Traditional professional investors--Asness calls them "quals"--search zealously for a handful of undervalued companies in which to invest. They interview management teams, evaluate corporate strategies, and analyze demand for products and services. AQR, like other quant firms, relies mostly on a roomful of powerful computers running proprietary models to evaluate reams of publicly available data. AQR never talks to management before investing. Asness and his partners were among the first to build a stock portfolio--and now a very successful business--by using computer models to combine two simple concepts: buying undervalued stocks (a strategy known as value investing) and betting against overvalued ones (which are called "momentum" stocks, referring to the tendency of securities that are rising in price to keep going up for a time, even when they're overvalued). Using a variety of metrics, the AQR models spit out the names of hundreds and hundreds of stocks that are undervalued (which the firm buys and holds) and hundreds more stocks that are over-valued (which they short, or bet will fall).
Asness explained the differences between quants and quals this way: "A qual digs very deeply into potential investments, but he can only do that with so many stocks, so he needs to have a relatively high level of conviction that he is right, since he's going to hold a pretty concentrated portfolio, say 10 or 20 stocks ... A qual needs to be careful about not making mistakes--one bad mistake in a 10-stock portfolio can get ugly!" He continued: "A quant, on the other hand, has the ability to study thousands of stocks at once, and thus can hold much more broadly diversified portfolios. Because quants hold so many stocks, ones that are even slightly misvalued may still make sense ... If you can find 500 stocks to bet on where each has a 51 percent chance of beating the market, then through diversification, the odds of your overall portfolio start to look pretty good."
Asness declined Goldman's invitation to invest in Facebook at a $50 billion valuation, which he considered excessive
AQR's September filing with the Securities and Exchange Commission shows that the firm owns stock in roughly 2,000 companies, from ADC Tele-communications to Zymo-genetics. "What a quant tries to do is spread their bets," he said. "You can still be dead wrong as a quant, but you're dead wrong if the average result doesn't hold. You should never be dead wrong because three stocks did the wrong thing." In a television interview recently, Asness said, "Diversification is famously called the only free lunch in finance. Some people ... don't fully believe in that. I do. And when you see a free lunch, the rational thing to do is eat it."
In essence, AQR is betting that markets will revert to the mean, and that investors will act "rationally" once information about individual companies is fully digested. (As an example, he said he recently declined Goldman Sachs's invitation to invest in Facebook at a $50 billion valuation, which he considered excessive.)
Quants sometimes speak about having found the Holy Grail of investing, the ability to construct vast portfolios of stocks that are nearly perfectly hedged--bets on value on one side, bets against momentum on the other--and that they believe should be, over the long haul, relatively immune to the market's increasingly violent vicissitudes. Scott Patterson refers to this phenomenon as the belief that they have discovered "The Truth." "Quants will say, 'No, we don't believe anything like that.' But actually when you sit down with them over a couple drinks, they'll start talking like that," he explained. "It's this belief that it's all captured in mathematics and models."
While quant investing remains a relatively small part of the financial world--perhaps $500 billion now, according to eVestment Alliance, out of the tens of trillions of dollars invested worldwide--in their effect on professional investors, the quants punch well above their collective weight, because what they're doing is considered so cutting-edge. Firms like D. E. Shaw, Renaissance Technologies, and Barra attract waves of Ph.D.s eager to create models that might lead to the next great investing technology, and to personal fortunes. Other investors can't help but take notice and try to emulate them.
Next page: "Potentially devastating consequences"