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Fact, Fiction, and

Value Investing

CLIFFORD ASNESS, ANDREA FRAZZINI,

RONEN ISRAEL, and TOBIAS MOSKOWITZ

The Voices of Influence | iijournals.com

Practical Applications of

Fact, Fiction,
and Value Investing

Bernstein Fabozzi / Jacobs Levy Awards Winner

Authors: Clifford Asness, Andrea Frazzini, Ronen Israel and Tobias Moskowitz
Source: The Journal of Portfolio Management, Vol. 42, No. 1.
Report Written By: Aimee Picchi
Keywords: Value Investing, Momentum Investing, AQR Capital Management

Overview
Clifford S. Asness
Value investing has a long history in the financial markets, with Benjamin Graham
[email protected]
and David Dodd advocating for the strategy in their 1934 classic book Security
Analysis. It is practiced today by many well-known practitioners, including Cliff is a Founder, Managing Principal and
Berkshire Hathaway CEO Warren Buffett. Yet, the strategy is subject to a Chief Investment Officer at AQR Capital
number of faulty beliefs from both adherents and opponents. In an interview with Management. He is an active researcher
and has authored articles on a variety of
Institutional Investor Journals, Andrea Frazzini and Ronen Israel provide
financial topics for many publications,
insights into what many get wrong—and right—about value strategies.
including The Journal of Portfolio
Management, Financial Analysts
Their award-winning research appeared in The Journal of Portfolio Management.
Journal and Journal of Finance.
It was co-written with AQR Capital Management colleagues Cliff Asness and
Tobias Moskowitz (who is also a professor at the University of Chicago Booth He has received five Bernstein Fabozzi/
School of Business). Their article—Fact, Fiction, and Value Investing—was named Jacobs Levy Awards from The Journal
Outstanding Article in the 17th Annual Bernstein Fabozzi/Jacobs Levy Awards. of Portfolio Management, in 2002, 2004,
2005, 2014 and 2015. The Financial
Analysts Journal has twice awarded him
Practical Applications the Graham and Dodd Award for the
year’s best paper, as well as a Graham
• Look beyond Buffett. Many believe value investing only works best in a and Dodd Excellence Award, the award
concentrated stock-picking style, similar to Buffett’s approach. In fact, a for the best perspectives piece, and
systematic, diversified value strategy also produces strong long-term results. the Graham and Dodd Readers’ Choice
Award. In 2006, CFA Institute presented
• Think beyond equities. Other asset classes, even currencies and commodities, Cliff with the James R. Vertin Award,
demonstrate reliable value premiums. which is periodically given to individuals
• Act beyond single strategies. A system that incorporates value and momentum can who have produced a body of research
notable for its relevance and enduring
boost returns.
value to investment professionals.

Practical Applications Report Prior to co-founding AQR Capital

Management, he was a managing director
Value investing remains subject to a number of misperceptions, despite dating back and director of quantitative research
for the Asset Management Division of
to Victorian England and being popularized by Graham and Dodd in the early 20th
Goldman, Sachs & Co. He is on the
century. This disconnect between reality and perception became clear to principals at
editorial board of The Journal of Portfolio
AQR while they were working on a previous article that sought to dispel myths about Management, the governing board of
momentum investing. That article, Fact, Fiction, and Momentum Investing, was the Courant Institute of Mathematical
published in JPM in 2014.

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 “We realized that something like value, which has perhaps been talked about and traded
on for a longer period time, had an equal number of misunderstandings, and we felt it
was the natural thing to try to attack the problem in a similar way,” Israel reports.
Finance at New York University, the
The AQR team identified nine myths and unrealized truths about value investing
board of directors of the Q-Group and
the board of the International Rescue by assessing academic research, evaluating perspectives from the trenches and
Committee. Cliff holds a BS in economics incorporating their firm’s own empirical analysis. The authors point out that even
from the Wharton School and a BS in value supporters can spread confusion about the strategy.
engineering from the Moore School of
Electrical Engineering at the University You can read about the myths—why they persist and how they are debunked—in the
of Pennsylvania, graduating summa cum full article. Here are some of them:
laude in both. He received an MBA with
high honors and a PhD in finance from • A value portfolio’s Sharpe ratio almost doubles when combined with stocks chosen
the University of Chicago, where he was for momentum and profitability.
Eugene Fama’s student and teaching
• An HML-style portfolio (Fama and French’s high minus low) that uses a
assistant for two years (so he still feels
guilty when trying to beat the market). composite of four value measures provides similar average returns as those built
with just a single value measure, but with 20% less volatility.
• During the past 88 years, the market-adjusted return to value within large-
capitalization stocks has only been 1.7% annually, or one-third of the return for
small-cap value stocks.
Key Definitions
Momentum investing THE BUFFETT PROBLEM
An investment strategy that buys or
Warren Buffett became a legend through his success at picking and holding
overweights stocks with high recent
returns and underweights or shorts stocks individual cheap stocks and thereby delivering strong, long-term results. Conversely,
with low recent returns. Buffett has dismissed diversification as “protection against ignorance,” Frazzini,
Israel and their co-authors note in the article. They repeat another Buffett quote that
Value investing elaborates: “It makes little sense if you know what you are doing.”
An investment strategy that buys or
overweights stocks with low prices relative
That feeds into a widespread belief that a successful value investor must eschew
to their fundamentals and underweights or diversification in favor of a concentrated number of deeply researched stocks, the
shorts stocks with high prices relative to authors point out. But in this case, Buffett is promoting a “fiction” about value that
their fundamentals. won’t necessarily benefit investors as a whole, they argue.

“You are always going to find people who did well like Buffett, but that doesn’t
mean you can’t capture value in a systematic way,” Israel says. “A diversified value
approach is very valuable in an investor’s portfolio.”

The Authors Strong, long-term evidence demonstrates that a systematic value approach to
diversified assets can provide solid returns over a long period. Buffett’s approach is
✓ Assessed academic just one aspect of value investing, and limiting oneself to picking idiosyncratic value
research. stocks can add further risks, as well as higher fees, Frazzini and Israel point out.

✓ Evaluated perspectives
from the trenches. THE FLIP SIDE TO BUFFETT

✓ Incorporated AQR’s Representing the flip side to Buffett is a group of pure value investors, who claim
they aren’t using a value strategy. This is an example of an unrealized truth. Their
own empirical analysis. portfolios are labeled with terms such as “fundamental indexing” and “smart beta.”
But the authors argue that these approaches that weight by fundamentals—such as
book value, dividends and other measures—instead of the market-cap weighting used
in traditional indexing are simply implementing a value tilt.

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 Back-testing a fundamental index, using data from large-cap stocks from 1962
through early 2014, verified this. Fundamental indexing “is capturing the value
premium,” Israel notes.

LOOK BEYOND EQUITIES

Another widely held myth about value investing is that it’s only applicable to
equities, which may be tied to the fact that most of the academic literature has

“perspective,
From an investor
putting
focused on stocks, the authors note. But that means that investors may be missing out
on applying value to other asset classes.

Frazzini recommends investors revisit a 2013 research paper by Asness, Moskowitz

these things together and another AQR colleague (and professor at New York University’s Stern School
and taking advantage of Business), Lasse Heje Pedersen, called Value and Momentum Everywhere. It
documents significant value return premia in assets including bonds, currencies and
of multiple factors
commodities from 1972 through 2011.
like momentum and
“Value isn’t just a stock-oriented phenomenon,” Israel says. “That’s a power in
profitability, we think, understanding value. The fact that it works in so many contexts gives us confidence.”
is the most important
thing.
”
—Ronen Israel
A COMPOSITE OF VALUE MEASURES

Aside from applying value principles across asset classes, investors should take
an “intuitive” approach to measuring value, the authors recommend. That is, use a
composite of variables, Frazzini and Israel explain.

Academia predominantly measures value through the book-to-market ratio, but

using multiple measures of value—such as earnings-to-price and cash-flow-to-price
ratios—helps produce more stable value portfolios with higher Sharpe ratios and
stronger returns, they report.

RETHINKING LARGE-CAP VALUE

Bucking earlier academic research that relied on data from 1963 to the early 1980s,

“pointAnweimportant
make is that
the authors find that there’s no strong value premium among large-cap stocks when
considering a longer, 88-year period. Still, there’s value in the segment. Combining
large-cap value with large-cap momentum boosts the Sharpe ratio to close to that
value should not be seen with the small-cap stocks using a similar mix of value and momentum, Frazzini
and Israel report.
considered as a stand-
alone strategy.
—Andrea Frazzini
” “From an investor perspective, putting these things together and taking advantage
of multiple factors like momentum and profitability, we think, is the most important
thing,” Israel says.

Frazzini adds, “An important point we make is that value should not be considered as
a stand-alone strategy.”

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 HELICOPTERS, ROCK N’ ROLL, FAMILY & TENNIS

Frazzini spends little time away from the world of finance, but he’s learning to fly
helicopters. He is a guitarist in a band that plays classic rock, such as Rolling Stones
songs.

Israel jokes he has limitations that Frazzini doesn’t. “First, I’m not Italian, and I have
three kids!” He spends his time outside of AQR with his family, and he plays tennis.

To order reprints of this report, please contact Dewey Palmieri

at [email protected] or 212-224-3675

The views and opinions expressed are those of the authors and do not necessarily reflect the views
of AQR Capital Management, its affiliates, or its employees; do not constitute an offer,
solicitation of an offer, or any advice or recommendation, to purchase any securities or other
financial instruments, and may not be construed as such. Diversification does not eliminate the
risk of experiencing investment losses.

Hypothetical performance results (e.g., quantitative backtests) have many inherent limitations,
some of which, but not all, are described herein. No representation is being made that any fund or
account will or is likely to achieve profits or losses similar to those shown herein. In fact, there
are frequently sharp differences between hypothetical performance results and the actual results
subsequently realized by any particular trading program. One of the limitations of hypothetical
performance results is that they are generally prepared with the benefit of hindsight. In addition,
hypothetical trading does not involve financial risk, and no hypothetical trading record can
completely account for the impact of financial risk in actual trading. For example, the ability to
withstand losses or adhere to a particular trading program in spite of trading losses are material
points which can adversely affect actual trading results. The hypothetical performance results
contained herein represent the application of the quantitative models as currently in effect on the
date first written above and there can be no assurance that the models will remain the same in the
future or that an application of the current models in the future will produce similar results
because the relevant market and economic conditions that prevailed during the hypothetical
performance period will not necessarily recur. There are numerous other factors related to the
markets in general or to the implementation of any specific trading program which cannot be fully
accounted for in the preparation of hypothetical performance results, all of which can adversely
affect actual trading results. Discounting factors may be applied to reduce suspected anomalies.
This backtest’s return, for this period, may vary depending on the date it is run.

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 Andrea Frazzini Ronen Israel Tobias J. Moskowitz
[email protected] [email protected] [email protected]

Andrea is a Principal on AQR Capital Ronen is a Principal at AQR Capital Toby is a Principal at AQR Capital
Management’s Global Stock Selection Management. His primary focus is on Management. He contributes to research on
team, focusing on research and portfolio portfolio management and research. He asset pricing and investment issues related
management of the firm’s long/short and was instrumental in helping to build AQR’s to domestic and international strategies
long-only equity strategies. Global Stock Selection group and its initial for AQR’s Global Alternative Premia
algorithmic trading capabilities, and he team. He holds the Fama Family Chaired
He is also an Adjunct Professor of Finance now runs the Global Alternative Premia Professorship in Finance at the University
at New York University’s Stern School group, which employs various investing of Chicago’s Booth School of Business
of Business. He has published in top styles across asset classes. and is a Research Associate at the National
academic journals and won several Bureau of Economic Research.
awards for his research, including the He received an Outstanding Article Award
Smith Breeden Award, the Fama- as part of the 17th Annual Bernstein He has won the Amundi Smith Breeden
DFA Prize, the BGI best paper award, Fabozzi/Jacobs Levy Awards from The Award for the best paper published in the
several Bernstein Fabozzi/Jacobs Levy Journal of Portfolio Management in Journal of Finance, the Brattle Group
Awards, and the PanAgora Crowell 2015 and the Special Distinction Award as Prize for the best corporate finance
Memorial Prize. Prior to joining AQR, part of the Harry M. Markowitz Prize for paper published in the Journal of Finance,
Andrea was an associate professor of the best paper published in the Journal the BGI Michael Brennan Award for
finance at the University of Chicago’s of Investment Management in 2015. the best paper published in the Review
Graduate School of Business and a He is on the executive board of the of Financial Studies, twice, the 2015
research associate at the National Bureau University of Pennsylvania’s Jerome Bernstein Fabozzi/Jacobs Levy Awards
of Economic Research. Fisher Program in Management and for Outstanding Article in The Journal of
Technology and is an adjunct professor Portfolio Management. In 2007, he was
He also served as a consultant for of finance at New York University. Ronen awarded the Fischer Black Prize by the
DKR Capital Partners and J.P. Morgan has been a guest speaker at Harvard, American Finance Association, which
Securities and on the board of directors of Columbia, the University of Pennsylvania recognizes the best financial economist
the Center for Research in Security Prices and the University of Chicago and is a under the age of 40, and the Ewing Marion
at the University of Chicago. He earned frequent conference speaker. Kauffman Prize Medal for Distinguished
a BS in economics from the University of Research in Entrepreneurship in 2012 by
Roma Tre, an MS in economics from the Prior to joining AQR, he was a senior the Kauffman Foundation, which recognizes
London School of Economics and a PhD analyst at Quantitative Financial the largest contribution to entrepreneurial
in economics from Yale University. Strategies. He holds a BS in economics research under the age of 40.
from the Wharton School at the
University of Pennsylvania, a BAS in His work has been cited in numerous print
biomedical science from the University media, television appearances and in a
of Pennsylvania’s School of Engineering 2005 speech by former Federal Reserve
and Applied Science and an MA in Chairman Alan Greenspan. Toby earned
mathematics, specializing in mathematical a BS in industrial management/industrial
finance, from Columbia University. engineering with honors and an MS in
finance from Purdue University, as well
as a PhD in finance from the University of
California at Los Angeles.

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