advisor briefing capital management, llc two greenwich plaza greenwich, ct 06830 p: +1.203.742.3600...

AQR Capital Management, LLC

Two Greenwich Plaza

Greenwich, CT 06830

p: +1.203.742.3600

f: +1.203.742.3100

w: aqr.com

Advisor Briefing

Why Alternatives?

Key Ideas

• Alternative strategies generally seek to provide positive returns with low correlation to

traditional assets, such as stocks and bonds

• By incorporating alternative strategies, investors may enhance returns and lower portfolio

volatility, thus potentially improving risk-adjusted returns

• Portfolios that include alternative investments have shown more consistent performance across

difficult market environments

Please read important disclosures at the end of this paper.

Advisor Briefing: Why Alternatives? 1

The Evolution of Alternative Investments

Traditionally, alternatives were characterized by limited transparency, illiquidity and high

investment minimums; they were investments accessible only to institutional investors. But the

alternative investing framework has evolved, and now many of these strategies are available as

mutual funds – a structure that addresses investor concerns over transparency and liquidity.

Mutual funds can offer various benefits to investors: they are subject to greater regulations, offer

daily liquidity and provide transparency in holdings. Additionally, alternatives offered in a mutual

fund structure may also have lower fees than their private fund counterparts. In this briefing, we

focus on liquid alternative strategies and provide insight into why we believe advisors should

include alternatives in their asset allocation decisions.

What Are Alternatives?

Alternatives are typically thought of as investments other than long-only stocks and bonds.

Generally they can be divided into two categories: alternative asset classes, such as commodities

or real estate; and alternative strategies, such as classic styles or hedge fund investments.

Alternative asset classes are usually long-only and benchmark-oriented, while alternative

strategies are commonly long/short and compared to their peers or a cash benchmark.

Alternative strategies have flexibility with regard to their investment approach – for example, a

long/short strategy has the opportunity to profit in a stock’s rise or decline and, as such, offers the

potential to perform well in up or down markets. This paper focuses on long/short alternative

strategies, which are described in Exhibit 1. The exhibit includes traditional hedge fund strategies

and classic styles, both of which can be thought of as ‘alternative risk premia.’ These strategies are

well-known, empirically-tested, uncorrelated potential sources of returns that can be

systematically harvested through dynamic long/short strategies.1

The general aim of investing in an alternative strategy is to add a complementary source (or

sources) of return; one that doesn’t necessarily move in lock-step with traditional long-only assets,

whether they be equities or fixed income. In the case of convertible arbitrage, the source of return

is the “convertible bond premium,” or roughly the difference in price between the convertible bond

and its underlying components. Historically this convertible arbitrage premium, or the returns

from convertible arbitrage investing, has provided a positive return with a fairly low correlation to

a portfolio of 60% equities and 40% bonds. Another way to achieve low correlation is to focus on

strategies that seek to take advantage of a mis-pricing between relatively similar assets (i.e.,

relative value opportunities, such as equity market neutral).

1 Style exposures such as “smart betas” and other systematic tilts can be used to improve long-only portfolios, but we believe investors can maximize style benefits by using long/short strategies.

2 Advisor Briefing: Why Alternatives?

Exhibit 1 | Objectives of Alternative Strategies

Major Hedge Fund Strategies

Convertible Arbitrage Capture the discount of convertible bonds relative to the fair value of their constituent parts (bond + equity call option)

Dedicated Short Bias Profit from the inability of many investors to go short companies that are overpriced relative to their fundamentals

Emerging Markets Pursue strategies including Global Macro and various equity strategies by trading securities and currencies of emerging markets

Equity Market Neutral Capture systematic mispricing in global equity markets, typically between different stocks in the same sector

Event Driven Trade mispriced securities whose value should converge in a corporate event

Fixed Income Arbitrage Capture a range of mis-pricings in global bond and currency markets, including those

created by market participants who are not profit-maximizing

Global Macro Capture mis-pricings across major global asset classes, including stock, bond, currency, and commodity markets

Long/Short Equity Pursue a range of opportunities in global stock markets, including relative value

between sectors and growth-based stockpicking

Managed Futures Profit from the tendency of assets to exhibit short- and long-term trends

Style Premia Strategies

Value Take advantage of the tendency for relatively cheap assets to outperform relatively

expensive ones

Momentum Profit from the tendency for an asset’s recent relative performance to continue in the near future

Carry Capture the benefits of higher-yielding assets providing higher returns than lower-

yielding assets

Defensive Pursue assets with lower risk and higher quality in order to generate higher risk-adjusted returns

Source: AQR. These objectives may be subject to change and there is no guarantee they will be achieved. Note: These descriptions are meant to provide insight into the drivers of the above alternative strategy returns. While this list is not exhaustive, we believe it describes the major strategies pursued by alternatives managers.


Diversification Benefits of Alternatives

Exhibit 2 provides a framework for how alternatives can improve a portfolio’s risk/return profile.2

It shows possible combinations of risk and return for two different portfolios: one that allocates

only to traditional investments, such as stocks and bonds (the purple line), and another that

incorporates alternative investments (the green line). Investors who allocate only to stocks and

bonds may have a portfolio with risk/return characteristics shown by point A. To enhance returns

beyond the level at point A, investors in traditional assets can increase their allocation to equities;3

thereby moving along the purple line to the right of point A. However, these higher returns are

achieved by adding additional risk to the portfolio. If, on the other hand, a portfolio can allocate to

dissimilar (namely, uncorrelated) strategies in addition to stocks and bonds, it may be able to

achieve a higher return without having to increase risk. This is shown by the move from point A

on the purple stocks/bonds-only line, to point B on the green line which also includes alternatives.

The results in Exhibit 2 show that a portfolio that used alternatives was able to achieve higher

returns without having to take on more risk (i.e., move from risk/return point A to point B), or

realize the same return by actually taking less risk (move from A to C).

Exhibit 2 | Alternatives Can Be Used To Enhance Returns or Lower Portfolio Risk 1990—2013

Note: Risk is defined as volatility or standard deviation. Source: AQR. Equities are the S&P 500, bonds are the Barclays Aggregate, and alternatives are the HFRI Fund-Weighted Composite Index. Equities and bonds are gross of fees, but alternatives are net of fees. A movement along the line from left to right represents an increasing allocation to stocks, and a decreasing allocation to bonds. The green line maintains a 20% static allocation to alternatives, and varying allocations to equities and bonds based on the same methodology. This example assumes no leverage, so the weights are constrained to sum to one. For illustrative purposes only.

2 Risk is defined as standard deviation, or portfolio volatility. 3 The model assumes no leverage. Returns could also be enhanced through leverage, without having to allocate away from bonds towards equities.

2%

3%

4%

5%

6%

7%

8%

2% 5% 8% 11% 14% 17%

Ex

ce

ss

of

Ca

sh

Re

turn

Risk

Uses excessreturns

C

A

B


Portfolios with Alternative Investments May Have More Resilient Performance

Even the best-performing individual strategies can realize substantial short-term drawdowns and

go through extended periods of low returns. In contrast, a well-diversified portfolio may be more

resilient to market turmoil.

To assess this, we can look at the performance of various portfolios over time. We can model how

a seemingly well-diversified portfolio – one with capital allocation of 60% stocks and 40% bonds –

compares to one that allocates 20%4 to alternatives, away from equities and bonds on a pro-rata

basis.5 We have chosen a pro-rata reduction so as not to make assumptions about investor

allocation preferences. If an investor chooses to allocate to alternatives from equities typically

they would want to invest in a similar-volatility alternative strategy, whereas those who fund from

bonds would typically choose a lower-volatility strategy.6

Different volatility alternatives can also be used to address investor’s objectives. If the investor is

satisfied with current return expectations, but wants to reduce portfolio risk they may look to

incorporate a more conservative alternative (i.e., a lower-volatility alternative) that behaves

differently than the existing assets in the portfolio.7 Conversely, if the investor is more concerned

with increasing portfolio returns they may opt for a more aggressive alternative (i.e., a higher-

volatility alternative) to enhance returns.

In Exhibit 3 we use a broadly diversified hedge fund composite (HFRI)8 to show how alternatives

can be used in different ways to accomplish different goals.9 We show that incorporating a more

aggressive version of the alternative can help enhance returns, and that a more conservative

approach can lower risk. The first row of the table shows that including alternatives improved

excess of cash returns: from 5% for a traditional 60/40 portfolio to 5.4% for a portfolio with an

allocation to a more conservative alternative to 6.5% for a portfolio with an allocation to a more

aggressive alternative. And these higher returns were achieved without having to take on more

portfolio volatility. As a result, the risk-adjusted return, or Sharpe ratio, improved from 0.54 for a

60/40 portfolio to as high as 0.70 for the more aggressive alternative.10

But return enhancement may not be the only goal for investors; we can also look at risk. The

second column of Exhibit 3 shows that incorporating a more conservative alternative

meaningfully lowered portfolio risk: from overall volatility of 9.2% for the 60/40 portfolio to 8.4%

for one that incorporated a more conservative alternative. Lower risk in a portfolio may translate

into a smoother ride during tough times.

4 Institutional investors often allocate more than 20% or their portfolios to alternatives; but the right percent allocation will vary based on each investor’s needs. 5 A central challenge for the 60/40 portfolio is its dependence on the equity premium. Though the portfolio has 40% in bonds, the overall performance tends to be driven by equity market performance, meaning a bad year (or decade) for equities is likely to be a bad year (or decade) for the 60/40 portfolio. As a result, reallocating capital away from equities can provide the greatest benefit to diversification (due to the concentrated equity risk). In this case we have chosen to reallocate away in a pro-rata sense, reducing equities 12% and bonds 8%. 6 From the period 1990-2013 the volatility of the S&P500 was 15%, while the volatility of the Barclays Aggregate Bond Index was 4%. 7 In other words, the alternative should be uncorrelated to existing assets. Alternatives that are highly correlated with traditional assets do little to improve a portfolio’s efficiency. 8 HFRI indices may have somewhat overstated returns due to various selection biases. 9 We look at two versions of the HFRI Fund Weighted Composite Index: the ‘low volatility’ approach realizes roughly 7% over the period, while the ‘high

volatility’ version is scaled up to 12%. 10 The more aggressive alternative only realizes 12% volatility — lower than that of equities.


Exhibit 3 | Incorporating Alternatives May Improve Risk-Adjusted Returns

Incorporating a Risk Reducing Alternative

Incorporating a Return Enhancing Alternative

60/40 Portfolio

20% Allocation to Low

Volatility Alternatives

20% Allocation to High

Volatility Alternatives

Excess of Cash Return 5.0% 5.4% 6.5%

Volatility 9.2% 8.4% 9.3%

Sharpe Ratio 0.54 0.64 0.70

Source: AQR. The 60/40 portfolio weights 60% in equities (represented by the S&P 500) and 40% in bonds (the Barclays Aggregate). Alternatives are the HFRI Fund-Weighted Composite Index. Stocks and bonds are gross of fees, but alternatives are net of fees. The low volatility version realizes 7% volatility over the period, while the high volatility version is scaled up to 12% volatility. The Exhibit shows the logarithmic returns. Past performance is not a guarantee of future performance.

$90

$180

$360

$720

$1,440

1990 1995 2000 2005 2010

60/40 Portfolio

20% Allocation to Low Vol Alternatives

20% Allocation to High Vol Alternatives

Simulated Growth of $1001990—2013


Alternatives Can Protect Against Adverse Market Environments

Portfolios can also be viewed by their sensitivities to macroeconomic risks. For example, stocks

tend to suffer when economic growth contracts or is lower than expected. Similarly, bonds tend to

suffer when inflation picks up or is higher than expected. But what about other environments,

such as illiquid or volatile markets? And what about alternative investments – which macro risk

factors are they exposed to? We believe that an understanding of these relations can help investors

build better portfolios, portfolios that may be more resilient to adverse market conditions.

With this mind, we look at performance during five difficult environments:

1. Economic Contraction: when growth is down and the economy is stagnating

2. Inflationary Environments: periods where inflation has been increasing

3. Rising Real Yields: when real yields are higher on a year over year basis

4. Volatile Environments: unstable market conditions or general periods of turmoil

5. Illiquid Environments: tightening market liquidity

Exhibit 4 examines excess of cash returns in these challenging environments for the three

portfolios previously outlined. The results show that in each environment over the period, a more

diversified portfolio was able to achieve higher excess returns. Adding alternatives to a 60/40

portfolio meaningfully improved performance when growth was down, inflation was up, real

yields were rising, volatility was up, or illiquidity was increasing. In our view, diversified portfolios

that incorporate alternatives can be good hedges against economic uncertainty.

Exhibit 4 | Portfolios of Traditional and Alternative Investments in Different Environments

1990—2013

Source: AQR. The 60/40 portfolio weights 60% in equities (represented by the S&P 500) and 40% in bonds (the Barclays Aggregate). Alternatives are the HFRI Fund-Weighted Composite Index. Stocks and bonds are gross of fees, but alternatives are net of fees. The low volatility version realizes 7% volatility over the period, while the high volatility version is scaled up to 12% volatility. Past performance is not a guarantee of future performance

Ex

ce

ss

of

Ca

sh

R

etu

rns

FUNDED PRO RATAexcess

2.0%

3.2%

7.1%

-0.6%

2.7%2.8%

3.9%

7.7%

-0.1%

3.0%

3.7%

5.0%

9.1%

0.1%

3.6%

-2%

0%

2%

4%

6%

8%

10%

Growth Down Inflation Up Real Yields Up Volatility Up Illiquidity Up

60/40 Portfolio

20% Allocation to Low Vol Alternatives

20% Allocation to High Vol Alternatives

Higher Returns


Conclusion

Alternatives matter because many portfolios rely on only two sources of returns – stocks and

bonds. Alternatives can provide a new source, one that could potentially add value even when

traditional assets struggle. When used in a prudent manner, we believe these investments can play

a key role in a portfolio: they can enhance returns, provide steadier performance, and may be

more resilient across adverse market environments.


This page intentionally left blank


Disclosures

This document has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer or any advice or

recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein

has been obtained or derived from sources believed by the author and AQR Capital Management, LLC (“AQR”) to be reliable but it is not necessarily

all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the

information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. 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. The

information set forth herein has been provided to you as secondary information and should not be the primary source for any investment or allocation

decision. This document is subject to further review and revision.

Past performance is not a guarantee of future performance

This presentation is not research and should not be treated as research. This presentation does not represent valuation judgments with respect to any

financial instrument, issuer, security or sector that may be described or referenced herein and does not represent a formal or official view of AQR.

The views expressed reflect the current views as of the date hereof and neither the speaker nor AQR undertakes to advise you of any changes in the

views expressed herein. It should not be assumed that the speaker or AQR will make investment recommendations in the future that are consistent

with the views expressed herein, or use any or all of the techniques or methods of analysis described herein in managing client accounts. AQR and its

affiliates may have positions (long or short) or engage in securities transactions that are not consistent with the information and views expressed in this

presentation.

The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons.

Charts and graphs provided herein are for illustrative purposes only. The information in this presentation has been developed internally and/or

obtained from sources believed to be reliable; however, neither AQR nor the speaker guarantees the accuracy, adequacy or completeness of such

information. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other

decision.

There can be no assurance that an investment strategy will be successful. Historic market trends are not reliable indicators of actual future market

behavior or future performance of any particular investment which may differ materially, and should not be relied upon as such. Target allocations

contained herein are subject to change. There is no assurance that the target allocations will be achieved, and actual allocations may be significantly

different than that shown here. This presentation should not be viewed as a current or past recommendation or a solicitation of an offer to buy or sell

any securities or to adopt any investment strategy.

The information in this presentation may contain projections or other forward‐looking statements regarding future events, targets, forecasts or

expectations regarding the strategies described herein, and is only current as of the date indicated. There is no assurance that such events or targets

will be achieved, and may be significantly different from that shown here. The information in this presentation, including statements concerning

financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other

reasons. Performance of all cited indices is calculated on a total return basis with dividends reinvested.

The investment strategy and themes discussed herein may be unsuitable for investors depending on their specific investment objectives and financial

situation. Please note that changes in the rate of exchange of a currency may affect the value, price or income of an investment adversely.

Neither AQR nor the author assumes any duty to, nor undertakes to update forward looking statements. No representation or warranty, express or

implied, is made or given by or on behalf of AQR, the author or any other person as to the accuracy and completeness or fairness of the information

contained in this presentation, and no responsibility or liability is accepted for any such information. By accepting this presentation in its entirety, the

recipient acknowledges its understanding and acceptance of the foregoing statement.

Gross performance results do not reflect the deduction of investment advisory fees, which would reduce an investor’s actual return. For example,

assume that $1 million is invested in an account with the Firm, and this account achieves a 10% compounded annualized return, gross of fees, for five

years. At the end of five years that account would grow to $1,610,510 before the deduction of management fees. Assuming management fees of 1.00%

per year are deducted monthly from the account, the value of the account at the end of five years would be $1,532,886 and the annualized rate of return

would be 8.92%. For a 10-year period, the ending dollar values before and after fees would be $2,593,742 and $2,349,739, respectively. AQR’s asset based

fees may range up to 2.85% of assets under management, and are generally billed monthly or quarterly at the commencement of the calendar month or

quarter during which AQR will perform the services to which the fees relate. Where applicable, performance fees are generally equal to 20% of net

realized and unrealized profits each year, after restoration of any losses carried forward from prior years. In addition, AQR funds incur expenses

(including start-up, legal, accounting, audit, administrative and regulatory expenses) and may have redemption or withdrawal charges up to 2% based

on gross redemption or withdrawal proceeds. Please refer to AQR’s ADV Part 2A for more information on fees. Consultants supplied with gross results

are to use this data in accordance with SEC, CFTC, NFA or the applicable jurisdiction’s guidelines.

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 capital.

Broad-based securities indices are unmanaged and are not subject to fees and expenses typically associated with managed accounts or investment

funds. Investments cannot be made directly in an index.

S&P 500 Index: a market value weighted index consisting of 500 stocks chosen for market size, liquidity, and industry grouping, and is meant to reflect the risk/return characteristics of the large cap universe.

Barclays Capital Aggregate Bond Index: is a broad-based index used to represent investment grade bonds being traded in the United States. HFRI Fund Weighted Composite Index: a broadly-used index of hedge fund manager returns, weighted by assets under management.

AQR Capital Management, LLC Two Greenwich Plaza, Greenwich, CT 06830

p: +1.203.742.3600 I f: +1.203.742.3100 I w: aqr.com

advisor briefing capital management, llc two greenwich plaza greenwich, ct 06830 p: +1.203.742.3600...

Documents