Book Review: 20 for Twenty

20 for Twenty: Selected Papers from AQR Capital Management on Its 20th Anniversary. 2018. Various authors and foreword by John C. Bogle.

Clifford Asness, the managing and founding principal of AQR Capital Management, is a superb demystifier. That quality is on display in this anthology commemorating the 20th anniversary of AQR’s founding. He and his colleagues understand the drivers of returns of investable assets as well as any other professionals in the industry. More fortunate for students of the market, including practitioners of all kinds, Asness and colleagues have the confidence to share them. Each chapter originally appeared in a leading financial journal between the firm’s founding 20 years ago and last year. Every year, AQR ranks in the top 20, and often in the top 10, of institutions worldwide for the number of academic working paper downloads. It is the only private firm in that elite company.

How often, though, are top-ranked articles on finance fun to read? Among the pieces constituting 20 for Twenty, Asness’s “My Top 10 Peeves” is not to be missed for sheer entertainment. For laugh-out-loud hilarity, see the excuses bulls give for “ignoring the math” at market peaks in Asness’s “Bubble Logic.” In addition to offering wit and humor, the writing in each article is straightforward and clear — proving that even technical ideas can be conveyed with verve and minimal jargon.

The articles in this collection will likely offer insights for even experienced professionals. A diversified stock portfolio outperforms a 60/40 stock/bond portfolio, right? Wrong. The chapter “Why Not 100% Equities” points out that a 60/40 portfolio actually outperforms stock only, provided it is levered to the same risk. Does the “Fed model” make sense? The article “Fight the Fed Model” says no because it compares a real number (P/E) with a nominal one (in addition to other issues, such as volatility differences). Have we learned everything there is to know about the value factor, a subject of investigation for some 30 years? No. For one thing, the value factor turns up in virtually every investable asset class, not just equities. For another, “The Devil in HML’s Details” shows that “by lagging the market price, the traditional academic value measure [B/P] introduces incidental (and likely unintended) exposure to momentum.” As is shown, that bias can be corrected to create a better measure of value.

What more is there to learn about alpha? Well, investors must make sure to distinguish it from beta, lest they overpay for the latter. In addition, AQR has invented, or at least named, a new factor it calls “craftsmanship alpha,” described in Chapter 20. Its deceptively simple premise is that implementation costs matter (a lot), and minimizing them can be a significant source of returns. The secret: If they are thoroughly understood across time and asset classes, “costs of implementation can be dramatically reduced by rebalancing and trading in a smart and patient way.”

Asness wrote his dissertation under Eugene Fama, recipient of the Nobel Prize in Economics for his work on market efficiency. The subject of Asness’s dissertation was, of all things, inefficiency — the evidence for momentum in asset prices. Two articles on that topic, “Time Series Momentum” and “Value and Momentum Everywhere,” lay out the evidence and make the case for exploiting momentum for diversification and better-optimized returns per unit of risk.

The pieces in this volume are never academic, in the sense of being abstract, but are instead practical and actionable. For example, in the opening article on market efficiency, “The Great Divide,” Asness and John M. Liew conclude with a series of specific recommendations for making markets work better. The extent to which markets are efficient “is partly a function of the care and thought we put into designing them and the rules around them.” “Style Timing” proposes a simple and actionable model for forecasting the relative performance of growth versus value by rewriting the Gordon Growth Model using basic tools of the financial analyst’s tool kit. The piece in Chapter 10 on risk arbitrage demystifies the strategy. It broke new ground when it was published in December 2001 by demonstrating that the strategy’s returns relate to its non-linear payoff — and that actual returns are lower than those typically reported because of unacknowledged transaction costs. “Size Matters, If You Control Your Junk” (yes, even some titles are funny), published just last year, revivifies the size effect, which had been on the defensive in recent years for being small and erratic. Controlling for quality, the size effect is significant and robust across markets globally.

“Buffett’s Alpha” addresses the Buffett mystery. Is the Oracle of Omaha just a lucky coin flipper? Is his outperformance the result of cheap financing? Shrewd stock picking? Smart management? A canny use of derivatives? It turns out — spoiler alert — it is all of the above except the first, however you slice the data or adjust benchmarks. This chapter distinguishes itself by breaking down Berkshire Hathaway’s performance through time into its components to explain the mystery of its returns.

“The 5 Percent Solution” explores in detail a theme that crops up throughout: the importance of diversification properly understood. Traditional asset allocations, such as 60/40 stock/bond portfolios, miss key sources of return. Asset managers worth their salt must harvest returns from the broadest possible set of sources and manage risk intelligently. Canny managers will target and exploit not only the equity premium but also the term premium, credit premium, commodity premium, value premium, arbitrage premium, and others and then assemble these premiums in a risk-balanced way. How should they manage risk? By using leverage to set the risk level consistent with risk tolerance, which could mean no leverage if market risk is high. And yes, they will even use short selling and derivatives. Finally, they will understand cost-effective portfolio construction and management, a potential source of returns as real as any others.

One small annoyance in this highly readable collection is the absence of publication dates at the beginning of chapters. Instead, a determined reader has to find them at the end of each chapter, after the footnotes and references. Without context, less determined readers might be left scratching their heads at some of the numbers and valuation levels.

Some of the articles in the collection were originally published toward the end of the past century. One might ask, how useful is a detailed analysis of, say, NASDAQ valuation levels prior to the tech crash 20 years ago? Answer: very. The chapter on that topic, “Bubble Logic,” is a case study and model of how to assess earnings growth and valuation relative to history. How many analysts and portfolio managers erroneously think that the long-term average earnings growth rate is more than 1.5%? It is hardly a stretch to hazard that more than a few analysts and pundits out there could use a dose of rigor to rein in their professional optimism. “Do the math” is a refrain in this volume because so many industry professionals in every era seem to think they can dispense with it, with predictable results for clients and the public.

References followed by extensive footnotes provide rich pickings for serious readers interested in elaboration on key points, sources in the professional and academic literature, and mathematical detail. Written in plain English, the footnotes display some of the same humor evident in the articles themselves.

There is no doubt in this reviewer’s mind that all investment practitioners could profit handsomely, both intellectually and professionally, from studying any of the articles in this volume — and have fun all the while.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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