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Markets, Management and Momentum
Cliff Asness is a legendary figure in the world of investing, and his research and writing have appeared across nearly all major financial publications.
Cliff is a Founder, Managing Principal and Chief Investment Officer at AQR Capital Management. Prior to co-founding AQR, he was a Managing Director and Director of Quantitative Research for the Asset Management Division of Goldman, Sachs & Co.
To prepare for Cliff’s appearance on Infinite Loops (dropping 12 January 2023), we reviewed and synthesised over eight years’ worth of blog posts, articles and journal entries posted over at Cliff’s blog, Cliff’s Perspectives.
Here’s the result of that exercise:
Theme 1: Hedge Funds
Active management is overrated. People try too hard to beat the market and pay too much for it.
Hedge funds often pursue (and charge a high fee for) strategies that are well known and therefore should be available at more reasonable fees and with more transparency. The fees charged by hedge funds are only justifiable for unique strategies.
Hedge funds should hedge more. By hedging away more of the risk they could justify the higher fees.
The general trend over the past 20 years or so has been hedge funds turning into traditional stock pickers, just with higher fees.
One of the central questions that has interested Cliff is how much active management is necessary? What would happen if everyone indexed? Indexing has been great for investor welfare.
Criticisms of hedge funds for not having a beta of 0.0 or 1.0 are misguided. Hedge funds are generally net long on about 40% of the stock market – the remainder should come from other things that should have no direct market exposure and there should not change the beta. This makes hedge funds look particularly bad during bull runs.
To what extent is Cliff’s criticism of hedge funds contingent on the high fees charged? If hedge funds charged lower fees would this be sufficient to compensate for the other issues Cliff has flagged (insufficient hedging, conventional strategies etc)
Why do hedge funds charge such high fees? Because they can? Or is there an underlying factor that we’re missing here?
Who are hedge funds for? What do they offer at the margins that can’t be found elsewhere?
What explains the psychological appeal of active management?
How will the hedge fund industry be affected by AI?
What impact will the end of the low-interest rate, low inflation decade have on the hedge fund industry? How will hedge funds adapt to an inflationary environment? Where are the key risks and opportunities?
Will the active management industry disappear?
Active management I think is overrated. I believe certain things can win. I’ve talked about a few of them, but on average I think people try too hard to beat the market and pay too much for it.
The point of hedge funds has never been just the “hedging.” It has been, and continues to be, that they include strategies that produce positive returns over time and aren’t very correlated with the markets (the hedging was only important to get these strategies without too much market exposure).
I argue that much of the “petering out” of hedge funds in the last third of our sample is likely due to hedge funds transforming from something mostly different from traditional stock picking (from say the early 1990s to the early 2000s – and likely even more true earlier in time, but unfortunately we don’t have reliable data much earlier) to something far closer to traditional active mutual funds (early 2000s to now) … but with higher fees. For years I’ve quipped that hedge funds have a unique hypothesis to explain the common finding that active stock picking doesn’t add value over and above fees. Implicit in their response is that they think the problem with traditional active management is that they just aren’t charging enough!
I mean that they are at least partly hedged investments. Put more bluntly, it is in the freaking name! In fact our nearly twenty year old critique of hedge funds essentially lambasted them for not being hedged enough, and we maintain this lambasting (which actually can cause a charley horse over this long a time). Had the world listened to us, and hedge funds hedged more, we think hedge funds would have been better and fairer (partly because they wouldn’t be charging a performance fee for cheap easily available beta exposure) investments, but the comparison over the last nine years of bull market would look even worse for them (instead of merely being less exposed to equities in a bull market they’d have been unexposed)
The reason to worry about hedge funds is decidedly and emphatically not that they’ve failed to keep up with 100% long stocks in a nine-year bull market. That was utterly predictable given a strong bull market. The legion of commentators effectively making this fallacious argument must now stop.
But I find the story that hedge funds as a whole are now much closer to regular old traditional active stock picking, and thus less special than before, quite plausible. Given traditional active stock picking is such a consistent long-term disappointment, this ain’t good.
The related topics of, “How much active management is necessary?” (and, conversely, “How much indexing would start to be a problem for market efficiency in both pricing accuracy and liquidity?”) and the more speculative, “What would happen if everyone indexed?” are perennials that have fascinated me and many others for many years.
But all such discussion always runs into the problem of Bill Sharpe. Well, not Bill in general, but specifically his observation that, properly defined (no easy task itself since this involves proper definition of the all-encompassing capitalization weighted investable market portfolio), all active management must net to zero (before fees and trading costs; and thus lower than passive returns after these subtractions).
Nothing Lasse has written says that indexing isn’t a gigantic positive for investor welfare. Nothing Lasse has written says that active management is generally a good deal for investors as it stands now (it can still be pursued by too many for society’s sake and be too expensive for what it provides). In my view Lasse’s current work does not mean it’s easy for you to find, ex ante, a good active manager net of fees.
The word “hedging “almost by definition refers to removing that risk. Trying to create returns that go up on average but at different times than stocks. You can get that again from Mr. Bogle for about 11 basis points, near a tenth of a percent. They don’t hedge enough and they charge a lot
There’s no investment process so good that there’s not a fee high enough that can’t make it bad.
I do think hedge funds don’t hedge away a lot of the risk in return. You can get much cheaper elsewhere and then simply — on average, broad strokes, I’m insulting some people unfairly including myself — but they charge too much.
Theme 2: Value Investing
AQR is a believer in (but not solely in) value investing – that cheap stocks will outperform expensive stocks.
Value investing had a very poor decade in the 2010s, but has made a triumphant return recently.
Lots of people argue that interest rates drive the value trade. So, when interest rates go up, value goes up, and vice versa. Cliff does not agree with this – over a long period the performance of value has not had a material relation to interest rate changes.
Value’s tough period in the 2010s can be partly explained by expensive companies growing earnings, relative to the cheap companies, more than what was priced in.
Accounting for valuation changes “rescues value from the dustbin of history that many want to throw it in”.
AQR is not only value, but it believes it is a good addition to any portfolio.
AQR trades value as industry neutral. Tech vs the market is one form of value investing – AQR try not to bet on that one. They do bet on long and short-diversified portfolios of global stocks, and not industries.
Why does value and momentum tend to be inversely correlated?
Why are value stocks still cheaper than growth equities? What explains this?
How interdependent are value and growth stocks?
Can Cliff chat us through the trajectory of value stocks of the last 15 years or so?
Did the low-interest rates of the 2010s justify the divergence between growth and value over that period?
What traits are required to be a value investor relative to, e.g., a growth investor? What unique skillset do value investors have?
How do efficient market proponents explain the success of value investing strategies?
Value is getting killed. Given, I talk once every 20 years, I become value guy. I'm often momentum guy, because that's what I actually added in my research to the value world, and we've done fine for long periods of value underperformance when value loses for what I call rational reasons. If value loses because the companies underperform on the fundamentals, that's bad for a pure value investor. But we're not pure value, as most investors aren't.
Frankly, the assumption of so many pundits who state, when value versus growth has been trading correlated to interest rates and they desperately need something to say, that it makes perfect sense as growth cash flows are much longer dated, is just wrong. They should stop repeating this easy, facile, mistaken and misleading observation.
I think I have a useful way to describe value’s tough 2009-2017 Again, it varied by value methodology but even measures of value that held up better still underperformed their historical norms. and I think it’s consistent with us doing well over this same period. In a nutshell: many forms of value “deserved to lose.” By “deserved” I mean the expensive companies grew earnings (relative to the cheap) more than what was priced in. Now, we believe value “works” The scare quotes around “works” is to remind that I mean “works on average over the long term and is a good addition to a portfolio.”
That is, the market tends to pay too little/much for cheap/expensive companies, but it does not assert that the cheap companies shouldn’t be at all cheap – everything has a price. , But “on average” is just that. Sometimes you don’t get the average even over some reasonably long periods.
Besides just an inherent discomfort with randomness, part of the issue is confusion about why value works at all. It does not depend on getting big events or trends right. It does not depend on having perfect accounting information. I say “perfect” for a reason. More accurate is always better. But some inaccuracy doesn’t necessarily destroy – and certainly doesn’t reverse a value strategy – it just adds noise, lowering the Sharpe ratio (a negative, but not certain doom). In fact, we know we never have perfect measures of valuation. They all contain some “noise.”
Value is exceptionally cheap today, and it gets cheaper (and becomes clearly the cheapest ever) the closer our analysis gets to realistic implementations.
We don’t just invest in value but value, momentum, low risk, quality, etc. In particular the value/momentum relationship is vital because of their high negative correlation.
The past couple months serve as a cruel reminder that a massive valuation dislocation says very little about the timing of when it falls back to earth (we’ve never claimed otherwise, just that it does fall back to earth, and often at the times your portfolio needs the most help!).
Indeed, value is an important element of our investment philosophy, one that suffered the most in the recent times, but also the one we believe has highly favorable medium-term odds going forward, as I explain in this post. With my necessary attention to value, it should not be lost on the reader that factor investing (value and other factors that we’ve written about extensively in the past) is only one component of what we do as a firm to create long-term value for our investors.
Value (or contrarian) investing and momentum (or trend) investing have long been core to what we do and, we believe, are the strongest empirical regularities in finance.
A good year for momentum is often a bad year for value, and vise versa.
So, given we’ve traded value as industry-neutral since Bill Clinton’s first term, you can see how I find the public commentary on value a little frustrating when it is all about how “tech” is doing!
Theme 3: Momentum Investing
Momentum investing involves selling losers and buying winners (easy!). This contrasts with the mantra that you should ‘buy low, sell high’
Cliff’s two explanations for why momentum investing works is (1) underreaction – people do not sufficiently update their priors in the face of new information, and (2) overreaction – people chase prices.
Momentum is subject to black swan events. It has a big left tail. Very bad events happen more frequently than very good events.
Momentum has had long-term success in the face of criticisms such as ‘it only works for going short’, or ‘it only works among small stocks’.
Momentum contradicts the efficient market hypothesis.
In Cliff’s opinion, the best explanation for momentum is that irrational behaviour and investor biases show up in prices.
How can the efficient market hypothesis deal with momentum? Has anyone tried to argue for momentum from an efficient markets angle? Could one make the case that the higher returns are the product of the higher risk (therefore becoming a product of the efficient market)?
Is risk management more important to momentum investing than other investing strategies?
Cliff has said a couple of times that momentum investing is more susceptible to black swan events. Why is this? What actions can be taken to mitigate this?
Is the ability to read people (or human OS) more important to momentum investing than other forms of investing?
A momentum investing strategy is the rather insane proposition that you can buy a portfolio of what’s been going up for the last 6 to 12 months, sell a portfolio of what’s been going down for the last 6 to 12 months, and you beat the market.
The first is called underreaction. Simple idea that comes from behavioral psychology, the phenomenon there called anchoring and adjustment. News comes out. Price moves but not all the way. People update their priors but not fully efficiently. Therefore, just observing the price move is not going to move the same amount again but there’s some statistical tendency to continue.
Take a wild guess what our second best, in my opinion, explanation for momentum’s efficacy is? It’s called overreaction. When your two best explanations are over- and underreaction, you have somewhat of an issue, I admit. Overreaction is much more of a positive feedback. It works over time because people in fact do chase prices. So if you do it somewhat systematically and before them you make some money.
Momentum itself, getting back to that one, it has negative skewness. The geeks call that a bad left tail. Nassim Taleb would call it a black swan event. It has standard deviations you’re not supposed to see. Big events.
That was me highlighting the good side of not being a one-factor bet (i.e., that we could do well for what’s been nearly a decade of poor value returns because the rest of our process was working more than enough to offset it). Of course, this also means the opposite can occur, particularly at short horizons. Momentum, by definition, is usually pretty bad at such inflection points. It’s over longer horizon value recoveries where the combination of value and momentum may be best realized.
The long-term success of the momentum factor seems to be a challenge to many observers. People say things like “momentum only works among small stocks” or “momentum only works for going short, not long.” These comments, which appear to be aimed at casting doubt on the implementability of momentum, seem to be spoken about more than written. There’s a reason for that. When you run the numbers, these statements are just not close to true. We’ve disproven a whole gaggle of them here. But, like many misperceptions, once in the zeitgeist they remain hard to kill.
This makes sense because, as Fama discusses, it’s one of the harder factors to reconcile with the Efficient Markets Hypothesis (EMH), a contribution for which he is justifiably acclaimed. In fact, he calls momentum the “biggest embarrassment to the theory” out there.
We do note that a well-constructed value strategy diversifies momentum (and vice versa) so well that a combination strategy of the two is far better than either alone and not particularly crash-prone (that is, value, properly constructed using up-to-date prices, has done quite well during the momentum crashes making the total diversified result not extremely “crash-like”).
So, I don’t think the historical evidence that momentum is particularly “risky” (in the sense economists generally mean “risky”) is very strong. This doesn’t mean we won’t eventually find evidence that momentum is really a risk premium — just that we haven’t yet.
Momentum’s success could be from some irrational behavior and investor biases showing up in prices (as biases will show up unless they perfectly and coincidentally offset). While the field is still debating what combination of biases explains momentum’s success best, and even back in the 1980s Professor Fama could fairly describe such a search as a “fishing expedition,” I still think it likely that the lion’s share of the real explanation for momentum’s success comes from this category.
A good year for momentum is often a bad year for value, and vise versa.
Theme 4: The Size Effect
The size effect is the idea that small stocks on average outperform large stocks over time. But – small caps are generally more expensive to trade, less liquid and have less capacity for investment.
What works in large caps tends to work better in small. This is NOT the size effect. Small caps have higher market betas.
AQR do not believe in the size effect. Small firms do not historically defeat larger ones by more than their market beta. Small firms only beat large firms historically when adjusting for market beta.
But – the position is more nuanced. Although AQR do not believe in the size effect as it is typically conceived, they do believe that small stocks are generally far lower quality than big stocks. Thus any return small firms generate is more impressive as historically quality is a rewarded factor. So the fact that small stocks have kept up with large stocks after market beta adjustment is impressive, given how much lower quality small stocks are.
If you adjust small firms for their quality they look far more impressive than large ones. However, this finding is not obviously implementable.
Can Cliff chat to us about the relationship between size, liquidity and quality?
Is there a behavioural explanation for the frequency of junky small stocks? If so, why hasn’t arbitrage stepped in to plug this gap?
More generally, how important are behavioural analyses to your worldview? Is human behaviour the underlying factor behind everything? Is anything ultimately more fundamental to investing?
Why are small firms generally more junky than large firms?
Cliff says that his findings for the QMJ size effect are not obviously implementable. But isn’t the answer ‘just’ to do your homework and find quality (i.e. non junky) small stocks?
Anything you find works in large‑caps tends to work somewhat better in small.
First off, we do not reject that historically small firms have had larger average returns than big ones (though the victory is pretty meager). Some think that shows the existence of the size effect. They’re wrong.
If small stocks outperform, but it’s solely because of having higher market betas, nobody in modern finance would (or should) call that a small firm effect.
So, net of using the more accurate databases today versus those used in the original work and this adjustment for underestimated betas (using lags), you really don’t find any size effect. Zippo. Nada. In our size/junk paper we went and confused some people (we really tried not to!). We confirmed the lack of existence of a simple size effect but showed that small stocks were far lower “quality” than big stocks. Thus, any return they generate is, in fact, more impressive as historically quality is a rewarded factor, so small stocks face a rather severe headwind. In English, it is quite a feat for small stocks to even keep up with large stocks (after market beta adjustment) given that small stocks are far lower quality. We found this decidedly non-simple size effect to be impressive.
In both papers we say that size doesn’t really work alone (the “simple” size effect adjusting for only market beta) and in both papers we say (the main focus of one paper and a section of the other) that only when considering they’re fighting the successful quality factor are small vs. large returns impressive. These are not at all contradictory.
We, consistently across both papers, find the simple small firm effect doesn’t exist, as small firms do not historically defeat large ones by more than their market beta. And we, consistently across both papers, find that small firms indeed look much more impressive than large ones if you also adjust for their lower quality (not generally what people have called the small firm effect!). The message is consistent and straightforward (if indeed more complicated than when quality is left out).
To summarize, - Small stocks beat large stocks historically but that’s only before adjusting for market beta, an adjustment we’ve all been doing in this field when studying size since the early 1980s. - Any way you slice the above there is nothing even resembling a long-term simple small firm effect (where the returns of small stocks are greater than larger ones by more than implied by their market betas). - Adding in lags to account for illiquidity takes the historically weak small firm effect and renders it non-existent. - This is most clear when looking at daily returns. Small stocks are so illiquid that even though they truly have betas considerably greater than large stocks, simple contemporaneous regressions erroneously show them to be much smaller. Adjusting for that leads to a dramatic turnaround in beta (and dramatic reduction in realized alpha) that perhaps even better illustrates the phenomenon than the monthly results we’ve focused on in prior work. - In separate work we show a different size effect, the size effect net of the quality factor, is quite strong (though we acknowledge this finding is not obviously implementable).
Does size matter? Certainly in financial markets, many researchers have questioned whether it does. In a new paper, we resurrect the size premium and restore it to its proper place alongside such stalwarts as value and momentum in terms of its efficacy and robustness
The perhaps surprising result is that despite this discount and premium in pricing, quality stocks strongly and significantly outperform junk stocks
In our paper, we introduced the concept of a Quality-Minus-Junk (QMJ) factor that captured this phenomenon. The many formidable challenges to size all disappear with the introduction of the QMJ factor. It turns out that small stocks are quite “junky” versus their larger counterparts, and it is this exposure that is dampening their performance.
Once you account for the QMJ exposure a large and significant size premium re-emerges
Along with much stronger economic and statistical significance, the small firm effect also, not shockingly, gets far more consistent when controlling for quality.
The long list of objections to the small-firm effect is crossed out one by one, when you control for quality/junk.
The standard size effect, as typically measured in the literature, is fighting a strong headwind from low-quality small stocks. Once the headwind is removed, focusing instead on quality-neutral stocks, the small-stock premium is strong.
We find that if you control for the other major factors, most importantly quality, there is a large restored (versus other work finding only a modest small-firm effect) premium to small versus large.
Theme 5: Leverage & Diversification
The conventional wisdom that sensible investors avoid leverage does not hold.
When applied correctly, leverage serves a useful purpose.
Leverage should be used to diversify, not to amplify. Concentration risk is real, and leverage allows investors to diversify away from this risk.
In other words, leverage can be used to allow investors to take on the same level of risk but with a more diversified and higher return for the risk-taken portfolio.
The cost of diversification is a story-telling one – it is very hard to explain and tell a story around the performance of a diversified portfolio. This makes it harder for people to stick it out during tough periods.
People may therefore pick concentrated strategies as they are easier to justify.
How will the role of leverage in the hedge fund industry change in an inflationary, high-interest rate environment?
Should hedge fund leverage be regulated?
Why is leverage typically used to amplify rather than diversify? What’s the explanation here?
How important a skill is storytelling to a successful investor? How has Cliff improved as a storyteller? How correlated does the story have to be with the truth?
What is Cliff’s opinion on Taleb’s barbell strategy? Does this fit within his model of diversification?
Again, leverage is not riskless. In the perfect theoretical world, not everyone should leverage to the moon if you’re very aggressive. But neither is concentration, neither is moving your money into fewer and fewer assets. We don’t tell people leverage is riskless. We do tell people we think people think it’s over-risky versus concentration.
But I think people prefer concentration risk to leverage risk to their detriment.
Conventional wisdom holds that sensible investors avoid leverage. This is unfortunate. Sadly, the valuable role of leverage, applied prudently and used to diversify, not simply amplify, is widely misunderstood.
Consider how investors often seek higher returns through more concentrated portfolios, say through greater equity exposure (concentrating in the more aggressive asset class). However, modest use of leverage can allow investors not to take on more risk, but to take the same level of risk but with a more diversified, more balanced, higher-return-for-the-risk-taken portfolio.
In this way, modestly levering a better, more diversified portfolio may improve upon an unlevered, much less diversified one — a rather sensible approach; one that is consistent with finance theory and will likely compensate investors for the necessity of employing some leverage.
Yes, lever, but in pursuit of diversification not just amplification, and prudently.
Maybe, maybe not, but if an asset is diversifying does it need to have as high an expected return as the most aggressive part of your portfolio? In a world where leverage is very expensive and/or scary and risk tolerances are quite high, this can be an interesting debate (if one wants higher return/risk but without the ability "or inclination" to lever, then risky unlevered assets like equities may be the preferred choice).
I think it is some debt aversion. It also might be less irrational and more constraint. There may be people who just can’t. Mutual funds can literally leverage a little. Most have in their charters, “we won’t leverage.” So, if you’re constrained, you have to do something.
Diversification is often called the only free lunch in investing. But, here, perhaps, we see that it has a more subtle cost coming through weaker intuition and harder story-telling (and thus portfolios that are harder to stick to – a prerequisite for any successful strategy). Perhaps this difficulty is why the strategy doesn’t get easily arbitraged away and is still available to those who can weather its tough times? A single stock portfolio is super simple and performance is quite easily explainable after good and bad times. But it’s a disastrous ex ante choice. While there may be exceptions, it seems the more truly diversified a portfolio is, often the less simple and intuitive are its returns.
Theme 6: Time Horizons
There is way too much focus on short-term performance.
Patience is worth a lot of alpha. Just hold on in there (provided of course that you are happy with your fundamentals). This is particularly hard in short-term down periods.
Natural human tendency is to try and get out in painful periods. It is not as easy to stick with it as it sounds.
Anything should be evaluated over as long a time period as possible.
AQR is broadly against market timing (investing based on predictive methods) – outperforming a passive buy and hold approach is harder than it seems. It has however argued that it can be good to “sin a little”, but based on the principles of value and momentum, and not based on high return for high risk hopes or binary action (e.g. getting out entirely)
What mental strategies has Cliff developed for dealing with short-term down periods?
There is a tension between (a) trusting the long term, and (b) being inflexible and failing to update your priors. How does Cliff resolve this tension? How does he determine the signal from the noise?
What does the investing community get wrong about market timing? Why is it so misunderstood? Why is it thought of in binary terms?
Let’s steelman market timing – what’s Cliff’s strongest case for it?
There is just way too much focus on short-term performance. The media write about it constantly, and investor flows in aggregate (not everyone!) seem to follow it too much.
The long haul is a really long time. It sometimes feels like several lifetimes to actually live through it. Without trying to quantify it here, I’d wager that remembering and implementing these lessons (patience, how long is long term?, basic relationships holding up if you only have enough patience, etc.) are worth a lot of “alpha” in a loose use of that word, and are available to all free of charge. Well, free of charge unless you count the internal organ damage some of those “short-term” periods can inflict.
As my colleagues pointed out, again written in very good times for us, much of Warren Buffett’s edge has not been about never losing or about possessing a 2+ Sharpe ratio (he doesn’t), but rather sticking with something good, in his case aggressively, for his preferred time horizon of forever.
Despite our shared belief in these ideas (or else why were we doing them together?), we knew (for quite a while and before any tough times hit) that sticking with them through the inevitable painful periods, which always seem to be at the outer edge of what you might have guessed possible, would be much harder than it should be in a world of cold scientific automatons.
At the risk of being too obvious – we think the lesson here is do something you believe in based on basic economics and as much evidence as humanly possible, that can be done at high capacity and generates reasonable risk-adjusted returns that improve your portfolio, and then stick to it Stick to it only after always reviewing whether you’re missing something or whether recent performance is a consequence of something understandable and perhaps preventable (in which case you shouldn’t stick to it like grim death… you should change!).
As we have demonstrated over the last 14-15 months, we cannot control short-term performance (we hope we have some control, we certainly do have confidence, in our ability to generate great outcomes for our clients in the long term).
we are largely left with continuing to enhance our process as we always do while rooting (and root we do!) for long-term themes (like value, momentum, carry, quality, etc.) that we believe in deeply to go back to delivering soon. There is just frustratingly little one can actually do (barring actually finding a smoking gun) in the short term when strategies with good,
It’s over longer horizon value recoveries where the combination of value and momentum may be best realized.
First, a disclaimer. We are not suddenly pro-market timing. We have always either advocated against it, or, at the most, argued for sinning a little (meaning don’t do much of it or only do it at true extremes – and even then don’t do that much of it!).
How much, if at all, you choose to sin or not sin because of super-low U.S. yields, is, of course, up to you. Our recommendation is, again, you probably should do less than you first think.
While we are clearly circumspect about betting a lot on contrarian market timing, we are certainly way more than circumspect, downright suspect, of this kind of anti-contrarian market timing!
We (and all other managers, as we’re all in the same boat) are not as good as many implicitly believe when we did great last month (or year or even sometimes longer), and certainly not as dumb as some will think after bad times.
Something that is often attacked, the high frequency trading, has made the world more just and fair, particularly for small investors.
Theme 7: Shorting
Responsible investing’s ultimate goal is to effect change. Shorting is a compelling way to achieve this (and more compelling than simply not holding offending stocks in your portfolio).
Shorting is also a way to hedge risks. Hedging is far easier with shorting.
Shorting allows portfolio managers to express their investment views. It also is a way to hedge risks. Finally, it actually has an impact on the shorted company.
Shorting raises the cost of capital. Ultimately, this makes certain projects less attractive as projects with higher capital are less likely to have positive net present value. So shorting offending stocks can ultimately dissuade certain projects from taking place, thus having a direct impact. This has clear applications to ESG – high emission projects etc.
Is ESG here to stay? Is ESG a Potemkin concept?
Could overly ESG-friendly companies be victims of short-selling? Short selling works both ways!
Cliff’s argument for short-selling badly behaved companies (rather than excluding them from your portfolio) seems fairly novel – I’ve seen it suggested in one place that the AQR fund offering this may be the first of its kind. Why is this? Do people have an aversion to this strategy? Why?
How different would the investing landscape be if short selling wasn’t permitted?
Well, the proper treatment of shorting matters for the ultimate goal of responsible investing: to effect change
First, shorting is a great way for portfolio managers to express their investment views. The obvious point is that if a manager expects a security to do poorly, simply not holding it is a less significant expression of that view than shorting. This is, of course, not particular to ESG. Second, shorting is a great way to hedge risks, including those of an ESG nature. Third, many ESG-oriented investors seek impact through their financial portfolios. Impact is never easy, but the most realistic case by far for affecting the real economy is holding a large position in an issuer, voting shares, engaging, and maybe even getting a seat on the board. None of this will happen if the investor takes no position in the company. But you can have some impact when you short a company – not as much as a long investor, but more than a non-investor (and, of course, adding shorting doesn’t detract from your ability to impact through your long positions).
Some might think this is a long-term view and that shorts are only useful for short-term positioning. That’s just not true, at least not for AQR and (probably) similar managers. We typically hold our shorts close to a year, and we have a nontrivial book of short positions that we’ve held for multiple years
We hedge risks, and to put it succinctly, hedging is far easier with shorting, and may sometimes be impossible without it
The problem of course is that getting to net zero is quite difficult, if not impossible, today – and for the foreseeable future – with just long positions. One would need to buy an enormous amount of carbon offsets to even come close to going net zero. But that is not the only option. An investor could use a combination of both offsets and shorts to meaningfully lower emissions to get close to, if not achieve, net zero.
What does that mean? It’s instructive to back up and examine how the more traditional non-shorting ESG approach of own less or none of the bad guys can matter to global emissions in the first place. If a significant fraction of the market doesn’t own certain securities (or insists on owning less than their index weights), then other investors have to own more. You can’t underweight something someone else won’t overweight, or, in econo-geek speak, “the market must clear.” Now, owning more than you previously wanted to is not riskless as it reduces your diversification. Thus these other (clearly not so virtuous!) investors will demand to be compensated for this extra risk. That comes through the offending firms being priced to a higher cost of capital. While the higher expected return to the non-virtuous is sadly necessary, if it’s any consolation, they may suffer real capital losses on the way there because an increasing expected return is, all else equal, the result of its price going down. The upside is that this higher cost of capital is what the emitters will have to use to evaluate every possible investment project they contemplate. This higher cost of capital will mean they do, well, less of the stuff we want them to do less of. Not my best sentence, but you get the point. Many seem to think not owning the bad guys itself will magically change the world. Well, it does, but it’s not magic, it’s the math that many of us were taught the second week of business school. That is, only pursue projects whose current and future cash flows are “positive net present value” after discounting for time and risk. By raising the cost of capital, or discount rate, on the bad guys we get them to do less of the bad stuff as fewer of their (bad for the world) projects clear the higher hurdle. This is the mechanism where we actually affect the real world. At least through our investment holdings. There are lots of other ways too, e.g., direct engagement, that are not my topic here but also part of our big tent