This Once-Popular Strategy Is Staging a Comeback

By Joel Litman, chief investment strategist, Altimetry

In 2015, Cliff Asness was about to become the next investing household name…

His hedge fund, AQR Capital Management, had a respectable $23 billion in assets under management (“AUM”). The fund’s strategy was based on something called “factor investing.” And it was taking the world by storm.

Factor investing falls somewhere between classic stock picking and a fully quantitative approach. It involves determining the various “factors” driving market returns at any given time… and buying stocks that fit those factors.

The S&P 500 lost 1% that year. AQR gained roughly 15%. And by 2017, AQR had grown into the largest hedge fund in the world, with $226 billion in AUM.

AQR seemed unstoppable… And then, factor investing stopped working.

Over the next four years, the fund seriously underperformed the S&P 500. When the market fell 6% in 2018, AQR fell more than 10%. And when the S&P 500 rebounded 30% the next year, the fund barely eked out a 5% return.

Investors moved on, redirecting their money to fully quantitative hedge funds like Citadel and Point72 Asset Management. AQR is down to less than half its peak AUM these days… only $99 billion.

Investors are convinced factor investing is dead. However, while they’re “all in” on quantitative strategies, AQR has been quietly staging a comeback.

And as we’ll explain, that’s good news for all stock pickers… not just hedge funds.

Decades of research went into developing today’s most popular factors…

The first was the “value” factor, developed in 1977. McMaster University Professor Sanjoy Basu tested decades of stock returns. He determined that cheap companies – those with low price-to-earnings (P/E) ratios – outperformed expensive companies in the long run.

From there, practitioners and academics developed tons of other factors… like Eugene Fama and Kenneth French of the University of Chicago, who found that small stocks tend to outperform large stocks.

Several major factors have since emerged. High-profitability companies outperform low-profitability companies… stocks with positive momentum outperform stocks that are falling… and stocks with low volatility outperform volatile ones.

Here’s an important caveat, though – these factors outperform over the long term. Investors react to short-term moves.

AQR got popular at the exact wrong time… right when its strategy stopped working for a few years.

The fund seems to be back on track now. Its flagship fund returned 17% in 2021. It beat out the S&P 500 in 2022, with a 44% gain versus the market’s 18% loss. And it returned 19% last year, not far off the S&P’s 24%.

So AQR has been able to close the gap during strong years for the S&P, while outperforming the market during down years.

The factors that drive funds like AQR are working again…

That means plenty of buying opportunities are on the horizon.

We still expect the U.S. to enter a recession soon. And when that happens, the stock market will likely dip.

It will create a perfect opportunity to buy factor stocks. AQR focuses on small stocks with low volatility, low valuations, positive momentum, and high profitability.

The market rallied so much in 2023 that it’s now hard to find cheap, high-quality companies. The next time there’s a dip, true factor stocks will finally start showing up again.

Happy hunting…

Regards,

Joel Litman
January 8, 2024