Paying a high fee for an investment strategy isn't always a bad thing, but advisers need to be very selective when picking those strategies.
“Not all sources of return should cost alpha fees,” Cliff Asness, co-founder of hedge fund AQR Capital Management LLC, said at Charles Schwab & Co. Inc.'s Impact 2012 conference in Chicago.
“Don't pay high fees for high-capacity, easy-to-access, correlated and commoditized exposures,” he said. “Do be willing to pay higher fees for low capacity, idiosyncratic, truly diversifying sources of return.”
The investment principles of The Vanguard Group Inc. founder John Bogle, keeping costs low, re-balancing, and resisting panic and euphoria, are “80% of the investment game,” Mr. Asness said.
The other 20% comes from identifying those strategies that are actually diversifiers.
The traditional 60/40 portfolio of stocks and bonds, for example, may have just 60% of its assets allocated to stocks, but those holdings make up 90% of the risk in the fund, according to AQR.
“That's not diversification,” Mr. Asness said. “You need to think about allocating risk, not just dollars.”
To lower the overall risk of a portfolio, advisers should think about breaking down a portfolio by looking at things such as equitylike risk, assets that have high risk and high reward, interest rate risk, inflation risk and credit risk to get better diversification and therefore better overall risk-adjusted returns.
The trade-off is a smoother ride toward the end goal, but perhaps a lower overall expected return.
“You can't eat risk-adjusted returns, it's true,” Mr. Asness said.
To get the most out of a risk-adjusted portfolio, AQR uses leverage, “one of the dirty words in finance,” Mr. Asness said.
“Leverage is scary and it can be a risk. You've got to handle it with oven mitts,” he said.