AQR And Fama: Misunderstanding Warren BuffettVW Staff
For the purpose of this letter, we would like to summarize four core attributes of the AQR model and contrast them with how we perceive Buffett actually invests, thus highlighting ways we think AQR’s model could be improved. The first attribute consists of Fama’s original “value” factor. The other three represent, in part, how these researchers augmentedFama’s three-factor model in an attempt to emulate Buffett’s returns. Our understanding of these four characteristics of the AQR model can be summarized as:
- Value: Defined as the ratio of a company’s book value to its market value.
- Quality: Defined as the composite of a variety of features, including profitability measured in multiple ways and the proportion of earnings paid out to shareholders, all viewed in the context of a company’s growth, volatility of returns, and balance sheet leverage. Companies with high marks on this composite are considered quality companies and are given positive weights in AQR’s simulated portfolios. Companies with low marks are considered junk companies and are given negative weights. This factor is termed Quality Minus Junk.
- Betting-Against-Beta: Building on research that suggests low-volatility stocks have produced higher risk-adjusted returns than high-volatility stocks, the AQR researchers adopted a factor termed Betting-Against-Beta. In this context, companies with high betas (high volatility in their share prices) are given negative weights. Companies with low betas are given positive weights.
- Leverage: Berkshire operates with leverage in the form of deferred taxes and low-cost insurance float. What AQR found is that if a model constructed on the above three factors is leveraged by 1.6X, it would show similar historical returns to those realized by Berkshire Hathaway from 1976 to the present. They found Berkshire’s actual historical leverage to be generally consistent with 1.6X.
Using these attributes and several others, the AQR model constructs what would effectively be a long-short portfolio representing hundreds of positions. Some companies across these factors would have net positive weights, and thus the AQR model would have a long-position in those companies. Other companies would have net negative weights across these factors, and AQR would be effectively short those companies. With this model, as these holdings would be periodically rebalanced to reflect companies’ shifting fundamentals and prices, AQR can estimate the returns this model would have achieved in the past. When these returns are amplified by 1.6X leverage, the AQR model shows estimated returns that resemble Berkshire’s superior record.
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