Diversification is one of the key elements in style
Source: AQR. premia portfolio design. While each of the styles
employed is strong by itself, they also naturally
diversify each other (Exhibit 4) to provide even
Finally, Exhibit 5 analyzes the risk-reward
stronger performance. Furthermore, a robust
relationship of different style premia to equity
portfolio of all style-asset pairs leads to more
markets using a concept of tail return, defined
Investing with Style: The Case for Style Investing 9

consistent returns over time. While some style- long-run risk target, so as to minimize tail
asset pairs appear stronger than others over our risk.
sample period, we believe that the long-term
Risk overlays. One aspect of diversification is
efficacy of each pair is sufficiently similar to (or
making sure risk isnt too heavily
statistically indistinguishable from) others that
concentrated in any particular industry or
our aim is to build a well-balanced, diversified
country. Even after these efforts, there may
portfolio and not to over- or under-weight certain
be some unintentional directional bets that
styles. Even within styles, as discussed above, we
we then also try to mitigate by overlaying a
also try to diversify our definitions to avoid over-
final strategy beta hedge.22
reliance on any one particular measure. We are
conservative in specifying predictors, trying to Drawdown control. Beyond ex-ante
avoid complexity and overfitting, while trying to diversification, risk targeting, and exposure
capture as much of the style premia as possible. controls, we also apply disciplined drawdown
control if ex-post returns disappoint. At pre-
Beyond diversification, skillful portfolio specified drawdown levels, we scale position
construction is required, as is cost-effective sizes mechanically down based on realized
execution. When putting the building blocks losses and short term tail risk estimates. The
together, we employ many portfolio design drawdown control is only applied at the total
features that help achieve this aim, including: portfolio level (no strategy-specific stop-loss
Well-balanced risk. Balanced contributions
are maintained with the help of dynamic Efficient implementation. We seek to control
position sizing to more accurately target costs by avoiding excessive turnover and
volatility/risk. In practice, we cannot achieve trading using algorithms that systematically
exactly equal risk allocation across styles, but seek to provide rather than demand
we get close. liquidity. Each style is traded at a frequency
that allows efficient style capture without
Volatility targeting. Overall, we target 10% to
excessive trading costs. When portfolios are
12% portfolio volatility in the long run, but
built, they are optimized by taking into
allow short-term deviations from this target
account the various styles and forecasted
when agreement across style factors is
trading costs, and are traded in an efficient
abnormally high or low (as explained next).
and patient manner that seeks to minimize
Factor agreement. This reflects the amount transactions costs while maintaining low
by which the various styles lead to similar tracking error to each style.
positions. For example, if the value signal
favors European stocks but the momentum To illustrate the potential benefits of
signal favors U.S. stocks, the net position of diversification and skillful portfolio construction,
such offsetting signals will be modest. We do we simulate a composite portfolio that is roughly
not want to scale up such weak views to equally weighted (in risk terms) across the four
achieve some long-run target risk. In contrast, 22
The style premia portfolio emphasizes a market-neutral approach also
when all style signals are in agreement, the by focusing on cross-sectional long-short strategies and by avoiding
directional styles (market timing). The emphasis is on strategic harvesting
overall portfolio risk could become quite high. of consistent return sources rather than tactical positioning.
In that situation, we might cap it above the Frazzini, Israel, and Moskowitz (2012) discuss trading costs in value,
momentum, and other equity strategies.
10 Investing with Style: The Case for Style Investing

styles, following the weighting scheme above for upward biases that might be present in the
asset classes. Exhibit 6 presents summary simulated results. We think this more realistic
statistics for the composite portfolio, showing the portfolio maintains the characteristics of the four
attractive risk-adjusted, uncorrelated returns that style premia and the composite, providing strong
are obtained by combining all four style premia risk-adjusted returns (Sharpe ratio close to 1) with
into one portfolio. little correlation to traditional assets.

Exhibit 6: Style Premia Composite Simulations Exhibit 7: Style Premia Portfolio Simulations
1990 2012 1990 2012
Annual Excess Return 25.2% Annual Excess Return 9.8%
Volatility 10.0% Volatility 10.0%
Sharpe Ratio 2.52 Sharpe Ratio 0.98
Correlation to Equities 0.02 Correlation to Equities 0.01
Correlation to 60% Equities/40% Bonds 0.05 Correlation to 60% Equities/40% Bonds 0.02
Equity Tail Return 16.7% Equity Tail Return 3.0%
Skew 0.22 Skew 0.05
Kurtosis 0.51 Kurtosis 0.33
Auto-correlation 0.15 Auto-correlation 0.16
Source: AQR. Please see the Appendix for important disclosures. Source: AQR. Please see the Appendix for important disclosures.

A Sharpe ratio in excess of 2 is almost certainly not Exhibit 8 shows the cumulative excess returns
achievable, even when it is for a highly diversified (log scale) of the strategy and graphically depicts
portfolio (as it is here). As is common in academic the impact of each of the main adjustments to the
and industry writings, this Sharpe ratio is based on simple, simulated gross returns. Overlaying
simple, simulated gross returns of long-short trading costs reduces the long-run Sharpe ratio
portfolios without subtracting trading costs or fees from 2.5 to 1.9, while discounting simulated
and without any discounting for the possibility of returns reduces it further to just below 1.0. The
overfitting or 'the world has changed' arguments. further impact of risk exposure and drawdown
As a result, Exhibit 7 presents the results of a controls and that of management fees is more
realistic portfolio that starts with the composite limited once these other adjustments are
portfolio presented above, overlays real-world incorporated.
value added portfolio design and implementation
considerations, and then applies conservative,
estimated transactions costs and a level of
discounting (as high as 50%25) to adjust for any

Even if every researcher individually is meticulously careful about not
overfitting, or data mining, the general field of study may still contain
overfitted results due to the literature and practice focusing on those
studies that yielded significant results and discarding or ignoring those discounting in the more recent periods. The discounting methodology
that did not, where it is likely some of those results could have been simply subtracts off the average return over the period multiplied by the
generated by chance. Apart from overfitting concerns, it may be argued discount factor for that period from each months simulated returns,
that when factors become well known, or the costs of accessing them fall, without affecting the realized volatility of each series.
their prospective returns decline. Note that some of the benefits of aggressive risk diversification,
The actual discounting schedule varies through time, whereby there is dynamic volatility targeting and industry neutralization (in stock selection)
a greater amount of discounting in the early part of the sample and less were already included in the gross returns.
Investing with Style: The Case for Style Investing 11

Exhibit 8: Moving from Theoretical Gross Exhibit 9 plots the time-series of correlations
Returns to More Realistic Expectations between the style premia portfolio and the global
60/40 strategy as well as the DJCS hedge fund
Cumulative excess return,

8000 t-costs index. Correlations are estimated using rolling 36-
discounting month windows. There is significant time-
log scale

800 variation in the correlations through time. The
dark blue line in the graph shows that the
80 correlation of the style premia portfolio with the
60/40 traditional global portfolio ranges from -0.4
and +0.4, averaging zero over the long run. Even
Theoretical Composite Apply t-costs at the most extreme correlation of +0.4, there are
Apply discounting Apply risk overlays
Apply fees still significant diversification benefits from
investing in style premia, and over time those
Source: AQR.
benefits are larger. The same is true for the
correlation between style premia and the hedge
Part IV: Style Premia as a Portfolio Diversifier fund index, indicated by the light blue line. The
The broad style portfolio itself is highly correlations range from -0.4 to +0.5, which means
diversified, but it is more important to many there are tremendous diversification benefits
investors that it serves as an effective diversifier even at the most extreme end. Finally, the orange
for their own portfolios. We examine the line on the graph plots the correlation between
correlation of our style premia portfolio to the traditional global 60/40 portfolio and the
traditional portfolios as well as to alternatives DJCS hedge fund index. Here, the correlations
such as hedge funds. Since many institutional are much higher, averaging 0.6 over time and
portfolios hold 60% in equities and 40% in bonds, ranging from +0.3 to +0.9. Thus, the
it is appealing that the correlation between the diversification benefits of combining a traditional
style premia portfolio and the global 60/40 portfolio with traditional, hedge fund alternatives
portfolio in stocks and bonds is 0.06 on average are much smaller than they are from using style
essentially zero. The correlation between the premia. Perhaps even more disturbing is the
style premia portfolio and the hedge fund upward trend in correlations between the
composite index from DJCS is a little bit higher, traditional 60/40 strategy and hedge funds, which
but still only 0.20 on average. Hence, style premia has been creeping up over time and currently
provide extremely low correlations to traditional hovers around 0.9. The style premia portfolio
portfolios and alternative investments, making does not exhibit these trends and offers much
them a very attractive diversifier to most existing lower correlation.

We present style premia as long-short strategy returns. More
constrained investors may apply style tilts to their long-only portfolios
and get a meaningful portion of the return improvements but limited
diversification benefits. Ilmanen and Kizer (2012) show that style
diversification is more effective than asset class diversification mainly
when short-selling is allowed. Long-only style-tilted portfolios have higher
correlations with each other, with equity markets, and with other
traditional portfolios.
12 Investing with Style: The Case for Style Investing

Exhibit 9: Rolling 36-month Correlation of Style Conclusion

Premia Portfolio to Global 60/40 Portfolio and
Although the equity premium is thought to be the
Hedge Fund Index
1990 2012 most reliable source of long-run returns, most
1 investors over-rely on it and overweight it. We
believe excessive dependence on any single


0 source of risk is inefficient diversification, even

-0.5 (or perhaps especially) if everyone does it. In a
-1 world with multiple risk factors, in our opinion
there are better ways to construct portfolios. We
believe the most reliable way to sustained
Style Premia Composite vs. Global 60/40 investment success involves cost-effectively
Style Premia Composite vs. DJCS HF Index
harvesting multiple return sources such as long-
DJCS HF Index vs. Global 60/40
only market premia, style premia, and other
Source: AQR. The global 60/40 portfolio is a combination of the MSCI
World equity index and the Barclays Global Aggregate bond index. The forms of alternative risk premia. In this article we
DJCS hedge fund index uses data from the Hedge Fund Research hedge
fund index before 1994.
focused on the return and diversification benefits
of style premia and on how to construct an
efficient style strategy in a transparent and cost-
To illustrate the potential benefits of style
effective way to enhance any investment
investing as a diversifier for traditional portfolios,
Exhibit 10 shows the impact of allocating pro-
rata away from the 60/40 portfolio into the style So, why havent more investors embraced simple
composite (net of trading costs and discounting) style premia? One answer might be lack of
at three levels of investment: 10%, 20%, and 30% knowledge. Although the evidence in favor of
devoted to the style premia portfolio. As the these styles has existed in the literature for some
exhibit shows, the Sharpe ratio of the resulting time, it is somewhat scattered and not previously
combinations improves by a wide margin, linked together fully. As a result, investors often
indicating that adding a broad style composite view each style premium separately and often
may improve performance and should reduce risk chase returns across styles as their performance
exposure significantly. varies, failing to appreciate the diversification
Exhibit 10: Impact of Adding 10/20/30% benefits of combining different styles.28
of Style Premia Portfolio to Global 60/40
1990 2012 A second answer is the continual pursuit of

+ 10% + 20% + 30%

alpha. Too many investors think they can
60/40 STYLES STYLES STYLES identify alpha and find alpha producers. The
Annual Return 6.8% 7.7% 8.7% 9.6% reality is that the pursuit of alpha is very difficult
and expensive. Moreover, this pursuit has led to
Volatility 9.6% 8.8% 8.2% 7.8%
an overinvestment in high-fee hedge funds whose
Sharpe Ratio 0.30 0.44 0.59 0.74 largest exposure is traditional equity risk, since
alpha (including style premia) is often buried
Correlation to Equities 0.99 0.98 0.94 0.86
Source: AQR. Please see the Appendix for important disclosures. Indeed, one advantage of a multi-strategy style product is that it may
discourage investors from chasing recently winning strategies, which not
only provides better diversification, but also perhaps trading cost savings.
Investing with Style: The Case for Style Investing 13

within simple equity exposure. Investors

increasingly recognizing this problem have
sought alternatives. Self-servingly we note that, to
date, investors have not had access to a well-
managed broad set of long-short style factors at
reasonable fees and at risk levels that impact
their portfolios enough. Such a multi-strategy,
multi-asset-class product was simply not
available until now.

A third answer is the prevalent aversion to

leverage, shorting, and/or derivatives. An
efficient style premia strategy uses these tools.
Indeed, one of the main style premia
defensiveis itself the result of taking advantage
of other investors leverage aversion. For the
investor who can take a little LSD (leverage,
shorting, and derivatives, that is!), there is the
potential for huge rewards in terms of better and
more stable returns. Not everyone has the ability
to manage these risky tools, but we think they can
be managed successfully to produce large and
needed diversification benefits to most investors

Finally, there is also the risk of deviating from the

herd. In almost every endeavor, it is famously
dangerous to lose unconventionallyfar more
dangerous than losing conventionally. But
history also teaches us that great rewards await
pioneers, especially when the evidence is so
clearly in favor of a new path. A diversified, well-
constructed style premia portfolio may offer an
investor substantial long-term, risk-adjusted
returns that are uncorrelated with traditional
assets. We believe the improvement on the
efficiency of most existing portfolios is too great
to pass up.
14 Investing with Style: The Case for Style Investing

Related Studies

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16 Investing with Style: The Case for Style Investing


Antti Ilmanen, Ph.D., AQR Principal

Antti manages AQRs Portfolio Solutions Group, which advises institutional investors and sovereign
wealth funds, and develops the firms broad investment ideas. Before AQR, Antti spent seven years as a
senior portfolio manager at Brevan Howard, a macro hedge fund, and a decade in a variety of roles at
Salomon Brothers/Citigroup. He began his career as a central bank portfolio manager in Finland. Antti
earned M.Sc. degrees in economics and law from the University of Helsinki and a Ph.D. in finance
from the University of Chicago. Over the years, he has advised many institutional investors, including
Norways Government Pension Fund Global and the Government of Singapore Investment
Corporation. Antti has published extensively in finance and investment journals and has received a
Graham and Dodd award and Bernstein Fabozzi/Jacobs Levy awards for his articles. His book
Expected Returns (Wiley, 2011) is a broad synthesis of the central issue in investing. Antti recently
scored a rare double in winning the best-paper and runner-up award for best articles published in 2012
in The Journal of Portfolio Management (co-authored articles The Death of Diversification Has Been
Greatly Exaggerated and The Norway Model).
Ronen Israel, AQR Principal
Ronens primary focus is on portfolio management and research. He was instrumental in helping to
build AQRs Global Stock Selection group and its initial algorithmic trading capabilities, and he now
also runs the Global Alternative Premia group, which employs various investing styles across asset
classes. He has published in The Journal of Financial Economics and elsewhere, and sits on the executive
board of the University of Pennsylvanias Jerome Fisher Program in Management and Technology. He
has been a guest speaker at Harvard University, Columbia University and New York University, and is
a frequent conference speaker. Prior to AQR, Ronen was a senior analyst at Quantitative Financial
Strategies Inc. He earned a B.S. in economics from the Wharton School at Penn, a B.A.S. in biomedical
science from Penns School of Engineering and Applied Science, and an M.A. in mathematics,
specializing in mathematical finance, from Columbia..
Tobias J. Moskowitz, Ph.D., Fama Family Professor of Finance, Booth School of Business
A prominent figure in economics, who won the 2007 Fischer Black Prize, which honors the top finance
scholar in the world under the age of forty, Tobias Moskowitz is one of todays highly sought-after
economic thought leaders. He has been praised for his "ingenious and careful use of newly available
data to address fundamental questions in finance, and he brings his innovative thinking to financial
audiences around the world. Moskowitz is the Fama Family Professor of Finance at the University of
Chicago Booth School of Business and is a member of the National Bureau of Economic Research,
whose work has been cited in numerous publications and the media including CNBC, The New York
Times, Financial Times, Wall Street Journal, and a 2005 speech by then Federal Reserve Chairman Alan

We would like to thank Cliff Asness, April Frieda, Georgi Georgiev, Sarah Jiang, David Kabiller, Johnny Kang, John Liew, Thomas Maloney, and Mark Stein
for helpful comments and suggestions, and Jennifer Buck for design and layout.
Investing with Style: The Case for Style Investing 17


The information set forth herein has been obtained or derived from sources believed by the author and AQR Capital
Management, LLC (AQR) to be reliable. However, the author and AQR do not make any representation or warranty, express
or implied, as to the informations accuracy or completeness, nor does AQR recommend that the attached information serve as
the basis of any investment decision. This document has been provided to you 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 be construed as such. This document is intended exclusively for the use of the person to whom it has
been delivered by AQR and it is not to be reproduced or redistributed to any other person. AQR hereby disclaims any duty to
provide any updates or changes to the analyses contained in this presentation.

Hypothetical performance results (e.g., quantitative backtests) have many inherent limitations, some of which, but not all, are
described herein. No representation is being made that 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 hypothetical performance results and the
actual results subsequently realized by any particular trading program. One of the limitations of hypothetical performance
results is that they are generally prepared with the benefit of hindsight. In addition, hypothetical trading does not involve
financial risk, and no hypothetical trading record can completely account for the 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 points
which can adversely affect actual trading results. The hypothetical performance results contained herein represent the
application of the quantitative models as currently in effect on 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 will produce similar
results because the relevant market and economic conditions that prevailed during the hypothetical performance period will
not necessarily recur. There are numerous 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 of hypothetical performance results, all of
which can adversely affect actual trading results. Discounting factors may be applied to reduce suspected anomalies. This
backtests return, for this period, may vary depending on the date it is run.

Diversification does not eliminate the risk of experiencing investment losses.

Past performance is not an indication of future performance.

There is a risk of substantial loss associated with trading commodities, futures, options, derivatives and other financial
instruments. Before trading, investors should carefully consider 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 trading derivatives or using leverage. All funds committed to such a trading strategy should be purely risk

The Drawdown Control System described herein will not always be successful at controlling a funds risk or limiting portfolio
losses. This process may be subject to revision.
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