E427: AQR's Peter Hecht on AI, Market Bubbles & How the Best Investors Build Portfolios

David Weisburd (0:00)

Pete, at AQR, you have $242 billion assets under management. You're one of the largest hedge funds in the world.

And one of the things I wanted to start with is one of my biggest pet peeves in this industry is this concept of a tracking error. Tell me about tracking error, and is it a misnomer?

Peter Hecht (0:19)

We're familiar with concepts like volatility, which sort of gives you a sense of the range of outcomes for an investment's return. Tracking error is the volatility, but it's the volatility of the relative return, your return versus a benchmark. So let's say the S&P 500

So tracking error is going to give you a sense of how far a manager's relative return, how different it can be from the S&P 500 So like a tracking error of 3% means if you think it's a normal distribution, you're going to have a return that's going to be either 3% ahead of the S&P 500, 3% behind the S&P 500 with roughly a 66% probability. So it gives you a sense of how much active risk am I taking and is it consistent with my risk tolerance in terms of my willingness and ability to tolerate lagging the benchmark.

David Weisburd (1:17)

Can tracking error be a good thing?

Peter Hecht (1:20)

Yes, because if you want to beat the benchmark, if you want to try to add value, you have to take tracking error.

So I always tell people you can take bad tracking error, right? That's with a manager that does not have a good process for determining what's an attractive security and not an unattractive security. Or you can invest with the manager you think has a good process. You have to take tracking error to beat your benchmark. The more tracking error you take gives you more possibility for beating the benchmark, but it also means you might actually lag the benchmark by more when your manager experiences bad luck.

David Weisburd (1:56)

Speaking of the markets, they don't operate in a vacuum. The more passive investing becomes a norm. So now we're still in this era of passive investing.

Active investing seems to have more room for alpha. Is that generally true?

Peter Hecht (2:12)

There's a big debate there in terms of whether the rise of passive is distorting prices, making it harder for active managers.

I would say from my vantage point, while passive has become more important, and it is a large part of the market, I still believe there are enough active managers that are going to take the time to read the information, process the information, and pound that information into prices. And so whether they're being more passive or not is good for active managers, sort of depends, right? Because it sort of depends on who's getting fired to go passive. If it's really bad active managers that are getting fired and should be going passive, right? Now all of a sudden the remaining active managers on average are higher quality. But if it's actually some good active managers actually getting fired, maybe there's less competition in terms of being able to harvest, identify and harvest alpha. So it sort of depends on what you believe in. So there is no hard set answer.

David Weisburd (3:18)

I spoke to former president of Peter Thiel's Hedge Fund, and he talked about this reflexivity and the volatility that's caused by the passive amount of capital. So now you see oftentimes in the market, markets go up or down because everybody's making the same trade. Does that make the market inherently more volatile?

Peter Hecht (3:38)

There have been some academic papers and it's early innings, and there's people who disagree with it.

That believe that the rise of passive have made markets more inelastic. More inelastic means flows will actually move prices, even if those flows are for non-fundamental reasons, which would lead to a more volatile stock market, for example. That's possible that with more passive investors, people who just take prices as given aren't as sensitive to prices. I can see the possibility that you would see more inelasticity, and thus for a given flow, maybe today, maybe there is slightly more sort of market impact flow-based movements and prices than what we saw before, which would lead to more volatility. It's early innings, and in academia, sometimes it takes 20 years to figure out who is right.

David Weisburd (4:30)

AQR has $242 billion. You have all these different strategies, but at the core, how would you describe your philosophy?

Peter Hecht (4:37)

First off, we believe in diversification.

So we are a systematic fundamental manager. Some people call us quant. I like to actually say systematic, because within quant, there are people who are mathematicians. Like, I have a PhD in finance. Okay? Most systematic managers have a small edge for any single security that they trade. And you might ask, well, then how do you actually develop strategies that have good returns? Well, like a casino, a casino would never exist if it could only play blackjack against you, one person. They bring in thousands of uncorrelated blackjack customers.