Aqr Case Report - Momentum Mutual Funds

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HML refers to High minus Low for the momentum”10 minus 1” portfolio.

2.3 Is this the right way to think about AQR’s momentum mutual funds?

It is not an appropriate way to think about AQR’s momentum mutual fund, since it only longs positions but not short. Therefore, we should only use the return data on U to calculate the correlation. The correlation between U and HML is not negative any more.

Table 2: Correlation between Different Strategies

Mkt-RF

HML

SMB

U

Mkt-RF

1

HML

0.114

1

SMB

0.412738

0.075269

1

U

0.93434

0.097964

0.607245

1

2.4 What types of investors might be interested in AQR’s retail momentum funds?

Investors who do not have the qualification to invest in the hedge fund but are confident in the momentum strategy might be interested in the AQR’s retail momentum funds.

3. Publish of AQR strategy

3. 1 Purpose of the momentum indexes

AQR is introducing the Momentum mutual funds as a cost-effective way to access this proven approach. The launch of these new funds furthers our efforts to provide clients with innovative ways to gain diversification for their portfolios. It combines two desirable qualities: momentum tends to do well when value is out of favors, yet unlike growth its long-run returns have out-performed broad market averages. A combination of value and momentum is a better way to build diversified portfolios than the more traditional value and growth combination.

The purpose of deep-pocketed institutional investors (hedge fund and institutional equity funds) is to profit from the strategy. AQR wonder if it is also applicable to retail investors. Research on momentum suggests that stocks with positive momentum tend to out-perform market averages in the following months. AQR created momentum indexes to demonstrate investors that momentum strategies offered strong performance potential. And the index could be especially helpful when investment style is new, because it gives investors a chance to familiarize themselves with both the construction of the underlying strategy and its past performance. It served an important educational role for investors interested in the new momentum strategy. Also, the regulations of U.S securities do not give permission to the back testing of results. By implementing the momentum index, mutual funds can arouse investors’ interest and therefore market its products. The AQR index has many advantageous: 1) Returns formed on past returns outperform other indexes and other investing styles. 2) Property of less volatile, meaning more stable and solid. 3) Sharp ratios and information ratios are higher. 4) Excess return: negative correlation with that of comparable index, small indices and the market

3.2 Peril of publishing

As fees and trading costs are considered, the actual performance through momentum investing is expected to exceed the benchmark. Yet the index will have most benefits of momentum investing considering the costs and restrictions for retail mutual fund investors, the exceed of benchmarks might not be likely in real practice. Also, if error risks are emphasized by some investors, the outperformance might not be advantageous. Thirdly, with the momentum index, it will be very clear to see whether there is any track during the fund’s operation. Fourthly, the momentum index might not be able to fully express the revenue of the portfolio as its predictions may solely depend on the past performance. Therefore it might not thoroughly dependable in its future predictions.

3.3 Time to publish AQR’s momentum index

The time to publish AQR’s momentum index should be the a bit early of launching new funds. Reason: as claimed in the case, when AQR starts to enter mutual fund market or when the style for investment is new, the momentum index is especially helpful. By providing index performance, investors will be interested in the new momentum strategy. Therefore if the index is published after the launch of new funds, it will not have the advantage of attracting the investors to new funds. However, it is also not recommended to be published too early before the launch of new fund as it will incur fees to S&P 500.

4. Alphas of 1-factor model and 4-factor model

4.1 Describe the two models

Both the single factor (CAPM) model and multifactor model are used to explain the portfolio performance. CAPM model uses only market factor to compare a portfolio with the market. However, when doing the regression model, we can add other factors for pursuing a better r-squared fit. The general method is the three factor model developed by Fama and French, adding additional two factors besides market factor, HML and SMB. SMB stands for small minus big, i.e. the returns of small caps over the market. HML measures high minus low, i.e. the returns of caps with a high book-to market ratio over the low ones. In the AQR case, a new performance factor used is UMD which utilizes up minus down, i.e. the returns of winners over the losers.

4.2 Difference between two alphas based on efficient and inefficient theory

From the table exhibit 3, we can see that the difference between 1-factor alpha and 4-factor alpha is obvious. The estimated 1-factor alpha (L/S 10-1) was 18.57, while the multifactor alpha was 3.24, only about one-sixth of 1-factor alpha. In the AQR case, CAPM model was used signal model to calculate the alpha, showing a significant positive result. According to the inefficient market theory, the great alpha results from the systematic errors that include investor irrationality or behavioral biases. After adding the other three