In this report we check in with the team at Brandes to get their thoughts on how trade issues are impacting valuations for Chinese stocks, where the fund is finding investment opportunities, and the overall valuation for their portfolio.Brandes_Emerging_Markets_Value_Annual_Report
The fund’s performance was flat in the third quarter, down 8.3% year to date, and down 18.8% over the trailing year, compared to a 0.8% gain, a loss of 5.1%, and a loss of 9.3% for the SG Trend Index for the same time periods.
The fourth quarter of 2016 was the period where the fund diverged most sharply from the index, falling 11.5%, compared to a loss of 4.5% for the index. Commodities were the biggest detractor during that quarter, and the markets that most impacted the fund included energies and precious metals. Energies were range bound and choppy on speculation about OPEC policy and whether there would be an agreement with non-OPEC members on reducing oil output. Precious metals saw a reversal of their previous bullish trends, driven in part by rising yields in the United States. Aspects of AQR’s balanced approach likely hurt them that quarter, as many competitors tend to concentrate risk in fixed-income trends, and some focus more on shorter-term signals and use some non-trend strategies like carry that performed well in much of 2016. The second quarter of 2017 also saw a significant negative divergence from the index (the fund was down 7.1% versus a 5% decline for the index).
This year, the fund reached its maximum exposure in equities as a percentage of risk, which has hurt it on a relative basis, since equities have been the strongest-performing asset class during that time. The SG Trend Index’s realized beta to the S&P 500 Index on a rolling three-month basis has been consistently higher than the fund’s over the last nine quarters, likely indicating many trend followers are allowing more risk concentration in equities. This makes the index look better as long as equities keep going up but will of course hurt the index the next time equities enter a protracted decline. Interestingly, since the inception of the original fund (which has a 10% volatility target), all asset classes have contributed positively except equities, even with the sustained rally, as losses from short-term signals have slightly outweighed gains from long-term signals. AQR believes that maintaining a diversified portfolio rather than allowing heavy concentration in one or two asset classes will produce a smoother trajectory over the long term (by avoiding large losses when those markets reverse); however, that has obviously worked against the fund more recently. Again, this is why we diversify our exposure in managed futures across several managers with differing styles of implementation.
AQR’s 10% volatility target strategy (the HV fund has a 15% volatility target) has produced a 1% annualized return for the 7.75-year period since inception, with a standard deviation of a little over 9%, for a Sharpe ratio of about 0.1. This is very disappointing performance, but within the range of historical expectations. (That period is at about the 15th percentile historically—AQR would expect 85% of seven-year periods to be better.) They still expect to achieve a long-term Sharpe ratio in the 0.5–0.6 range and don’t believe that any of the factors that create trends (mainly human nature/behavioral biases and non-profit-maximizing actors in financial markets) have disappeared. They note that the strategy can experience periods of sharp gains (and over short periods), but it’s impossible to time when those will happen, so it requires patience (and sizing at a level you can handle) to realize the long-term benefits. Of note, the ex-ante volatility target for the HV fund increased to 15.3% by the end of the third quarter from 11.8% at the end of second quarter. This may bode well for performance going forward, as the ex-ante volatility tends to rise when there is stronger agreement among the longer- and shorter-term trend signals, which is the only modestly reliable “timing” indicator for the strategy.
—Jason Steuerwalt, CFA (11/22/17)
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