AQR Case

After careful consideration, it seems sensible for AQR to pursue the launch of the new Momentum Funds

within the retail mutual fund market. It is clear from the Fama-French UMD (Up minus Down) data that the

average annual return for the momentum-based strategy (10.92%) between 1927 and 2008 far exceeded that

of the Nasdaq value-weighted portfolio in the same period. This is further emphasized by the differences in

cumulative returns seen in Exhibit 2. The momentum strategy also outperformed other investment strategies

such as value and growth investing, as shown in the summary statistics of Exhibit 5.

Obviously, the UMD strategy is an extremely active investment style, with the portfolio being adjusted monthly,

and a large number of short positions taken in stocks with low momentum. Both of these characteristics of

UMD provide complications when creating a momentum index, specifically due to the limitations in mutual

funds ability to take short positions and due to the high transaction costs, that excessively trading incurs.

However, if we plot the returns of a portfolio taking long positions in portfolios with the highest average value-

weighted returns based on past returns between 1927-2008, we see that the returns on the portfolios are

higher than the returns on the UMD portfolio (Figure 1 of appendix). These excess returns come at a price, as

the volatility of such an index is higher than the UMD, HML or SMB portfolios, but with reduced transaction

costs as it is an easier investment strategy to implement in a mutual fund environment. The comparative

volatilities between UMD, SMB, HML portfolio’s, and portfolio’s taking only long positions in high momentum,

high value or high growth investments between 1927-2008 is shown in Figure 2 of the appendix. Taking all

this into account, it is clear the restrictions placed on mutual funds constrain their ability to implement

momentum and similar strategies such as value and growth as effectively as they could by taking short

positions. However, the strategies can still be profitable.

Specifically, the correlation between value and momentum portfolio’s is of interest, and should be advertised

to investors. The fact that the momentum stocks are negatively correlated with value stocks, means that by

launching Momentum Funds, AQR can provide retail investors with a new, innovative way to diversify their

portfolios. This will attract investors and allow them to lower the volatility of their existing portfolio’s, eventually

leading to increased profits.

A sensible benchmark that AQR can set for the Momentum Funds would be the new momentum indices it has

launched using the help of Standard & Poor’s Inc. The momentum indices aim to measure the returns of

stocks that have positive momentum in universes consisting of large-cap U.S, small-cap U.S and large-cap
International Stocks. These indices will be a representation of the past performance of such trading strategies,

and will therefore act as a benchmark for AQR to achieve in the future. It seems unlikely that AQR will be able

to exceed these benchmarks, since the indices created by Standard & Poor’s will not accurately reflect the

fees and trading costs which AQR will incur when implementing the strategy in the real-world. Trading costs in

particular will be high for AQR, since they aim to alter their portfolio quarterly, in order to account for changes

in stock’s recent returns and track momentum accurately in the markets they are trading.

AQR will be able to get closer to achieving these benchmarks, if their investors allow leeway with regard to

tracking error risk. Obviously, trading costs could be lowered if AQR were allowed a margin within which they

did not have to alter their portfolio, since changing a stock which was only marginally outside the top 1/3 of

momentum stocks, for one marginally inside, would arguably be counterproductive once trading costs are

accounted for. This is dependent on AQR’s investors though, and since one of the main advantages for AQR

in launching the fund is that they are the first to do so, it is likely that investors in the fund will want tracking

error to be kept to a minimum. Overall, therefore, it is unlikely that the funds performance will exceed that of

the S&P indices.

Overall, we conclude that hedge funds adopting mutual funds strategies is beneficial from if they can find a

profitable and novel approach that would generate stable returns which will attract investors and allow them to

lower the volatility of their existing portfolio’s, eventually leading to increased profits.

Appendix

Figure 1: Comparative Returns and Volatilities of Different Investment Strategies

100
- outperformed market

50
- financial advisor channel. Access to more investors (wealthier)

0
ear 932 938 944 950 956 962 968 974 980 986 992 998 004
-50
Y 1 1 1 1 1 1 1 1 1 1 1 1 2
-100
High UMD Low

Figure 2: Annualized Average Return of UMD versus positions in only Long Positions of High and Low Momentum
Stocks