Rethinking Risk & Return with Cliff Asness

Greg Dowling (00:01):

Welcome to the FEG Insight Bridge. This is Greg Dowling, head of research and CIO at FEG, an institutional investment consultant and OCIO firm serving nonprofits across the U.S. This show spans global markets and institutional investments through conversations with some of the world's leading investment, economic, and philanthropic minds to provide insights on how institutional investors can survive and even thrive in the world of markets and finance.

Greg Dowling (00:31):

Today on the FEG Insight Bridge, we have Cliff Asness of AQR. He is one of my favorite people to speak with. He is both insightful and humorous, and that is a hard combo to pull off, especially for a PhD from the University of Chicago. Cliff is best known as the co-founder of AQR, but he has published, edited, and reviewed more academic research than we have time to mention. We've entitled this podcast "Rethinking Risk and Return." This allows us to address a myriad of important topics, from return expectations to portfolio construction, private equity, and diversification. Enjoy.

Greg Dowling (01:10):

Cliff, welcome to the FEG Insight Bridge. Would you mind introducing yourself and AQR?

Cliff Asness (01:15):

Sure. I'm Cliff Asness, I'm the co-founder and managing principle of AQR Capital Management. We are a quantitative money manager who's been around since 1998, which was actually quite a while ago, now that I think about it.

Greg Dowling (01:30):

[laughs] You have been around a long time, but that does not make you old, Cliff.

Cliff Asness (01:33):

No, but plenty of other things do.

Greg Dowling (01:35):

[laughs] Very good. Well, we thought it'd be fun to bounce around a little bit. We're gonna cover some of the obvious questions that investors might have, but hopefully we're going to hit on a few topics investors might not be thinking about. Probably the most important question is: Where are investors going to get their returns from? If you look at capital market assumptions--and your capital market assumptions--they look like they're gonna be pretty low. So how are investors gonna be able to hit their hurdle?

Cliff Asness (02:03):

It's gonna be hard. I want to give the standard cowardly yet accurate caveat that these have close to no power over the next year. You can say this, and for 10 years it can not happen. But we're not talking about what might happen, we're talking about what's the smart expectation to form. And real interest rates are below both on the long and the short end of the curve. Stock prices--perhaps, or perhaps not is an argument about this, fairly because of low interest rates--are extremely high against fundamentals, whether or not that's fair in some interest rate context doesn't change the fact that you make less over the ensuing long term. And I'm being consciously wishy-washy about defining that, but if I'm ever pushed, I say, "Call it 10 years."

Cliff Asness (02:49):

Forecasts are nowhere near perfect at 10 years. These kind of numbers, starting valuations for stocks and bonds--call 'em on the order, for the fellow geeks who might be listening, 40% to 50% are squares. At the risk of being completely non-quantitative and embarrassing myself, I will point out that that is not 100%. Plenty of other things can happen. Fundamentals can do wonderful. Fundamentals can collapse. You can end at a bubble. You can end at a depression. And end points matter. So it's all out explaining a fair amount historically, and it's pretty darn--to me, at least--reasonable. You can always get regressions that look good, but do they make sense? Expecting less when you're paying more for the cash flows, or getting less of a real interest rate. And the fact that that does predict fairly well. Again, not perfectly. The medium- to long-term future is very intuitive to me.

Cliff Asness (03:41):

So by and large, a stock and a bond portfolio, call it U.S. 60/40. You could do a million different versions of this, right? And to this day, I don't know why we all use 60/40. I don't think I've literally ever met anyone after 35 years in this business who has that as the exact plan benchmark. But if you look at 60/40 in the U.S., that's historically returned 5% over inflation. You may be used to looking at bigger numbers, but this is including 40% bonds and versus inflation. We think a rational expectation for the next call at 10 years would be--call it half that, I don't want to be over-precise. If you read our stuff, there's sometimes too many decimal points, which is hubris in this business.

Cliff Asness (04:20):

One of my set pieces of schtick is when a young person at my firm brings me a number and says, "We expect to make 7.316% on this strategy on average each year." And I'm like, "0.316, huh? You feel strongly about that?" We're in an industry where we're lucky if we know the sign of something often, let alone the decimal point. But call it half of history. I should point out that our forecasts--or as you call them, "Our capital market assumptions," which is a little wishy-washier than forecast--they don't include mean reversion in prices. You could go to some people I really respect, to GMO to Rob Arnott and get their forecast, and they're actually decently more bearish than ours. Because assume not just that the starting valuation is high--which has a yield effect. If you buy cash flows at a higher price, the price doesn't have to mean revert. It's like buying a bond at a lower yield.

Cliff Asness (05:11):

They also assume, and I don't want to--I think I'm getting this right, but if they disagree go with them. They also assume that these high prices today will mean revert at some point, to different degrees over different time periods. So you can get a worse medium-term forecast but a better forever forecast if that happens, because you'll be back to... So it all depends on your time horizon. There are people with time horizons long enough that they--a lot of us find it really hard to actually do this, but they should hope for a mean reversion that would be a big fall in prices now, because they're gonna earn the higher rates much longer. So I should point out that we are forecasting positive risk premium. Though if there were serious mean reversion, that could not happen. You could get a loss instead of a smaller than normal positive. But the good news is if you have a 20, 30-year horizon, that could actually be what you want. So a lot of moving parts, but we forecast, call it decently lower than history. Because everything on earth, apparently with a possible exception of value stocks, which is me talking my own book, are priced extremely expensive versus history.

Greg Dowling (06:15):

That's great. And I appreciate the caveat about talking your own book. That's always an important admittance when we're doing these things.

Cliff Asness (06:22):

Greg, I don't know how to do it another way. I always laugh when people say, "I'm not talking my own book." I'm always like, "So wait, you're not betting on what you're telling us?"

Greg Dowling (06:29):

[laughs]

Cliff Asness (06:29):

It actually almost should be assumed. But you're right, it is good to always mention.

Greg Dowling (06:33):

You stated the obvious, that interest rates are pretty low. What's the role of bonds in a portfolio and when are bonds impaired?

Cliff Asness (06:40):

Well, in a sense of a lower expected return, they're impaired right now. But in a sense of a role in a portfolio--this will sound strange as the guy who was just being pessimistic, but we think their role in a portfolio is not very different than normal. Their expected returns are very low versus history, but not appreciably lower than stocks versus history. That gap is relatively normal. The question is, can they provide diversification in a bad environment, for instance, for stocks? And there are a lot of different versions of a bad environment, right? An inflationarily bad environment... I don't think that's a word, inflationarily, but I'm going to use it.

Greg Dowling (07:17):

Go with, it.

Cliff Asness (07:18):

Would probably be bad for both of them. There are states in the world that both suffer, but there are plenty of states, particularly growth shocks, where bonds have historically protected you--growth stocks or panics where bonds have protected you well from equities. We've done a fair amount of work--and some of my colleagues have really dug into this. How much could bond yields drop from here? There's this feeling like we have this barrier at zero, so they're impaired. Two things. One ,while way lower than normal, they're still well off of zero. You get a pretty big appreciation in bonds if they drop.

Cliff Asness (07:52):

Second, the one thing I think the whole world--I feel bad about getting this wrong, but I think virtually everyone in finance got this wrong, so I have some company. If you asked me 10 years ago, can interest rates go negative? I would've said the same thing everyone else has said, "No, we just put the money in a mattress. Why should you pay a negative nominal yield?" And then it came along over the last 5, 10 years, with QE and whatnot that we do not have multi-trillion dollar mattresses. We looked around and we discovered we didn't have them. So rates can clearly go negative. And at some extreme point, people build those mattresses. I don't wanna get all science fiction on you, but if interest rate... I'll make up--now, these are not serious numbers. But if interest rates went to -10% and you could still take out your cash, people would figure out how to build Fort Knox for cash.

Greg Dowling (08:41):

Right.

Cliff Asness (08:42):

Because 10% pays a lot. But at 1% do they? I don't know. So we think while bonds are expensive, I'm not saying anything really positive about bonds in terms of the expected return, we think they're more symmetric in their outlook than many others kind of casually will throw out. Which means you're upset that everything's expensive, but you still get a benefit of diversification, in our view, though an imperfect one. It's just negatively correlated. There are states of the world where they both go down.

Greg Dowling (09:11):

That's great. I think the... Maybe to help make your point, at a certain point, you're actually just paying storage costs. If you have a lot of money, you're paying a bank to hold your cash safely.

Cliff Asness (09:23):

To hold your money safely.

Greg Dowling (09:24):

And that can make sense. Think about it like a storage unit where you have extra furniture or extra tchotchkes or whatever. And to your point about the world changing, we have digital currency.

Cliff Asness (09:32):

Yeah.

Greg Dowling (09:32):

Maybe you can't store digital currency, or digital money, in a mattress.

Cliff Asness (09:36):

And in that sci-fi world of seriously negative rates--I'm not for this at all--but the government probably has to do something to restrict the ability to take out cash and put it either in a mattress or in digital or whatnot, because then their negative rates have no power. So you get into a really weird world I don't expect to see of gigantically negative rates, but they clearly have room to be decently more negative than we thought 10 years ago. One of my favorite stories is, Fischer Black--maybe the smartest man I ever got to know in a fairly deep way. I worked right next to him at GSAM, Goldman Sachs Asset Management in the early 90s. He once called the whole fixed income team, the traders, the portfolio managers, into a room to announce that he has found something. Fischer. I said he was a genius. Nine out of 10 things he said were wacky.

Greg Dowling (10:23):

[laughs]

Cliff Asness (10:24):

One out of 10 things were smarter than anyone else ever thought about, because he didn't suffer from any group thing, and it was worth it. The tradeoff was more than worth it. It killed to be able to talk to Fischer still. But he calls everyone in and goes, "We have a new model out. I just thought you guys should know, nominal interest rates can't go negative." I don't know if he actually said that, but it was the same concept. And the whole room looked at him and kind of was like respectful, because it's Fischer, "We know that." And here are the two ironies. One, he was telling people this when rates were about 7%. So even who cared, was one thing. Fischer was not the most commercial guy all the time. But second, we all made fun of Fischer, and it turned out Fischer and all of us were all wrong, that rates actually can go at least some degree negative. So that's why I say one of the great things that the whole financial world--again, I'm not saying there wasn't two exceptions somewhere, I haven't polled every single person--what we collectively got very wrong was this notion of negative rates.

Greg Dowling (11:20):

That's absolutely true. And I want to build on the other point that you made about the 60/40 world that we live in--60/40, 70, whatever it is. It really relies, the bedrock of that is stock-bond diversification, but that's not constant. Right? What happens if that breaks down?

Cliff Asness (11:35):

If that breaks down, it could end up being good or bad, but basically volatility goes up a lot. You put these two together to reduce volatility. Historically, big negatives are not always the norm. Zero may be closer to the norm. Even small positives have existed for long periods. Large positives in correlation between stocks and bonds tend to exist in some combination of rising or volatile or high inflation. I think of it very, very simply when growth is the issue, they're negatively correlated, when inflation is the worry, they are more positively correlated. The correlation of stocks to inflation is actually quite complex. On the one hand, we're all familiar with the idea that when inflation spikes, it usually hurts stocks in some way, it's viewed as a negative for both discount rate reasons and for messing up the system reasons.

Cliff Asness (12:23):

It's also often indicative of some underlying problems. But long term, a lot of us own stocks, I think properly, because they're a great inflation hedge. They are contradictory, but they're operating in very different timeframes. If inflation increases to a new steady state and then stays there, stocks absorb that and usually are okay--maybe after some initial pain--because their earnings tend to grow faster when inflation's higher. So a lot of it is about what your time horizon is. Over decently long time horizons I still think they're big diversifier because I don't think stocks will suffer as much. Bonds will suffer if inflation just keeps going up. Over short horizons, I think volatility gets decently higher when you're in that more inflationary, positive correlation stock-bond world. You can see it in both directions. If that inflation ends up being--overused word these days, but transitory, then you can have a very good time for both going forward.

Cliff Asness (13:14):

It's not necessarily saying the portfolio is going to do worse. It's just saying it's more volatile because these things that you wanted because they're un- or negatively correlated are now positively correlated. A lot of different firms have different approaches to this and I'm not gonna talk up one or the other, but some just only deal in dollars and ride that out. Some target risk, and that is possible. It has its own risks; if you get it wrong, you can induce other issues. But if you're targeting risk, you probably have smaller dollar positions to when the correlation was running positive. So it's definitely an issue. It doesn't make me want to throw bonds out of the portfolio. Again, compared to equities adjusted for the lower risk level of bonds, they're really not worse in terms of valuation. We do think they're symmetric. But it is a scarier time than it used to be. I do think the chance of positive--which would raise everyone's ball and if you didn't take any action on it, you'd just have to ride that out--is certainly much larger than normal right now.

Greg Dowling (14:08):

Some listers may have heard of risk parity and that's kind of the basic concept of balancing it by risk.

Cliff Asness (14:13):

Yeah.

Greg Dowling (14:13):

I've heard a lot of market participants talk about the 70s and stagflation. If we have a period of stagflation, how does that diversification help or does the correlation change at all? How did the 60-40 portfolio do in the seventies?

Cliff Asness (14:27):

During the period of stagflation--and you could define it differently and whatever the end points are, someone's gonna check me and tell me I got it slightly wrong--but it was a fairly terrible time for the two. It's kind of in the name. Stocks often can hedge rising inflation if people believe their earnings will go up commensurate with it, but stagflation means a lot of people don't believe that, so you lose on both stocks and bonds. That is an extreme example of the positive-correlation-type environment that I said is certainly more of a worry today than it used to be. It is too histrionic to assume we're going to 1979 with certainty or immediacy, but are we 10% closer to that in terms of worry? Yeah, I think we are.

Greg Dowling (15:14):

Histrionic. I like that. I may add that to my lexicon. That's pretty good.

Cliff Asness (15:17):

I have my histrionic moments.

Greg Dowling (15:19):

So you were educated at the temple of market efficiency. Has your view changed on market efficiency?

Cliff Asness (15:24):

Yeah, it has. Though I have to point out, at that temple I wrote my dissertation for a guy named Gene Fama, and if that's a temple, he's the God of market efficiency.

Greg Dowling (15:34):

[laughs]

Cliff Asness (15:35):

Even Gene will tell you... Well he always shocks the class. I took the class and then I TA'd it for the next two years, so I sat through the entire class three times because you always want to know what they're knowing this week, because you're gonna do the review session that week. And it's always--or least it used to be, I'm a little out of date on this--the third week of class or something where he looks at the class and says, "Well obviously markets are almost certainly not perfectly efficient." And only in Gene Fama's class at the University of Chicago can that statement get a crowd gasping. Anywhere else it's like the Fischer Black conversation, people look at you and go, "Yeah, we know, perfect efficiency is a little crazy."

Cliff Asness (16:15):

But Gene's not crazy, he's brilliant, and he's often painted as a little more dogmatic than he is. He certainly thinks the market is more efficient than I do, probably than you do. And maybe the default assumption of efficiency is a better start for most people, but perfect efficiency is way too extreme. But I wrote my dissertation for Gene on the success of the very simple--and since then, we've all tried to expand it and it's gotten a little more complex--but the very simple price momentum strategy: buy what's going up and sell what's going down. And it was one of the scarier moments of my life or career. And he was very nice to me. He's a nice man. But this is more respect fear than danger fear. I don't want him to lose respect for me.

Cliff Asness (16:57):

I'm in his office and I say, "I think I might want to write my dissertation at least partly--it had some other things--on price momentum." And then I swear to God I mumbled the next part.

Greg Dowling (17:07):

[Laughs]

Cliff Asness (17:07):

And it works very well because that is not a very Gene concept. You can tell tortured stories, some have tried, where buying what's been going up and selling what's going down it's consistent with a fishing market that only compensates you for rational risk. I have never found any of those stories to be even vaguely reasonable. I think the notion that markets aren't perfectly efficient so they keep going a little bit more in the same direction and it also leads into why value might work, because to get misvaluations going in the same direction for a while, feels pretty consistent with eventually getting to a point. So even when I was 23, 24, I was already further from a perfect efficient marketer than Gene.

Cliff Asness (17:50):

By the way, his response after I stopped mumbling and told him the actual plan was to say, "If it's in the data, write the paper," which I still get a--in all honesty, I still like, I don't quite tear up, but I'm in the direction of tearing up. It was a beautiful statement. It was a statement from an intellectually honest man. He's not telling me, "Write what will support my work." He's saying, "If it's in the data, write the paper." And I did, and he was very supportive of it. That was then. Over time, I've certainly drifted more towards behavioralism than the efficient market risk-based story. I've not drifted all the way. For instance--people get these very confused, the idea that markets are not perfectly efficient or even substantially so doesn't imply that there's a better alternative to allocating capital.

Cliff Asness (18:34):

It's sometimes used to throw out markets and I'm like, "Okay, I totally agree they're not perfect, and sometimes they're really imperfect. What's a better way?" And it's not eight people in a room setting prices. People can go too far with this. I always hate admitting this because then it's gonna sound worse. But if you wanna make a really rough guidepost, when I was Gene's TA writing a dissertation on momentum, I believed in both. One thing, people forget all the time when they argue about these is, if there are two possible explanations, it's not either or--they both can be part of the story. I was probably two-thirds efficient markets, one-third inefficient behavioralism. Over the years, probably from living through periods like the Tech bubble in '99, 2000, the GFC, and the last few years, have moved to two-thirds, one-third the other way. I'm a little bit more of a behavioralist.

Cliff Asness (19:25):

Though again, in many parts of my career, I'm the guy who throws gasoline on a fire and starts some arguments, this is one of the few areas I consistently am the guy throwing water on the fire, saying, "Look, there's something of both these stories and it's highly unlikely that they both don't play a role." So more answer than you wanted, I'm sorry. But I still feel guilty, by the way, about it, because I love Gene. And I've been accused of sounding more like an efficient marketer when I'm in the Midwest that I do on the coast because of proximity to Gene.

Greg Dowling (19:55):

So to sum it all up, you're a Protestant, not an atheist.

Cliff Asness (19:58):

[laughs] I may be a Unitarian.

Greg Dowling (20:02):

[laughs] All right. Well we did agree that in the temple of market efficiency that Gene is Zeus, or the God, and certainly one of the pillars of that is value investing. Has your view on value investing, especially systematic value investing, changed over the years? It's been a tough few years, tough decade actually.

Cliff Asness (20:19):

Up until maybe six months ago my view was pretty unchanged. Just the world goes nuts on occasion. We know that we've actually seen it before. We've lived through it before. We've lost money during it. Both other times. Mostly '99, 2000, but also a shorter part of the GFC saw a pretty horrible value period. We've made more than all of that back. So I've been pretty calm. While I say that, I'm known for occasionally punching my computers. So calm doesn't mean I like a losing day. Calm is the intellectual, "All right, I've calmed down. The computer is smoldering in the corner. Has this actually changed anything for me?" And answer's been "no." If anything, this will sound really stubborn to some people on this, but recent research--I've written a blog on this--has made me a little more confident in the long-term returns on value.

Cliff Asness (21:08):

One thing I looked at recently, and I'm not the only one ever to look on this, but I think I did a pretty exhaustive job, is when value gets cheaper... And there's a concept, we call it the value spread. You could construct it lots of different ways, which adds confusion. Your version might not be the same as mine if you believe in different value indicators, if you do it over a different universe. But in general, the concept is the same. I can always sort stocks into expensive and cheap. Pretty much this is something we invented in '99 when we were in pain and trying to codify what it looked like going forward. At that point, to my knowledge, no one had looked at how expensive and how cheap. The academic work all sorted stocks and compared returns and ignored magnitude.

Cliff Asness (21:50):

So the value spread is, "All right, sometimes the expensive stocks scale by fundamentals, they might be price-to-book, price-to-earnings, price-to-sales." Sometimes they are five times more expensive than the cheap stocks, how you've defined it. Sometimes they're three times more expensive, tighter. And sometimes they're 12 times more expensive. Well, it turns out over both this ugly last three or four years... Value has been tough since the GFC, frankly, but a lot of forms of value actually held in there more than maybe the generic ones you hear about. You hear about price-to-book a lot, probably because of Fama, he deserves credit for that. But I do accuse him of making us all focus on price-to-book too much when it doesn't dominate our portfolios and Russell made half their index on price-to-book, which also kind of when [inaudible] did--I don't think it's the be-all end-all by any means.

Cliff Asness (22:35):

So other forms of value were flattish till the end of '17. Generic value by readabout was down already. It all got much worse. I always say the last 3 years--this has actually been a mildy good year for our versions of value. So I've got to update my story. If I say the last three years, it sounds like it's still going on. When I say last three years, if I keep saying it, I mean 2018, '19 and '20. What happened? Value lost and lost quite badly over that period, more than 100%, because the expensive got more expensive and the cheap got cheaper. That doesn't have to be the case. Value can lose or win. I don't want to put it in the negative, it's symmetric. But let me go with the loss case. It can lose because it lost on the fundamentals.

Cliff Asness (23:17):

If your earnings used to be X and now it's X divided by two, then just because the stock fell by a quarter, you got more expensive, not cheaper. And that does happen for the seven years or so after the GFC, when value had a tough time, it was mostly on the fundamentals. I'm putting a moral statement of some kind on it, I don't mean to, but a justified loss to value. It lost because the companies did worse than even what was built in the prices. And it turns out for multifactor quantitative managers--which I often forget we are these days and other people forget because value... Like every 10 years it dominates our life and I've got to remind myself and others that there are a lot of other things going on. But those seven years were a wonderful seven years for us, even though value was, for us, mediocre, and other versions were down. Because a rational loss for value means rational other factors: quality, fundamental momentum, things like low-risk investing all have a chance to save you.

Cliff Asness (24:11):

When value loses for what I will call irrational reasons, which I do believe those three years were, it turns out that price momentum is pretty much your only hope. The other ones... It's not--the fundamentals are actually fines, so if you have fundamental momentum or quality in your model that doesn't really help you, because that's not the problem, the problem is just irrational payments. And there's a limit to how much price momentum anyone... I was one of the yearly discoverers--not 'the,' I was a little bit behind Jegadeesh and Titman, but I'm still bitter about that, maybe six months behind. I like price momentum as part of a model, but too much--it has a famously bad left tail.

Cliff Asness (24:47):

As part of a model, it works great. That left tail is often offset by value. Too much of it, it starts to dominate. So there's only one thing I think has great hope to work in an irrational bubble like loss for value, and there's a limit to how much of that you can want. So this is the known dark period for a process like ours, that looks for value plus a lot of rational fundamentals. An irrational loss to value is very hard to hedge. By the way, we're not in--we're not done looking. If we ever find a factor that does great in any bubble loss for value but also does great over the long term... It's easy to find a factor that does well when value loses in a bubble, it's called "short cliffs."

Greg Dowling (25:27):

[laughs]

Cliff Asness (25:27):

And some people might be attracted to that. I have trouble recommending that to people, but I think we've made money long term, so it doesn't fulfill the second one. So kind of a holy grail of quant investing for me would be finding something that did that, but I'm not holding my breath. A process can have a period it doesn't like. If you can't predict when that's going to happen or if it starts to happen and you have no way to predict if it's going to continue or reverse, then you just have to live with it. You make your money long term, and that's your tough period. But over the last three years, we've seen value spreads move out by more than the loss in value. So it's been more than all tastes changing. And I am a believer that tastes don't change forever, they can't change forever in the same direction. We're not going to go--here's a bold statement: We're not going to go to infinite value spreads.

Cliff Asness (26:14):

And while they may or may not mean revert, the chance of it goes up the crazier they get, and they are at--the way we measure them, everyone's portfolio might measure out a little different--they are at a historical maximum exceeding the tech bubble now. So I think value is a good strategy. The odds get better and better. If I can gild the lily one more way, when I referred to recent research, I was actually talking about the long-term return on value, which is actually positive, and that's why people like us have it in models. It's positive even after the last few years. Spread started... In most historical periods people look at, the most common ones, that value spread started fairly tight--so not big differentials--and has ended, as you see now, at record levels.

Cliff Asness (26:57):

For a factor very similar to the Fama French factor. Instead of making about 1.5% per anum--that sounds like a little if you think about it compared to asset classes, but that is a spread between cheap and expensive that you can add on top of other things, so it's not that little--but it would've made... And you could say, "Would've, could've, should've," I'm talking about a hypothetical. It would've made 3% of a spread if valuation started and ended at the same point. And careful researchers often look for periods like this. So I think even a 50-, 70-year track record for value currently looks at least a little worse than the strategy should be expected to perform over the next 50, 70 years.

Cliff Asness (27:38):

Because even over that long of a period, tripling in the valuation differences can trim half of your return away. And unless you expect those value spreads to triple again--which I don't, I won't be here to tell you about it if that happens. But unless you expect that, you should use the estimate that is closer to an unchanged world. And again, just like my comment before, that's not assuming mean reversion in the spread, that's just saying we don't see a tripling again. Value is actually a better strategy than it looks like. I know it's an odd time to be lauding value's long-term track record, even, but contrarians got to contrary.

Greg Dowling (28:16):

You know, I've heard about the reverse-Arkk ETF. I like the concept of the reverse-Cliff ETF, I think that could be very valuable in certain periods.

Cliff Asness (28:24):

You know, I'd be in for the other side, if anyone's interested.

Greg Dowling (28:27):

[laughs] To all the--all your comments and how we started this whole conversation out on just traditional markets, the capital market assumptions for the next, call it 7 to 10 years, are probably gonna be below average. And so a lot of investors look at your capital market assumption page and it's like a menu and they go, "Well, I want 'this,'" and "this" right now is private equity. So many investors have said, "I need to get to my hurdle. I'm gonna do private equity." I even heard some big institutions are levering up to buy private equity and that's part of their secret sauce. I'd like to hear your thoughts on how to model private equity.

Cliff Asness (29:02):

They're going to be a wildly contradictory schizophrenic set of thoughts, though I know you'd expect no less. But they're really not, because they're looking at it in different ways. First, private equity is something I think we need in the economy. There really are these mezzanine firms. If you're gonna go to venture, startup firms. Or, again, more older firms that need a buyer and aren't in the position to go public, they're too small. That's an important function of the capital markets and private equity people. And there are parts of the world. Long-short value is something I believe in. It's something I believe is conditionally very attractive right now. I can't tell you you can't have a capital market without it. You could have a capital market without anyone ever doing that. I think you'd have a serious part of the capital markets if we didn't have something that looked like private equity.

Cliff Asness (29:49):

So in that sense, I'm a fan. I think the way to model it--and people have done this--it looks a lot like levered small cap, maybe levered small cap value. And that's more debatable, it's harder to tease out of the data, but the advantage it has--and here's where I'll put my very cynical hat on--is you don't market to market in any way, shape or form. I guess eventually you do, but it's a long, long time. And I think the evidence is sure, if you pick the best private equity managers... You commonly hear people say, "Well, you gotta be top quartile. "And I don't understand why people think it's so easy to be top quartile in private equity but not in anything else. There's not an asset class, strategy, way of managing money that if you're guaranteed your top quartile--on top of whatever the normal return is. In a really bad period, maybe top quartile gets you to flat, but you're looking good if you can guarantee top quartile.

Cliff Asness (30:38):

So I'm a little dismissive of that. It's a standard comment people make. I think most of the attraction to private equity--the extra attraction--again, is needed in an economy; therefore, it should be part of portfolios. But the extra attraction these days is, when AQR has a bad few years, we tell you about it every painful second of the day, if you want to know every painful second of the day. Private equity has had some horrible time and you often just don't know about it. Here's where I wrote a very iconoclastic piece on this saying, "We've always casually assumed that private equity earns a premium in return, a discount in the prices they pay for firms--it's very confusing because you can call it a premium or a discount depending on which you focus on--because of the illiquidity premium, that you should be paid more for the fact that you can't trade it."

Cliff Asness (31:25):

And I posed the question that--it's more than half serious, I think there's a very good chance this is part of it--that we may have the sign backwards on that. That people may be willing to give up some return for illiquidity. They could do that because they're missing it. They're just not clued in. I don't think most of them. I think investors are smart. I think they realize it often makes them a better investor. The fact--and if I can make this deeply personal--that after a very bad period for us, you have the option to redeem. There are plenty of people who actually don't want to, but they report to somebody else who doesn't know as well what's going on and it's just the path of least resistance. So the lack of that option--I think there are some smart people who value that.

Cliff Asness (32:06):

Now it's a great frustration to me because it means you're treated more harshly for providing something that we all used to think was a good thing. Insight into what the valuations are and the ability to get your money back when you want. You know, the world doesn't work out how I like it. Though I think it is important, because it means if that's true, it means adjusted for risk. And again, private equity is often levered equities, so they should have a very high expected return. The question is: is it better than you could create yourself if you levered equities? I don't think it is. I think it's actually worse, if I'm right about the premium, because people are actually paying a little extra to have that smooth returns.

Cliff Asness (32:43):

The question, of course, is even if you could build something that is both theoretically and actually gonna be long-term better than private equity by--I'll make it up--levering small cap 2.5 to 1, you're gonna have to live with that and report it to people. And I don't know if you've noticed 2.5 to 1 levered small cap, no hedge going on here. It's not long-short. You get some bone chilling returns out of it. And again, to my point, if private equity had to actually sell... I've got to tell you one more old Goldman Sachs story. This is from virtually the same time period. We had a head of private equity--whose name I will leave out, because it's not a flattering story for him and it's like 7 generations ago, so no one will know--who came up to me. This was fall of '97.

Cliff Asness (33:25):

There was something everyone's forgotten about called the Asian debt crisis, which is exactly what it sounds like. I'm going to be very insightful and tell you it was a debt crisis originating in Asia. But great contagion. The S&P dropped 7% in one day. We didn't know long-term capital is gonna happen in '98 and then the GFC was gonna happen, so that was a lot back then after a very calm period. It's a lot any day, but it was particularly crazy because the world had been very calm for about 5 years. We were thrilled, running our long-short portfolio, because we thought we'd be flat when all the dust cleared. Our P&L--a side story on the side story is our P&L actually showed we were up decently and the then-head of Goldman Sachs came by our machine. He'd just taken his tour that day, it's a terrible day. How we doing? They had a lot of money with us. Looks at our screen and it says up, I forget how much, 5%. And he's doing a little victory dance--not implying Jon Corzine actually did a dance--

Greg Dowling (34:23):

[laughs]

Cliff Asness (34:23):

--it may have been metaphoric. But he was like, "This is awesome. It's the only thing I've seen that's up today." And I had to bring him down. I had to say, "Jon that's artificial. There are some things we trade--we're actually short the U.S. and long Europe, and the U.S. is crashing while Europe is closed." A great way to look like a genius is to be short something crashing and long something closed. We thought we'd be flat and we did turn out to be flat when Europe opened up down similarly the next day. But you can't take a--a man should be thrilled with flat on that day. But if you take a man from up 5% to flat, you've depressed him.

Greg Dowling (34:57):

No dancing.

Cliff Asness (34:58):

Yes, whatever the opposite of dancing is. So that same day, a little bit later, our head of private equity comes by and just says, "How you guys holding up today?" And I had gotten smarter, I didn't let him see the machine. I said, "We're flat." And he said, "Oh, that's great, us too." I wasn't the calm elder statesman I am today who never, ever gets upset about anything, I was a younger fierier me--that's first part was sarcasm, but I was worse. I had hair then to pull on. I'm like, "You're not flat today." He goes, "What do you mean?" I go, "Well, if you went to actually sell the portfolio today versus yesterday, you're levered long equities, you'd be down, I don't know, 10%, 15%, 20%." And, to his credit, he goes, "Oh, at least," and then adds the kicker, "but we don't have to sell today."

Greg Dowling (35:48):

[laughs]

Cliff Asness (35:49):

So, again, I'm a fan of private equity in the economy. I'm a little bitter that I don't think they're actually better in terms of a risk-adjusted return than a lot of alternatives, not just ours, but they have this advantage and that I think some of their smarter clients... I used to think everyone was an idiot, that they didn't understand the volatility in private equity. And I now--this is the benefit of age and maybe some wisdom--I now think they were just smarter than me. They did get it, but they realized it actually helped them.

Cliff Asness (36:16):

And I'm not forecasting this. If we see not the AQR capital market assumptions, but the GMO capital market assumptions over the next 10 years, private equity can hide for a long time. It can't hide for a full decade. So in a timeframe that should matter a lot to people, I think they are as risky as what they own. Eventually, you're as risky as what you own. But I think it does make it a much easier ride. So I think people are a little more rational to like it, they may be paying a little too much for it, but it might still be worth it to them. And I'm very bitter that we have to tell people exactly how we're doing every day.

Greg Dowling (36:49):

You've written a lot about fair fees. And I think that in the context of private equity--and I know a few people internally at AQR have sort of coined the "Asness law." I don't even know what it is, but what is this?

Cliff Asness (37:01):

Yeah. I tried to get this. I wrote about it in a few blogs. Pathetic when you try to get a law named after you.

Greg Dowling (37:06):

Like a Sharpe ratio or something like that.

Cliff Asness (37:09):

Yeah, it just doesn't catch on. I tried, I made an effort. But it's not a law, It's really just a pithy statement, it's: There is no investment product, so good that there's not a fee that can make it bad. You know, it's not great insight. It's just a way of thinking about it. Take the famous Renaissance Medallion Fund. I don't know what the hell those guys are doing. I have a few vague ideas. But they're in a world different than everyone else. Whenever a client brings up, by the way, whenever a client brings them up to me, sometimes they'll say, "Are they better than you?" And I'll go, "Oh hell yes!"

Greg Dowling (37:40):

[laughs]

Cliff Asness (37:41):

But they won't take a nickel of your money. I think we're pretty darn good, and we actually will. So why is that relevant, that they're better? And by the way, I love Renaissance. I respect the hell out of them. But when they do institutional size mandates, they look a lot like us. They look human, like good quants, not it's only the one they keep for themselves. But that product historically has charged--when it had outside investors--very, very high fees. But if they charged 9 in '90, you'd lose in that. So to beat the obvious, fees matter, that matter a lot. I had the good fortune to be quite close to Jack Bogel. He wrote a forward to a book we wrote commemorating 20 years. It was reprints of 20 articles with new chapters introducing them. And even he wrote that it's an odd couple, an E index fund proselytizer and someone who believes in a non-perfectly efficient market, as we discussed before, and is running long-short funds.

Cliff Asness (38:37):

We did try--when we started out at AQR in '98, the first thing we did was a full hedge fund fee, very aggressive product. We always planned to build a much wider product line. We did that at Goldman Sachs. We used the same models. You don't get a different opinion about a stock if you're a long-only, beat-the-benchmark investor with us, than long-short. It was a little ironic in launching a new business to say, "We wanna run long-only, low tracking error money at a low fee." People said, "Come back when you're older and have a five year track record." And when you tell people "We have a really hot hedge fund and it's closing," they go, "Gimme some."

Cliff Asness (39:13):

And so the riskier, more expensive thing was the path of least resistance. But over time we've built out all sides of that business. And one big jump--and a lot of this occurred post-GFC--was a realization, even to ourselves and was slow-coming, that some of the things we do are fairly proprietary and we think we wouldn't give them away for a very low fee, but much of it is public and we've written about, and those things should be available at a much lower fee. And we charge more than you do for a Jack Bogle index fund, if it's a long-short factor, but if it's a long-short factor where maybe you think you're doing a very good version of something that is generally publicly known, you both shouldn't and over time you can't--back then you still could. But we lowered our own fees without pressure on that, we started differentiating what is known versus not known.

Cliff Asness (40:01):

Known and not gonna work anymore, nobody wants. But known and you still think it will generate a similar... Take for instance, value. You still think it's gonna generate money going forward. If you charge hedge fund fees for that, it's just not fair. And that's one of the things I'm most proud of in this industry, we were leaders--and everyone can argue about a specific fee, but in differentiating that fee based on capacity, how big it can be run, and how unique it is. We do think we are people who are very fee conscious, but Asness' Law is overrated. It is just a sarcastic, pithy comment about fees.

Greg Dowling (40:36):

So it's not gonna be the Treynor ratio, no Sharpe ratio. Just a very good but sarcastic comment.

Cliff Asness (40:43):

Yeah, I haven't given up total hope. It could still catch on.

Greg Dowling (40:47):

[laughs] So maybe a little bit of a retrospective from you. You hear these acronyms, and sometimes have no idea what they stand for, but AQR stands for applied quantitative research. You were one of early quants out there. Where is the industry now versus where it was when you started?

Cliff Asness (41:02):

Obviously it's a much more well-developed industry in that people know what quants are. Yeah I literally started trading quantitative strategies live in 1994 at Goldman Sachs and then relaunched them at AQR in '98. So I'm on year 27 of trading them live. My dissertation ended its data in 1990. So I like to refer to the last 31 years as my personal out-of-sample period. And by the way, if you showed me the next 30 years when I finished my dissertation, for instance, particularly for value, I would've done cartwheels that it's been nicely positive over 31 years. That's an out-of-sample test. And that's what we all want to survive. We all want something that is real, that is not just a figment of the data that holds up. I would've looked at '18 through '20 and said, "Oh man, that's gonna stink," but I would've signed for the whole thing.

Cliff Asness (41:53):

But over time, there are still problems with definitions. Calling two firms a quant, they may be uncorrelated to each other. They may do very different things, short-term versus long-term, quality versus value. So it's not like if you say, "I'm putting 10 merger-arm managers together." They're generally all long v. target, short v. acquirer. They may have different firms, but there's probably more of a commonality. Though again, because things are public, there's certainly some commonality among quants. Fees have come down for the reason we said. Over time you can't keep publishing on something again and keep trying to say, "I've got to charge premium fees for that." And it's much more of a part of the firmament for good and for bad. Bad would be if it ever got over-capitalized to the point that things got arbitraged away, which is certainly possible.

Cliff Asness (42:40):

Anyone who says that's impossible is not telling the truth. You can't get an infinite amount of blood from a stone, right? Remember that value spread I talked about before, Greg? If the history--and I'm making it up was 3 to 12, with the average being in the middle. If it went to 1.5, which it never was before and stayed there, you might say, "Well, maybe that's not an inefficient price differential. Maybe that's what the growth stocks are worth." And it's a lot of the reason we've been monitoring this thing since '99. It's not just for periods like now where we get to point at it and say, "This is ridiculous. Someone's gonna make an awful lot of money on this going forward," but it's to monitor in case it ever gets arbitraged away. I will enjoy that process.

Cliff Asness (43:20):

A running joke I've made at AQR that I don't think anyone else appreciates but they don't have the guts to tell it to me is, I look around a room with a client if they ever ask about it being arbitraged away--used to be the most common question I got before 2017. "This stuff is obviously so good, why doesn't it get arbitraged away?" Now the most common question I get is, "How can anyone stick with this stuff?"

Greg Dowling (43:41):

[laughs]

Cliff Asness (43:42):

And sometimes from the same people, which is kind of funny. "That's just the business we have chosen," as they say in the godfather. But if it ever gets arbitraged away, it probably won't come in a day. It'll be a long, slow process. And much for the same that I told you I think value returns are understated in terms of what they theoretically will generate over the long term, because they've cheapened over time, we will have--the royal "we," anyone doing value, not particularly at AQR--if it gets arbitraged away, we will have a much better than normal period getting there.

Cliff Asness (44:12):

Keep in mind, today we're, I think, the opposite of arbitraged away. We're at the nobody gives up "blank" and "blank," as opposed to fair value, as opposed to arbitraged away. But if it ever does go from here to the opposite situation, the good news is we can get a signal about that. As much as I talk about value all the time now, I'd have no problem never doing it again if it went to a level where I didn't think it would provide excess returns and you make more than normal over that period. Basically, being arbitraged away is very unpleasant going forward. It is very pleasant while it's occurring. It's someone buying what you're overweight or long and selling what you're underweight and short to narrow. It's like buying a bond because it's high yield and it becomes low yield. It's not as good going forward, but you really enjoyed that process.

Cliff Asness (44:56):

But the joke I make at AQR that gets me in trouble is I look around the room, pick the youngest AQR person and say, "So imagine 10, 15 years from now I'm ready to retire. It's all been arbitraged away. I look at Stephanie in the corner, who's taking over and say, 'The good news, Stephanie, is you are in charge. You have battled your way to the top of the AQR pyramid. You are the senior person. The bad news is I, the old guy, used up all the return. So good luck.'" Hypothetical. If it happens, we'll deal with it. I think the world has certainly changed other things. I should point out the downsides. I shouldn't only be rosy. In August of '07 there was a crazy event for quants. Many more standard deviations down in a few days than any "normal" distribution.

Cliff Asness (45:39):

That is not shocking. quants are often painted as naïve for no reason, like we all believe in a perfect bell curve. I don't know any real-world quat that doesn't think markets are fat-tailed, particularly at the very short term when you can have panics. But the size--clearly once you believe things are so-called "fat-tailed," that big things can happen more than they should. It's art, not science to say how big those things could be. And that was clearly position reductions. There are a lot of different ways to look at it. I'd written a piece at the time. I wrote a 10-year retrospective on it. That was clearly people just dumping. And when quants are a tiny part of the world, that risk is negligible because yeah, people can sell value stocks, but they're not selling something very akin to what you're doing in a systematic way.

Cliff Asness (46:24):

So there is an additional risk factor in the world. People acting the same. I think that risk factor is much lower now than it was five years ago, because we were very popular five years ago and we're not very popular now, and that risk factor is proportional to popularity. I don't think it affects long-term returns very much at all, if any. You just have to weather these periods and survive them. But I do think anything that is more widely known and accepted--and it's not unique to quant, you pick whatever you want to look at, asset classes, strategies that have been adopted by many--one of the big differences from the past is they're now susceptible to coordinated action and you do have to have some art, science, and common sense in sizing your positions so you can survive that. And we did that time, we actually added to our positions very close to the bottom, but you are in a somewhat different world when something is more well-known.

Greg Dowling (47:14):

That's helpful. And I just want to maybe ask you your opinion. Everybody talks about artificial intelligence like they know what it is. Like, "Hey, what about AI?" What is AI and is it having any impact on what you do on a day-to-day basis? And maybe how big of an impact--the magnitude of it.

Cliff Asness (47:29):

Yeah, I'd say a small one now and possibly a bigger one over time. We have a big research effort in it. In fact, I'll go further, Greg. People do say AI without really knowing all what it is, but they also say "AI big data," as if it's one big word. And it's not crazy, they do go together. Big, particularly unstructured, big data sets are things traditional statistics don't deal with super well and AI does deal with better. But you can have either of these things separate. You can have big data where you could build an old-fashioned linear model you think can work or you could have AI over more narrow decisions. But they're not crazy. They should be careful to say they're really two totally separate things. We have new database that are huge, that have nothing to do with AI techniques. But AI techniques they're not crazy, they are more applicable.

Cliff Asness (48:15):

I have a bunch of kind of scattered thoughts on it. Number one, there are some things that's not gonna change. Whether there's a value premium or not. I find it very hard to imagine. AI is about unstructured data sets, teasing something out of the data. You get one long-term realization on value... By the way, I don't want to focus just on value. The equity risk premium, you can look at it over 100, you can look at it prospectively using current valuations. I could be talked out of any of this, I'm open minded, but I don't see AI having a great impact in our view of the equity risk premium. It's not that there's so much data we haven't looked at, it's not that going to finer increments can tell us much more about the average long-term drift.

Cliff Asness (48:55):

I think of AI as much closer to an evolving arms race. Firms like ours--and we do have a big effort on this and we are implementing some of it already. So it is small, I would say, in the total impact, but there is an impact. I think it'll be much more about finding things that don't last forever. Value can last forever if markets stay some degree of inefficient, where people overdo their optimism and overdo their pessimism. You might see huge ups and downs, but there can be a positive premium to value forever in that world. I think of AI--the canonical AI is a new data set is created that didn't exist before, only a handful of firm get access to it. Because, by the way, if you're building an AI trading situation, getting access to data, negotiating for the price of data so that your clients retain a fair amount of the upside, not just the data provider, because they can charge a lot when they offer a proprietary data set, that's a big part.

Cliff Asness (49:47):

There's a practical side to implementing AI that's not all geeky. But if you are early to a new data set and have a good framework for analyzing it using machine learning, you have the chance of creating a very high, Sharpe ratio strategy that has two downsides. It will generally be lower capacity than things like value, momentum, quality, equity risk premium, certainly bond premium or huge capacity. And that, by its nature, first to a new data set, usually it's a higher frequency kind of trading. AI, again, is not particularly suited in my opinion to, "I'm gonna hold this for the next 10 years." That's more about, "Is it worth the price?" And AI--not a lot of insights on that. So I think it will create lower capacity, but also potentially--and I think in actuality--much higher Sharpe ratio strategies, risk-adjusted return for the length of time you have them.

Cliff Asness (50:38):

So look, we try to get every piece of blood out of the stone we can. We have a big effort on this, a guy named Bryan Kelly leads it for us. He's both a Yale professor and a senior person at AQR. So we're gonna keep pushing that. But I almost see it as separate than the rest of quant. The skills are fairly fungible. If you have hardcore great quants, or great academics that quants like us try to work with, those same people, not surprisingly, might be good at linear regression and at AI, but I see them as very different kinds of strategies. And AI is here to stay. Big data is here to stay. It is just a question of how far you can take it and how long it lasts.

Greg Dowling (51:15):

And the machines will not become self-aware and take over?

Cliff Asness (51:18):

You know, The Terminator is scary. I'm old enough--I only saw this in reruns, my dad made me watch it on like channel five in New York, if that means anything to anyone. But there was a movie called Colossus: The Forbin Project. That's actually my--it's very cheesy, but it's the U.S. And the USSR both build super computers for the Cold War and they start talking to each other. And of course, they decide that humans are the problem. Smart people, from Elon Musk to others, are worried about that. I have an undergraduate degree in computer science, but it was from a time I like to refer to as the 1980s and in a language I like to refer to as Fortran, so I'm not sure I'm the full up to speed on whether AI is gonna become sentient and evil. And it has to be both. If it's sentient, that's a little weird, but if it's nice, that's fine. If it's evil but not sentient, I don't even know what that means. Sentient and evil is pretty bad.

Cliff Asness (52:09):

I don't think there's a zero-risk to society on a hundred-year basis. From everything I read, it's not something I'm gonna worry about right now. And for most of us, it is what the finance geeks will call "an unhedgable state of the world." Meaning it may be terrible, it may be great, but there ain't nothing you can personally do about it. So figuring that in your plans... You know, I had a class taught by a guy named George Constantinides, he's a wonderful professor at Chicago who was giving this example of a security--totally made up--and he wrote down states of the world and the only state it was disastrous in was where the Earth is hit by way too large of an asteroid. And people are sitting there trying to debate how packs the valuation, and I hope this was me--I always remember the story as me, it might not have been me--but someone in the class said, "It's completely irrelevant. Why do we care about the return on the security where almost all of us are dead?" And it was a little morbid, but it was still the right answer. So I hope I'm not leaving everyone at the depths of despond.

Greg Dowling (53:09):

Well you've done it in a humorous way. We appreciate that. And, Cliff, this was epic and histrionic, am I using that word correctly?

Cliff Asness (53:17):

Histrionic generally means hysterical. Hysterical not in a funny way, but in a losing your "blank" kind of way, so I hope you've misstated with histrionic on that one. But I can get there, I know, at times. I've enjoyed it too, Greg, these are great questions, stuff I love talking about, and I appreciate you giving me the time and the audience.

Greg Dowling (53:35):

It was really our pleasure. And for anybody who's listening, Cliff and AQR at all, they put out a lot of great stuff. It's on their website. Go there, get signed up. Lots of both insightful and humorous items there. So, Cliff, thanks for your time today.

Cliff Asness (53:49):

Thank you, Greg.

Greg Dowling (53:51):

If you are interested in more information on FEG check out our website at www.feg.com and don't forget to subscribe to our communications so you don't miss the next episode. Please keep in mind that this information is intended to be general education that needs to be framed with the unique risk and return objectives of each client; therefore, nobody should consider these to be FEG recommendations. This podcast was prepared by FEG. Neither the information nor any opinion expressed in this podcast constitutes an offer or an invitation to make an offer to buy or sell any securities. The views and opinions expressed by guest speakers are solely their own and do not necessarily represent the views or opinions of their firm or of FEG.