AQR On Evaluating Defensive Long/Short Strategies
By DailyAlts Staff Heightened market volatility has many equity investors contemplating a move to defense. But in this environment, are defensive stocks too expensive to work? This is the question considered by AQR Principals Antii Ilmanen and Lars Nielsen and Vice President Swati Chandra in the November white paper Are Defensive Stocks Expensive? A Closer Look at Value Spreads . Value Spreads The paper’s authors begin by explaining the concept of value spreads: “Value” quantifies the “cheapness” of a long-only asset “relative to a fundamental anchor.” For a long/short style factor such as “defensive,” value spreads can be measured by comparing the value of the long portfolio (the most “defensive” stocks) to the value of the short portfolio (the least “defensive” stocks). When the style grows cheaper, the value spread “widens” – when the style becomes more expensive, the value spread “narrows.” Valuation and Strategies It only makes sense that a wide value spread is preferable to a narrow one, since a wide spread will (presumably) have the tendency to revert back to the mean, thereby “narrowing” and becoming more expensive (i.e., outperforming); while a historically narrow spread is more likely to “widen” and get “cheaper” (i.e., underperforming). AQR’s Cliff Asness and others have published research indicating that “over medium-term horizons, the future return on value-minus-growth stock selection strategies is higher when the value spread is wider than normal.” But Messrs, Ilmanen and Nielsen and Ms. Chandra argue that “valuations may have limited efficacy in predicting strategy returns” – strategy returns as opposed to asset returns. The authors highlight the “puzzling” case in which a defensive long/short strategy performed well during a recent two-year period when its value spread “normalized from abnormally rich levels.” They conclude that the relationship between valuation and performance – strong for most asset classes – is weaker for long/short factor portfolios. Wedging Mechanisms Buying a “rich” investment, seeing it cheapen, and yet still making money – how is this possible? Ilmanen et al. cite the following “wedge mechanisms” that allow the managers of long/short factor portfolios to loosen the “presumed strong link” between value spread changes and returns: Changing fundamentals Evolving positions Carry Beta mismatches Fundamentals May be Offsetting The efficacy of value spreads in predicting returns relies on the assumption that changes in valuations are primarily driven by prices, so that an asset or portfolio that becomes more expensive necessarily appreciates in price. This assumption, combined with the assumption that value spreads will always mean-revert, make the case that wide spreads are preferable to narrow ones. But valuation measures always compare price to a fundamental factor , and improving or deteriorating fundamentals – more than just price – can loosen the links between valuation and performance. Evolving Positions Portfolio returns are based on the price appreciation and “carry” of the portfolio’s holdings, as they evolve , but value spreads only consider the portfolio’s current holdings. Thus, the link between valuation and performance is therefore weakest for the most actively traded, fastest-evolving portfolios. Carry Returns Value spreads look entirely at prices, but portfolio returns are the sum of changes in price and portfolio income – i.e., dividends and interest. Portfolios that derive a greater-than-average percentage of their total returns from so-called “carry returns” will thus naturally have a weaker link between valuation and performance than portfolios that derive their returns more primarily through price changes alone. Misaligned Betas In AQR’s study, this final “wedge” had the most impact: Since the value spread will generally have a net non-zero beta, while a long/short portfolio may target beta-neutrality, the value spread could indicate cheapening or richening driven by its beta to the market, while a long/short portfolio designed for beta-neutrality won’t fluctuate with the market. Conclusion So are defensive stocks expensive right now? The authors give a concise answer to that question: “Yes, mildly, taking a 20-year perspective.” But as the “Tech Bubble” proved, mispricing can persist for a long time. The important thing, in the view of the paper’s authors, is for investors to be cognizant of the mechanics of value spreads and spread design choices.