Cliff Asness is one of the most important thinkers and money managers in the business today – but I must admit I found myself utterly confounded by his Barron’s interview this weekend. There were enough inherent contradictions and non-sequiturs in the discussion that I put the iPad down and scratched my head more than once as I read it.
I was especially confused about his take on the traditional 60-40 stocks and bonds portfolio. He basically says 60-40 won’t work very well going forward because of the expensiveness of both stocks and bonds right now relative to history but provides little evidence as to why or that his alternative (risk-based weightings and leverage) will fare any better.
But perhaps the most interesting portion of the discussion centered around how Cliff Asness thinks about alpha and what type of performance is acceptable to people paying fees on ’40 Act mutual funds…
One of the quick-and-dirty definitions of alpha is outperformance against a benchmark. How do you think about alpha?
It gets a little more subtle than that. As we see it, there are three ways to generate returns. To conceptualize alpha, we actually draw a little pyramid with a base, a middle, and a top. The base is passive markets. Now, we can fight about what the allocation should be for a 60-40 portfolio, but the base of the pyramid is markets. They go up more than they go down, and over the long term, there is a positive risk premium. The top of the pyramid is alpha, but that should be truly something very few, if anyone, can produce—something that’s kind of hand-crafted, a skill that’s unique, or at least relatively unique, to one person or a handful of people. That’s worth a lot.
By the way, it can apply to a quant, as well; it doesn’t have to be a stockpicker. If you find a factor that has a great story, great data, and that no one else is on to yet, that’s alpha. If you implement the big four better than someone else, that’s alpha. But the basic idea of tilting toward value isn’t alpha. The truly unique “we visit the company and ferret out things no one else knows” approach is still worth a high fee, but what I’m discussing is worth somewhere in between that fee and an index-fund fee. And the world is moving toward making that distinction, which is positive for investors.
Is Asness right?
Are investors willing (or able) to see past the S&P 500 or a blended benchmark of traditional asset markets to mentally justify the high cost of a fancy product? I don’t think so, but maybe he’s having different discussions than I am.
Investors want lower drawdowns in down-markets and higher-than-benchmark gains in rallies – often from the same strategy or product. Irrational? Yes, of course. But that’s the expectation, no matter how vociferously a manager talks down the chances of that being feasible. I agree with Asness that this changing would be a positive for investors – I just don’t think it ever will change.