In 2015, Cliff Asness’ hedge fund AQR had a respectable $23 billion in assets under management (“AUM”). And his strategy, based on something called “factor investing,” was taking the world by storm.

The strategy is between a classic stock-picking approach and a fully quantitative approach.

It involves determining various “factors” that are driving stock market returns at any given time and buying the stocks that fit within those factors.

In 2015, when the S&P 500 only returned 1%, AQR returned roughly 15%. By 2017, AQR became the largest hedge fund in the world at $226 billion in AUM.

Then, factor investing stopped working. For the next four years, AQR seriously underperformed the S&P 500. When the market fell 4% in 2018, AQR fell over 10%. And when the S&P 500 rebounded more than 30% the next year, the fund barely eked out a 5% return.

And so, investors moved on. AQR is down to less than half of its peak AUM… only $98 billion.

Investors moved all their money to fully quantitative hedge funds like Citadel and Point72, thinking that factor investing is dead.

However, that’s missing the bigger picture. AQR has been quietly staging a comeback for factor investing.

Decades of research went into developing today’s most popular factors.

The first was the “value” factor developed in 1977. McMaster University professor Sanjoy Basu tested decades of stock returns to determine that cheap companies—those with low price-to-earnings ratios—outperformed expensive companies over the long-term.

From there, practitioners and academics developed tons of other factors. For instance, University of Chicago professors Eugene Fama and Ken French found that small stocks outperform large stocks.

Since then, several major factors have emerged. High-profitability companies outperform low-profitability companies, stocks with positive momentum outperform stocks that are falling, and stocks with low volatility outperform volatile ones.

Here’s an important caveat… these factors outperform over the long term. Investors by nature react to short-term moves. And so AQR got popular at the exact wrong time… right when its strategy stopped working for a few years.

That said, it already seems to be back on track. While AQR got crushed from 2017 until 2020, its last few years have been much better.

Its flagship fund returned 17% in 2021, another 44% in 2022, and 19% last year.

And that means the factors that drive hedge funds like AQR are working again.

We still expect the U.S. to enter a recession soon. And when that happens the stock market is likely to dip.

When it does, it’s a perfect opportunity to buy “factor” companies. For AQR, that means focusing on small stocks with low volatility, low valuations, and positive momentum. And the companies should have high profitability.

After the market rallied so much in 2023, it’s hard to find cheap, high-quality companies.

So, get ready for a happy hunting ground whenever there’s a dip because true factor stocks will finally start showing up again.

Best regards,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research

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