Andrea Frazzini

The Small World of Investing: Board Connections and Mutual Fund Returns

This paper uses social networks to identify information transfer in security markets. We focus on connections between mutual fund managers and corporate board members via shared education networks. We find that portfolio managers place larger bets on connected firms and perform significantly better on these holdings relative to their nonconnected holdings. A replicating portfolio of connected stocks outperforms nonconnected stocks by up to 7.8 percent per year. Returns are concentrated around corporate news announcements, consistent with portfolio managers gaining an informational advantage through the education networks. Our results suggest that social networks may be important mechanisms for information flow into asset prices.

Leverage Aversion and Risk Parity

The authors show that leverage aversion changes the predictions of modern portfolio theory: Safer assets must offer higher risk-adjusted returns than riskier assets. Consuming the high risk-adjusted returns of safer assets requires leverage, creating an opportunity for investors with the ability to apply leverage. Risk parity portfolios exploit this opportunity by equalizing the risk allocation across asset classes, thus overweighting safer assets relative to their weight in the market portfolio. In our article, we show that leverage aversion changes the predictions of modern portfolio theory: It implies that safer assets must offer higher risk-adjusted returns than riskier assets because leverage-averse investors tilt their portfolio toward riskier assets to achieve high unleveraged returns, thus pushing up the prices of risky assets and reducing the expected return on those assets. Therefore, safer assets are in relatively low demand and offer high risk-adjusted returns. Consuming the high risk-adjusted returns offered by safer assets requires leverage, which creates an opportunity for investors with the ability and willingness to apply leverage. A risk parity (RP) portfolio exploits the high risk-adjusted returns of safer assets in a simple way—namely, by equalizing the risk allocation across asset classes and thus overweighting safer assets and underweighting riskier assets relative to their weights in the market portfolio. Although an unleveraged RP portfolio has a lower risk than the market portfolio (and the 60/40 portfolio) owing to the higher allocation to safer assets, the RP portfolio can be leveraged to achieve the same risk as the market portfolio and a higher expected return. Consistent with our theory of leverage aversion, we found empirically that risk parity has outperformed the market over the last century by a statistically and economically significant amount. Indeed, in the United States, an RP portfolio with the same risk as the market portfolio outperformed the market portfolio by about 4 percent a year over 1926–2010. Furthermore, the RP portfolio delivered higher risk-adjusted returns than the 60/40 portfolio in each of the 11 countries covered by the J.P. Morgan Global Government Bond Index over 1986–2010. We performed extensive robustness tests and analyzed the related evidence across and within countries and asset classes. Editor’s Note: The authors are affiliated with AQR Capital Management, LLC, which offers risk parity funds.

Trading Costs of Asset Pricing Anomalies

Using nearly a trillion dollars of live trading data from a large institutional money manager across 19 developed equity markets over the period 1998 to 2011, we measure the real-world transactions costs and price impact function facing an arbitrageur and apply them to size, value, momentum, and shortterm reversal strategies. We find that actual trading costs are less than a tenth as large as, and therefore the potential scale of these strategies is more than an order of magnitude larger than, previous studies suggest. Furthermore, strategies designed to reduce transactions costs can increase net returns and capacity substantially, without incurring significant style drift. Results vary across styles, with value and momentum being more scalable than size, and short-term reversals being the most constrained by trading costs. We conclude that the main anomalies to standard asset pricing models are robust, implementable, and sizeable.

Quality Minus Junk

We define a quality security as one that has characteristics that, all-else-equal, an investor should be willing to pay a higher price for: stocks that are safe, profitable, growing, and well managed. High-quality stocks do have higher prices on average, but not by a very large margin. Perhaps because of this puzzlingly modest impact of quality on price, high-quality stocks have high risk-adjusted returns. Indeed, a quality-minus-junk (QMJ) factor that goes long high-quality stocks and shorts low-quality stocks earns significant risk-adjusted returns in the U.S. and globally across 24 countries. The price of quality – i.e., how much investors pay extra for higher quality stocks – varies over time, reaching a low during the internet bubble. Further, a low price of quality predicts a high future return of QMJ. Finally, controlling for quality resurrects the otherwise moribund size effect.

Low-Risk Investing Without Industry Bets

The strategy of buying safe low-beta stocks while shorting (or underweighting) riskier high-beta stocks has been shown to deliver significant risk-adjusted returns. However, it has been suggested that such “low-risk investing” delivers high returns primarily due to its industry bet, favoring a slowly changing set of stodgy, stable industries and disliking their opposites. We refute this. We show that a betting against beta (BAB) strategy has delivered positive returns both as an industry-neutral bet within each industry and as a pure bet across industries. In fact, the industry-neutral BAB strategy has performed stronger than the BAB strategy that only bets across industries and it has delivered positive returns in each of 49 U.S. industries and in 61 of 70 global industries. Our findings are consistent with the leverage aversion theory for why low beta investing is effective.

Fact, Fiction and Momentum Investing

It’s been more than 20 years since the academic discovery of momentum investing, yet much confusion and debate remains regarding its efficacy and its use as a practical investment tool. In some cases “confusion and debate” is our attempting to be polite, because it is nearly impossible for informed practitioners and academics to still believe some of the myths uttered about momentum—but that impossibility is often belied by real-world statements. In this article, the authors aim to clear up much of the confusion by documenting what we know about momentum and disproving many of the often-repeated myths. They highlight 10 myths about momentum and refute them, using results from widely circulated academic papers and analysis from simple publicly available data.

Fact, Fiction, and Value Investing

Value investing has been a part of the investment lexicon for at least the better part of a century. In particular the diversified systematic “value factor” or “value effect” has been studied extensively since at least the 1980s. Yet, there are still many areas of confusion about value investing. In this article we aim to clarify many of these matters, focusing in particular on the diversified systematic value strategy, but also exploring how this strategy relates to its more concentrated implementation. We highlight many points about value investing and attempt to prove or disprove each of them, referencing an extensive academic literature and performing simple tests based on easily accessible, industry-standard public data.

Size Matters, If You Control Your Junk

The size premium has been challenged along many fronts: it has a weak historical record, varies significantly over time, in particular weakening after its discovery in the early 1980s, is concentrated among microcap stocks, predominantly resides in January, is not present for measures of size that do not rely on market prices, is weak internationally, and is subsumed by proxies for illiquidity. We find, however, that these challenges are dismantled when controlling for the quality, or the inverse “junk�?, of a firm. A significant size premium emerges, which is stable through time, robust to the specification, more consistent across seasons and markets, not concentrated in microcaps, robust to non-price based measures of size, and not captured by an illiquidity premium. Controlling for quality/junk also explains interactions between size and other return characteristics such as value and momentum.

Betting Against Correlation: Testing Theories of the Low-Risk Effect

We test whether the low-risk effect is driven by (a) leverage constraints and thus risk should be measured using beta vs. (b) behavioral effects and thus risk should be measured by idiosyncratic risk. Beta depends on volatility and correlation, where only volatility is related to idiosyncratic risk. Hence, the new factor betting against correlation (BAC) is particularly suited to differentiating between leverage constraints vs. lottery explanations. BAC produces strong performance in the US and internationally, supporting leverage constraint theories. Similarly, we construct the new factor SMAX to isolate lottery demand, which also produces positive returns. Consistent with both leverage and lottery theories contributing to the low-risk effect, we find that BAC is related to margin debt while idiosyncratic risk factors are related to sentiment and casino profits.

Practical Applications of Fact, Fiction, and Value Investing

Value investing’s origins go back to well before the publication of Benjamin Graham and David Dodd ’s classic book Security Analysis in 1934. And today, it still reigns as one of the best-known and famously successful strategies—just look at the successes of Warren Buffet and Berkshire Hathaway. Even so, myths and misperceptions abound. Colleagues and co-authors from AQR Capital Management—Cliff Asness , Andrea Frazzini , Ronen Israel and Tobias Moskowitz —identified nine myths and unrealized truths about value investing by assessing academic research, evaluating perspectives from the trenches and incorporating their firm’s own empirical analysis. Their article— Fact, Fiction, and Value Investing —was named Outstanding Article in the 17th Annual Bernstein Fabozzi/Jacobs Levy Awards .