Preaching the Gospel of Momentum

QUANTITATIVE INVESTMENT STRATEGIES are shrouded in mystery. Most investors don't even try to understand them, and many practitioners won't discuss them, fearing that doing so could cost them their competitive edge.

One of the largest firms in the field is AQR Capital Management of Greenwich, Conn. Founded in 1998, it oversees more than $20 billion, primarily for institutional investors. AQR, which stands for Applied Quantitative Research, seeks to use some of best ideas of academic finance in the real world. It applies its proprietary models across a range of assets, including stocks, bonds and currencies.

Backed by a wealth of historical data, the firm believes in often-derided momentum investing, which favors buying stocks that have been doing well, relative to their peers or the overall market, and avoiding those with poor price momentum. AQR calls momentum investing an "undiscovered style" and a better complement to value investing than growth-oriented strategies. The firm seeks to overweight cheap securities that have strong momentum and underweight expensive ones that have weak momentum. Unlike most investment managers, AQR employs no fundamental analysts to cover companies. Instead, it seeks to hone its quantitative models and develop new ones.

The firm last month started three momentum-oriented equity mutual funds.

The first, AQR Momentum (AMOMX), which invests in the third of the 1,000 largest U.S. stocks with the best total return over the preceding 12 months. It will be rebalanced quarterly. The other two funds, AQR Small Cap Momentum (ASMOX) and AQR International Momentum (AIMOX), are similar. The funds are up since their inception but trail the overall market.

Earlier, in January, the firm launched AQR Diversified Arbitrage (ADANX). It focuses on five areas: convertible arbitrage, merger arbitrage, dual-share-class arbitrage, closed-end-fund arbitrage and special-purpose acquisition companies, or SPACs. SPAC shares typically are purchased when they trade at a deep discount to their net-asset value.

These funds might be unique. We know of no other mutual funds that employ a pure momentum strategy or pursue multiple arbitrage strategies. The no-loads are available through some fund supermarkets, including Fidelity's and Schwab's.

Barron's sat down last week with two of AQR's principals, Cliff Asness and David Kabiller, in Greenwich. The outspoken Asness gained some attention this year with his criticism of President Obama after the nation's chief executive had attacked hedge-fund investors who felt that they had gotten a raw deal as creditors in the Chrysler bankruptcy. He's also criticized Obama's health-care proposals. But in our interview, Asness focused on investing, not politics.

Barron's: What's AQR all about?

Asness: We use the best of modern portfolio theory techniques, not necessarily quantitative models, to help serve clients. It started back in 1994 when I was at Goldman Sachs, and they asked me to form a quantitative-research group. Where our process might have consisted of a few measures of value and price momentum 15 years ago, it now generally consists of many factors from more subtle measures of value and momentum to signals obtainable from the actions of management, short-selling activity and inventory changes for commodities. Our models form a diversified systematic opinion on what we like and don't like in all liquid assets. Then, a different portfolio is built for each client. For a traditional client seeking to beat EAFE [MSCI's international equity benchmark), we use our stock-picking around the world and our country and currency tilts.

You employ about 200 people. But none of them do fundamental research and follow companies like General Electric or Nestlé, right?

Asness: It's actually just me and David and one really big computer. This comes up all the time. We don't have analysts who cover each of the individual companies. We don't visit companies. A lot of what we do is asset-allocation work. To the extent that we visit countries, it's usually called vacation.

Having said that, a tremendous amount of work goes into our models. If someone asks why we're long a stock, we would list 17 reasons for it. We would list its valuation on 10 different scales: its valuation in the absolute sense, its valuation against its peers and its industry group, its health in terms of its improving margins, its momentum. A lot of what we do is value plus momentum. We try to buy cheap things that are starting to get better. You can get a lot from corporate managements without talking to them. Are they buying back shares or are they issuing shares? So when you ask if we do fundamental research, I would say it is absolutely fundamental. Very few of the variables in our model would be called technical, except maybe pure price momentum.

Kabiller: We have spent millions of dollars a year on income statements and balance-sheet data on companies. We process that information. We try to isolate those factors that are leading indicators of security prices and most of them are fundamental factors and some technical.

Asness: I won't paint it all as entirely positive, We give up the ability to have magical insight into one company. Having said that, it can be risky to have a lot riding on one stock if you happen to be wrong.

It's unfashionable to say you like momentum investing because it's often perceived to be a mechanical, dumb-money strategy.

Asness: One of the scariest moments of my life was telling University of Chicago professor Gene Fama that I wanted to write a dissertation on price momentum. And I think I mumbled the part where I said it works really well because it's not a very Chicago idea. To his credit, he said; "If it is in the data, write the dissertation."

Why do you think momentum investing works?

Asness: No one has nailed down why. We have a lot of theories. When I say "we," I don't just mean AQR. I mean the academic community and the practitioner community. Underreaction is probably our universally favorite story. Good news comes out. There is a phenomenon in behavioral finance called anchoring and adjustment, where people go, "Oh, that's great news," and they move halfway but they don't move all the way to incorporate the great news. So if you buy what's gone up, there's a little more to go. I won't pretend I have told you all the different theories.