BY

MA, HAO (140313)

NTARANGWI, FRIDAH (140155)
SAHIN, CIGDEM (140499)
SENAWIDJAYA, NELVILIA (140924)
ZENG, SIDA (140942)
HEDGE FUNDS AND INVESTMENT MANAGEMENT REGULATION

Company Profile
Facts
[1998] Established in by former Goldman Sachs workers: Clifford
Asness, David Kabiller, Robert Krail, and John Liew and headquartered in
Greenwich, Connecticut

Retail mutual funds limits

High qualified financial advisor

Open end - liquidity risk

channel

Stricter reporting and

Impressive historical performance

[2014] Over 411 employees

[Dec. 2014] Approximately $122.2 billion assets

Weaknesses

Strenghts

compensation requirements

track record for hedge funds

under

management, including assets managed by CNH Partners, an affiliate

of AQR
Hedge fund strategies focus on pure absolute return alpha, and
often involved taking both long and short positions in securities and using

Higher transaction costs

Reliable strong strategic

Higher volatility risks: common

partnerships

stock risk, counter party risks,

Extensive experience in
implementing momentum strategies

derivative risks, etc.

Increase in competitiveness

financial derivatives
First hedge-fund managers to voluntarily register at its inception

AQR

with the Securities and Exchange Commission (SEC)

In addition to traditional strategies, in 2004, the firm formed a partnership
with CNH partners, expanding their alternative offering to include

convertible arbitrage and merger strategies

[2009] AQR became one of the first investment managers offering

alternative strategies in mutual fund format

Alternative Investment
Strategies

Absolute
Return

Total
Return

Traditional Investment
Strategies

Equity

Investment Vehicles

Institutional
Investment
Vehicle

Registered Funds

Operates mainly in equity market

1

Feb. 2015 |

Funds
Mutual Funds & Hedge Funds
AQR Momentum
Fund

Hedge funds

Strong

Low

Strong

Strategy

Directional*

Directional; Arbitrage** &

Spread***

Directional

Horizon

Long or short

Long and/or short

Long

High

Low

Low

Beat the market (index

funds match the market)

Absolute return with low

volatility

Absolute return with low

volatility

Unleveraged

Leveraged

Unleveraged

Institutional and/or retail

Wealthy investors

Institutional & retail

(2010)/Institutional &
wealthy investors (2014)

Low

Min. $500,000/$1m

Min. $5000 (2010)/ min.

$5m (2014)

Liquidity

Open-end

Quarterly; lock-in period

Open-end

Short selling

Max. 30%

Unlimited

Max. 30%

Fixed by SEC

2/20 (bargain)

Fixed by SEC

Regulation

Return correlations
to market
Benchmark
(Un)Leverage
Targeted investor
Minimum Investment

Fees

Objective

Mutual funds

Replicate returns index

Actively manage portfolio

to generate active returns
Large-cap International (AIMOX)

Target
Investors

Retail &
Institutional

* A directional strategy is any trading or investment strategy that entails taking a net long or short position in a market. It is betting on the direction the overall
market is going to move in.
** Arbitrage is a trading strategy which involves the purchase and resale of an asset to exploit short-term price differences between markets in order to make a
profit.
***
2 A strategy that involves a position in one or more options so that the cost of buying an option is funded entirely or in part by selling another option in the
same underlying. Also called spreading.

Large-cap U.S. (AMOMX)

Small-cap U.S. (ASMOX)

AIMOX

ASMOX

AMOMX
Long
Term
Feb. 2015 |

Momentum Strategy
Definition
- Investment strategies
- Buying outperforming stocks
- Selling underperformed stocks
- Profit: the tendency of the outperforming
stocks to continue outperform in the near
future

Momentum Index
- Long-only
- Rebalanced quarterly
- Stocks with reasonable market cap and liquidity only as open-end

Intuition
Associated with inefficiency in markets;
driven by investor behavior:
Momentum

- Slow reaction to new information;

Long-only momentum index

Large-cap U.S.

Small-cap U.S.

Large-cap
international

Largest 1000 U.S.

stocks

Next largest 2000

U.S. stocks

Large 1000
international stocks

- Asymmetric responses to winning; and

losing investments (disposition effect)
- The "bandwagon effect
Implication
- All strategies: higher risk-adjusted
returns by adding momentum to their
portfolios
- Quality: momentum provides better
performance
- Value : momentum be an effective
complement
- Value & Quality: momentum as an
alternative to their growth allocation
3

Ranking based on performance during t-12 until t-2

Value-weighted index (by each firm in the portfolio by market
cap)
Top third ranking

MOMENTUM
INDEX

Feb. 2015 |

Challenging Issues
Boundary Stocks

Rebalance

Principle
Rebalancing frequency should be based on the primary objective of fund(= Actively
manage portfolio to generate active returns)

Frequent rebalancing => higher turnovers => higher

transaction costs => lower net returns

Rebalance quarterly
Korajczyk and Sadka (2004) : most profitable strategy for equal-weighted long
positions in winners and short positions in losers is J=11/S=1/K=3**

Tradeoff
More Frequent Rebalancing

Pros - Less tracking errors

Cons - High transaction costs

Optimal frequency
Optimal rebalancing period will be obtained when the difference between return
spread and transaction costs reaches its maximum value
Theoretical Formula:
Return Spread of Rebalancing Transaction Costs due to Rebalancing***

Critera
It is necessary to justify a trade if the transaction brings more return than
transaction costs it generates
Certain gap in rank should not be the criterion, unless it is more feasible to
implement

Scenario
Momentum strategy: based on past returns
Hybrid strategy: based on return forecast

Theoretical Formula
Return Difference of Two Stocks Transaction Costs due to Rebalancing

Example
AQR is holding the stocks of XYZ company which ranks 350th in the
Russell index this quarter
Meanwhile ABC company, not yet in the portfolio, ranks 333rd now.
If the difference in the returns of the two companies is higher than
transaction costs, then AQR can justify the trade

Solution
Excessive rate of return of fund 4.44% (Exhibit 3)
Transaction costs >1.11% (4.44%/4), the quarterly rebalancing will harm
the return of fund.
Grundy and Martin (2001): at round-trip transactions costs of 1.5%, the
profits on a momentum strategy become statistically insignificant

** (ignoring price impacts; transaction costs) (J=length of the period over which past returns are calculated; S=period of time before implementing a trading strategy; K=length of time the position is held)
***where Return Spread= Return after rebalance Return before rebalance

Feb. 2015 |

Challenging Issues
Price Impact

Tradeoff between price impact and the tracking error damage

If we sell the stocks with poor performance immediately , it will have a
price impact on the stocks
However, if we dont sell the stocks quickly, we will probably suffer
losses from the ongoing decline of stock prices

Theoretical Trade-off Formulas

Min (price impact loss + losses from tracking error)
The break-even point of funds size is important

Empirical study
Korajczyk and Sadka (2004): Taking price impact costs into
consideration, 11/1/3 momentum strategy will perform better using
value weights rather than equal weights
Value-weighting is concentrated in more liquid stocks than equalweighting
Specifically, the zero- break-even point is 200 million dollars for the
11/1/3 EW strategy, while it is more than 2 billion dollars for an
11/1/3 VW strategy

Solution
11/1/3 Value-Weighted strategy instead of Equal-Weighted strategy
to reduce the price impact and to help the fund reach a larger size
For example, the following selling period could be one option for
stocks with different exposure/ADTV ratios

Selected AQR Momentum Fund Holding Exposure (by Sep. 30, 2014)
Company

AQRs
Exposure

Average
Daily
Trading
Volume

Exposure
/ADTV

Sector

Sector
Weight in
Portfolio

Moodys Corp.

2.891.700

1.250.690

231%

Financials

6.3%

Walt Disney Co.

14.832.398

7.131.630

208%

Consumer
Discretionary

12.6%

Schlumberger Limited

15.721.274

9.960.300

158%

Energy

11.2%

Actavis PLC

3.281.408

2.605.690

126%

Health Care

14.1%

Microsoft

35.896.548

35.837.100

100%

Information
technology

31.3%

Exposure/ADTV

Recommended Selling Period

Dow Chemical Co.

9.308.100

9.625.960

97%

Materials

4.4%

E/A<20%

1 trading day

Level 3 Communications
Inc.

2.070.929

2.314.440

89%

Telecommunication
Services

0.4%

20%<E/A<40%

2 trading days

40%<E/A<60%

3 trading days

Boeing Co.

2.089.032

4.806.650

43%

Industrials

13.6%

60%<E/A<80%

4 trading days

American Electric Power

Co.. Inc.

1.023.316

2.729.030

37%

Utilities

1.0%

80%<E/A<100%

5 trading days

Coca-Cola Enterprises. Inc.

1.052.352

14.570.200

7%

Consumer Staples

4.5%

Source: AQR Capital Management. 2014 Annual Report.

Feb. 2015 |

Challenging Issues
Managing Tax
Core-and-satellite structure consists of an index-like core manager
surrounded by satellite managers
Core manager anchors the portfolio to the target benchmark where the
satellite managers have the freedom to take on added risk to achieve
higher returns
Core manager actively manages taxes and harvest opportunistically
losses which reduces the tax burden of the satellite managers
Core-and satellite structure can increase after-tax returns and/or
reduce risk
Goal is finding the allocation to the core that results in the best
risk-adjusted after-tax return over a specified period
The risk of the portfolio, as measured by tracking error, is modeled by
combining the risks of the component managers
Risk-adjusted performance is measured as the after-tax information
ratio
The allocation to the core maximizes the information ratio
Note that portfolio risk (tracking error) decreases as the core
allocation rises, because of the more tightly tracking core
The addition of a tax-managed core to a group of active managers
provides two important benefits:
(1) The core reduces the risk of the overall portfolio by providing
exposure to the broad equity market
(2) It improves after-tax return by generating capital losses to
offset realized gains

Active Approach

Seeks to outperform
Higher cost
Higher manager risk
Short-term focus
Lower tax efficiency

Core-Satellite Approach

Satellite
Core of longterm
investments

Index Approach

Seeks market returns

Lower cost
Lower manager risk
Long-term focus
Higher tax efficiency

Satellite

Combines the best

of both approaches

Tax return
After-tax returns are calculated using the historical highest individual
marginal tax rates and do not reflect the impact of state and local taxes
Actual after-tax returns depend on an investors tax situation and may
differ from those shown
After-tax returns are not relevant to investors who hold their Fund shares
through tax-deferred arrangements such as 401(k) plans or individual
retirement accounts

The answer to the question of how much to allocate to the core

depends on assumptions of market return, the pretax alpha of the
satellites, and the rate of their gain realization
6

Source: Core-and-Satellite Portfolios & Taxes, April 2003

Feb. 2015 |

Challenging Issues
Statistics of Portfolio Formed on Different Indicators
From 1964 to 2008

Short
Term
Reversal

Book
Value/Market
Value (Hi 20)

Operating
Profit (Hi 20)

Earnings/Price
(Hi 20)

Momentum
Decile 9

Momentum
Decile 10

Momentum
High-Low

S&P500

Average annual return

6.94%

15.87%

12.61%

15.90%

14.28%

20.04%

19.57%

10.67%

S.D. of annual return

11.53%

19.98%

18.92%

20.83%

19.47%

25.34%

20.44%

17.63%

Kurtosis

2.658

0.089

-0.236

0.168

0.052

-0.465

0.382

0.006

Skewness

0.721

-0.674

-0.353

-0.403

-0.309

-0.221

-0.677

-0.623

$16

$355

$105

$342

$200

$1,236

$1,473

$51

$1.00 invested grew to

20.0%

Momentum High-Low

18.0%
Earnings/Price

14.0%

BV/MV
Operating Profit

12.0%
10.0%

1,400
1,200
1,000
800
600

S&P500

8.0%

400

Short Term Reversal

Book Value/Market Value
Operating Profit
Earnings/Price
Momentum High-Low
S&P500

200

6.0%
Short Term Reversal
12.0%
11.0%

1,800
1,600

16.0%

Annual Return

Returns to One Dollar Invested

14.0%
16.0%
18.0%
20.0%
13.0%
15.0%
17 .0%
19.0%
21.0%

Annualized Volatility

Source: Adapted from Kenneth Frenchs Online Data Library, http://mba.tuck.Dartmouth.edu/pages/faculty/ken.French/data_library.html

Feb. 2015 |

Analysis Focus
Sharpe Ratio
Portfolio's returns due to smart
investment decisions or a result
of excess risk?
Good investment if higher
returns do not come with too
much additional risk
The greater a portfolio's Sharpe
ratio, the better its risk-adjusted
performance has been
Negative Sharpe ratio indicates

Tracking Error
Measures the deviation from the
benchmark
Portfolios are managed to

Information Ratio
Refers to skill of managers
Measures the excess return of
the manager's portfolio

benchmark (indexes):

divided by the amount of risk

Index fund have a tracking

that the manager takes relative

error close to zero; &

Actively managed portfolio
higher tracking error
Dividing portfolio active return

to the benchmark
The higher the information
ratio, the higher the active
return of the portfolio (given

by portfolio tracking error gives

the amount of risk taken) and

that a risk-less asset would

the information ratio, which is a

the better the manager

perform better than the security

risk adjusted performance

being analyzed

measure

Momentum Performance
Historical Performance of the AQR Momentum Indices Compared to Russell Index
AQR Momentum
Index

Russell 1000
Value Index

Russell 1000
Growth Index

Russell 1000
Index

13.7%

11.7%

10.6%

11.2%

18.6%

14.9%

18.0%

15.7%

0.38

0.35

0.23

0.30

2.5%

0.5%

-0.6%

8.1%

5.1%

4.9%

Information Ratio

0.30

0.10

-0.13

Correlation to Momentum Index

1.00

-0.50

0.43

1980 2009
Annual Return
Annualized Volatility
Sharpe Ratio
Excess Return over Russell 1000
Tracking Error to Russell 1000

AQR Small Cap Momentum Index

1 5 .0%
1 4 .0%

AQR Momentum Index

1 3 .0%

Russell 2000 Value Index

1 2 .0%

Annual ReturnRussell 1000 Value Index

1 1 .0 %
Russell 1000 Index
1 0.0%

Russell 2000 Index

Russell 1000 Growth Index

9 .0%

Russell 2000 Growth Index

8 .0%
1 2 .0% 1 4 .0% 1 6 .0% 1 8 .0% 2 0.0% 2 2 .0% 2 4 .0%

AQR Small Cap

0.7% Index
Momentum

Russell 2000
Value Index

Russell 2000
Growth Index

Russell 2000
Index

Annual Return

15.4%

12.8%

9.6%

11.2%

Annualized Volatility

22.2%

17.1%

23.0%

19.5%

Sharpe Ratio

0.40

0.36

0.13

0.24

Excess Return over Russell 1000

4.2%

1.6%

-1.6%

2009
Estimated 1980
Transaction
Costs

1 6 .0%

Annualized Volatility
0.6
0.5

Shar pe Ratio

Infor m ation Ratio

0.4
0.3
0.2
0.1
0
-0.1

Tracking Error to Russell 1000

7.0%

6.2%

5.7%

-0.2
-0.3

Information Ratio

0.60

0.25

-0.29

Source:
AQR Capital
Management. Given
9 Correlation
to Momentum
Index
1.00that the core research
-0.58on momentum was
0.51published in the early 1990s, a large portion of the results shown here are
out-of-sample. AQR Momentum Indices are historical indices and not the returns to actual portfolios

Feb. 2015 |

Momentum Performance
Adding Momentum to a Value & Growth Portfolio
Adding Momentum to a Value-Focused Portfolio

Adding Momentum to a Growth-Focused Portfolio

Growth-Focused
Portfolio

Value-Focused
Portfolio

Fully Replacing Growth

Partially Replacing
with Momentum
Growth with Momentum

5%

10%

10%

10%

Adding Some
Momentum

5%

3%
23%

45%

45%
45%
90%

8%
5%

50/50 Momentum
& Value Portfolio

68%

45%
5%

90%

90%

Portfolio Return

10.5%

12.2%

13.8%

Portfolio Return

11.8%

12.3%

12.8%

Volatility

18.2%

18.1%

18.7%

Volatility

14.9%

15.1%

15.9%

Sharpe Ratio

0.22

0.31

0.39

Sharpe Ratio

0.36

0.38

0.39

Excess Return over Russell 3000

-0.7%

1.0%

2.7%

Excess Return over Russell 3000

0.7%

1.2%

2.7%

Tracking Error to Russell 3000

4.9%

5.5%

7.9%

Tracking Error to Russell 3000

5.1%

3.3%

7.9%

1 5 .0%

Information Ratio

1 4 .0%

-0.14

Fully Replacing

1 3 .0%

Annual Return

1 2 .0%
Partially Replacing
1 1 .0%
1 0.0%
9 . 0 % Growth-Focused Portfolio
8 .0%
1 5 .0% 1 7 .0% 1 9 .0%
1 4 .0% 1 6 .0% 1 8 .0%

Annualized Volatility

10

0.6
0.5
0.4
0.3
0.2
0.1
0
-0.1
-0.2

0.18

S h a r p e Ra t i o

0.34

In for m a t i on Ra t i o

1 5 .0%

Information Ratio

Adding Some
1 4 . 0 Momentum
%
1 3 .0%
1 2 .0%

0.13

0.6
0.5

0.18

S h a r p e Ra t io

0.34

In for m a t i on Ra t io

0.4

50/50 Momentum &

Value Portfolio

1 1 .0%

Annual Return
Value-Focused Portfolio

0.3
0.2
0.1

1 0.0%

9 .0%

-0.1

8 .0%

-0.2

1 5 .0% 1 7 .0% 1 9 .0%

1 4 .0% 1 6 .0% 1 8 .0%

Annualized Volatility

Source: AQR Capital Management. January 1980 to April 2009. We assume a 90/10 split between large cap and small cap. The returns shown are gross of
transaction costs. Based on our research, adding transaction costs for the various strategies would not have a significant effect on the improvements shown.

Feb. 2015 |

Momentum Performance
Adding Momentum to a Value & Growth Portfolio

Large-Cap

Adding Momentum to a Value & Growth Portfolio

Fully Replacing Growth with

Momentum (50/50
Partially Replacing
Growth with Momentum Momentum & Value Portfolio)

Growth & Value

Portfolio

5%

5%
45%
45%

3%
23%

3%

45%

45%

45%
5%

5%

Portfolio Return

12.0%

12.8%

Volatility

15.8%

15.8%

15.9%

0.29

0.35

0.40

Excess Return over Russell 3000

0.8%

1.7%

Tracking Error to Russell 3000

1.7%

3.4%

1 5 .0%
1 4 .0%
Fully
1 3 .Replacing
0%

Annual Return

1 2 .0%
1 1 . 0 %Partially Replacing

1 0.0%
Growth & Value Portfolio
9 .0%
8 .0%
1 5 .0% 1 7 .0% 1 9 .0%
1 4 .0% 1 6 .0% 1 8 .0%

Annualized Volatility

11

Small-Cap

0.6

S h a r p e Ra t i o

In for m a t i on Ra t i o

International

Fund Type

50%
Percentile
1-Yr
Return

Fund Type

50%
Percentile
1-Yr
Return

12.21%

Small
Blended
Fund

4.24%

Internation
al Fund

5.76%

Large Value Fund

11.04%

Small Value
Fund

3.68%

AQR
Internation
al Fund

6.66%

Large Growth Fund

10.44%

Small
Growth
Fund

1.92%

AQR Large-Cap Fund

16.42%

AQR SmallCap Fund

17.72%

Fund Type

50%
Percentile
1-Yr Return

Large Blended Fund

23%

5%
11.1%

Sharpe Ratio

50% Percentile Returns of Mutual Funds with Popular Strategies (Source: Mutual
Fund Center Yahoo! Finance)

AQRs three momentum style funds outperformes the 50% percentile funds with other
strategies

Conclusion

0.5

Momentum strategy seems to be a nice way to have higher returns than other strategies

0.4

However, we cannot ignore that other strategies are also profitable

0.3

Combining strategies results in (see exhibit I):

0.2
0.1
0

Higher portfolio returns

Slightly decreases volatility
Higher sharpe ratio
Higher information ratio

Source: AQR Capital Management. January 1980 to April 2009. We assume a 90/10 split between large cap and small cap. The returns shown are gross of
transaction costs. Based on our research, adding transaction costs for the various strategies would not have a significant effect on the improvements shown.

Feb. 2015 |

Exhibit I
Performance of Value, Momentum, Profitability Strategies
U.S. Large Cap [1980 - 2012]
Simple value

Value

Momentum

Profitability

U.S. Small Cap [1980 - 2012]

VMP

Simple value

Value Momentum

Profitability

International [1990 - 2012]

VMP

Simple
value

Value

Momentum

Profitability

VMP

Return

12.6%

16.7%

15.2%

14.7%

17.3%

16.1%

18.8% 17.6%

17.5%

20.7% 8.5%

11.9%

7.7%

8.4%

11.2%

Volatility
Sharpe Ratio
Excess Return
Tracking
Error
Information
Ratio

17.2%
.45
0.6%
8.0%

18.1%
.65
4.7%
8.4%

20.6%
.50
3.2%
10.3%

16.8%
.58
2.7%
5.4%

16.6%
.74
5.3%
5.8%

20.2%
.55
4.0%
8.2%

21.7%
.64
6.8%
10.3%

23.9%
.53
5.5%
8.7%

21.5%
.58
5.5%
5.2%

19.9%
.79
8.6%
5.2%

18.4%
.28
2.4%
7.4%

18.7%
.46
5.8%
7.9%

17.5%
.25
1.6%
7.9%

15.8%
.32
2.3%
4.7%

15.7%
.50
5.1%
7.0%

.8

.56

.31

.51

.91

.49

.65

.63

1.06

1.67

.32

.74

.20

.49

.72

14

Source: The Case for Momentum Investing, AQR Capital Management, 2009

Feb. 2015 |

Recommendation

Only winners,
forget losers

MOMENTUM

QUALITY

Past 3-12 months of performance

Winners stocks outperform the
market going forward
Problem: Herding effect

Stocks of profitable, stable and growing

companies outperforms the market
going forward
Captures average-quality assets at
discount prices
Distinguish undervalued stocks from
value traps
Supply-customer chain analysis
E.g. Bershire Hathaway

Succesful
Investment

VALUE
Buy value,
pay less

12

Strategy

Fundamental to market ratios,

e.g. book equity to price, earnings
to price
Buy cheap stocks
High fundamental value stocks
outperform the market going
forward
Problem: low book to price ratios
can be overpriced

Profitability
counts

CORE-AND-SATELLITE
Taxable mutual fund investors are taxed on capital
gains or losses and dividends on stocks.
If an investment is sold then the sold part should
be identified to determine the lowest capital gains
rate or the taxable capital gain
The core-and-satellite structure provides tax
benefits
The allocation to the core that results in the best
risk-adjusted after-tax return over a specified
period

LAUNCH THIS MOMENTUM

FUNDS
Feb. 2015 |

Avoid
(double)
taxation

Recommendation (2)
Summary Stats (1927-2008)
Mkt-Rf

SMB

HML

UMD

Mean

7.64

3.56

5.14

10.92

StdDev

0.41

1.00

0.08

-0.09

Correlation Coefficients (1927-2008)

13

Mkt-Rf

SMB

HML

UMD

Mkt-Rf

1.00

0.41

0.11

-0.03

SMB

0.41

1.00

0.08

-0.09

HML

0.11

0.08

1.00

-0.30

UMD

-0.03

-0.09

-0.30

1.00

Ignoring transaction costs, Upminus-Down

momentum
strategy outperforms other
mainstream strategies in the
market

Apart from momentum strategys

outperformance, investors can
also adopt this strategy as an
complementary
to
other
mainstream strategies
Since
momentum
strategys
return is negatively related to
those of others, it can smooth the
volatility of investors total return

Feb. 2015 |