Monday, August 20, 2012

Buffett, Leverage, Beta, and Risk (AQR)

Pensions & Investments (P&I) published an interesting article about hedge fund AQR's research about Warren Buffett's success.  AQR says that Buffett's success comes from the usage of leverage on low-beta and high-quality stocks -- along with good risk management.

In particular, P&I reports:

For the 35 years of data studied, controlling for standard equity market factors such as company size, momentum and value did little or nothing to explain Mr. Buffett's success. However, controlling for low-beta stocks and high-quality stocks (defined as companies that are profitable, growing and paying out dividends) — when applied to systematic portfolios AQR designed to simulate Mr. Buffett's investment style — did manage to account for the bulk of his outperformance, according to the paper. 


Betting Against Beta

led a growing number of money managers to launch low-volatility or managed-volatility strategies in recent years: that a portfolio of stocks with bottom-quartile beta can match or exceed the returns of the broader market with only a fraction of the volatility.


 “betting-against-beta” version of that factor — which involves going long and leveraging low-beta assets while shorting high-beta assets — can produce “significant risk-adjusted returns.”


AQR's argument that Mr. Buffett takes on considerable risk, meanwhile, isn't incorrect if the context is modern portfolio theory's definition of risk as a function of volatility, noted Mr. Hagstrom. However, Mr. Buffett would likely opt for his own context and argue that buying high-quality, safe stocks at low prices effectively reduces his risk rather than increases it, he added.


Leverage, Risk & Return

With leverage a dirty word for many pension executives struggling with crisis-level funding gaps, the fact that Mr. Buffett is “a very big user of leverage” should serve as a reminder that the returns he enjoys aren't possible “without taking a lot of risk,” Mr. Kabiller said.
One period exemplifying that willingness to take — and bear — risk was mid-1998 to Feb. 29, 2000, the final stage of the Internet bubble, when Berkshire's stock price dropped 44% even as the broad Russell 3000 index was climbing 26%, according to AQR.
Diversified Investment Vehicle
Mr. Kabiller said Mr. Buffett's skill in structuring Berkshire Hathaway as an investment vehicle may be almost as important as his skill in making specific investments. In particular, the company's insurance affiliates accrue premium payments years before the policies pay out, strengthening Mr. Buffett's ability to maintain leverage in environments where less deep-pocketed investors would have to resort to fire sales, he noted.
Access to Capital / Funding
... Mr. Buffett's “low-cost insurance and reinsurance businesses have given him a significant advantage in terms of unique access to cheap, term leverage.”
The float from that insurance business has provided, on average, 36% of the funding Berkshire Hathaway uses to lever up its portfolio, at a cost AQR estimates at more than three percentage points below the average T-bill rate.

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