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Ocean Power Technologies’ (OPTT) CEO George Kirby Discusses Q1 2016 Results – Earnings Call Transcript

Ocean Power Technologies, Inc. (NASDAQ: OPTT ) Q1 2016 Earnings Conference Call September 8, 2015 14:30 ET Executives Allison Gross – The Blueshirt Group George Kirby – President and Chief Executive Officer Mark Featherstone – Chief Financial Officer Operator Good day, ladies and gentlemen and welcome to the Fiscal First Quarter 2016 Ocean Power Technologies Earnings Conference Call. My name is Chris and I will be your conference moderator for today. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes. And at this time, I would now like to turn the conference over to your host for today, Ms. Allison Gross [ph] with Blueshirt. Ma’am, you may proceed. Allison Gross Thank you and good afternoon. Thank you for joining us on OPT’s conference call and webcast to discuss the financial results for the three months ended July 31, 2015. On the call with me today are George Kirby, President and CEO and Mark Featherstone, Chief Financial Officer. George will provide an update on the company’s recent developments, key activities and strategies, after which Mark will review the financial results for the fiscal first quarter 2016. Following our prepared remarks, we will open the call to questions. This call is being webcast on our website at www.oceanpowertechnologies.com. It will also be available for replay approximately 2 hours following the end of this call. The replay will stay on the site for on-demand review over the next several months. Earlier today, OPT issued its earnings press release and will be filing its quarterly report on Form 10-Q with the Securities and Exchange Commission later today. All of our public filings can be viewed on the SEC website at sec.gov or you may go to the OPT website, www.oceanpowertechnologies.com. During the course of this conference call, management may make projections or other forward-looking statements regarding future events or financial performance of the company within the meaning of the Safe Harbor provision of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are subject to numerous assumptions made by management regarding future circumstances over which the company may have little or no control and involves risks and uncertainties and other factors that may cause actual results to be materially different from any future results expressed or implied by such forward-looking statements. We refer you to the company’s Form 10-K and other recent filings with the Securities and Exchange Commission for the description of these and other risk factors. And now, I would like to turn the call over to George to begin the discussion. George Kirby Thanks, Allison. Good afternoon, everyone. I will begin by reviewing our operations and provide an update on key activities and developments after which Mark will briefly review our financial results. Mark and I will then be available to answer any questions. So, let’s begin. First, we are excited that the company is continuing to achieve progress with both our new buoy designs and our commercialization efforts. And as announced earlier today, we have completed the deployment of our APB-350 A1. We have also established a Technical Advisory Panel, or TAP, which is a key development in our path to commercialization and will be instrumental in gathering commercial and technical feedback from industry participants and potential customers. I will be talking about the TAP in greater detail later on the call. Consistent with our strategic pivot, we also continue to make good progress on our technology roadmap, including the development of the APB-350 A2, which we are targeting to be ready for deployment later this fiscal year as well as advancing the development of the PB10. Our progress of APB-350 A1 utilizes the structure previously deployed in 2013, but with a newly designed power take-off. Our APB-350 A2 will feature an optimized hull geometry, which we expect to result in improved operating efficiency as well as reduced fabrication, transportation and deployment cost, all important factors in developing a commercial product for our target markets. The A2 PowerBuoy is expected to undergo a critical design review later this month and be ready for deployment this fiscal year. We believe that the APB-350 represents a very appealing value proposition to provide persistent and renewable power to offshore applications. The APB-350 is designed to provide a robust and cost effective alternative to incumbent solutions that utilize battery, solar and diesel power. An important element of our business strategy is to develop and expand our partnerships in key market areas, including ocean observing, defense and security, oil and gas and offshore winds. Based on our product and technology roadmap, we expect the APB-350 to undergo significant in-ocean testing throughout the next 6 to 12 months. And we are looking forward to sharing performance data with potential customers. As discussed in our earnings release issued earlier today, we have also recently formed a Technical Advisory Panel, or TAP, as part of our intensified effort to accelerate PowerBuoy’s commercialization and market adoption. The TAP consists of selected potential customers, end users and technical stakeholders from various markets, which cover a wide spectrum of applications and market requirements. Companies that make up the panel include a large international and multidisciplinary moving service company and the international certification body, which provides technical assessment, research, advisory, and risk management to the oil and gas industry, two major oil and gas operators, a large oil and gas equipment manufacturer and a leading meteorological and oceanographic sensor manufacturer. The University of Western Australia, Center for Offshore Foundation Systems is also a key TAP participant. The core function of the TAP is that the panel will review and provide critical industry feedback on market and application requirements and test protocols in order to increase our speed to market. This long-term collaboration is initially focused on the APB-350. However, it could extend to future PowerBuoy designs as well. Our goal is to provide reliable, durable and cost effective offshore autonomous power solutions where current solutions are either too costly or unavailable and we believe will enable many new customer applications. The TAP engages these market participants in the validation and commercialization process, which will help us to achieve our objectives more quickly and we will provide more detail on the TAP in the very near future. As we have discussed, there are four key markets which we are targeting, ocean observing, defense and security, oil and gas and offshore winds. We estimate that the total addressable market is well in excess of $1 billion and growing at 2% to 5% annually and we believe that our near-term opportunities could exceed about $75 million. Ocean observing applications for our PowerBuoy include weather forecasting, climate change monitoring, biological process monitoring, and ocean floor seismometry. We continue to see new applications as well, including power and docking systems for unmanned underwater vehicles, which could result in more frequent and reliable vehicle charging. Our objective within the next 1 to 2 years is to complete application demonstrations with our industry partners and to initiate our new product introduction through PowerBuoy leases and unit sales. Shifting to defense and security, the near-term addressable market encompasses remote sensor applications with high-frequency radar and sonar and network and communication systems. Our value proposition is that we expect our solution cost estimates to be substantially lower than incumbent solutions for manned and unmanned system operations, while providing persistent power to onboard payloads. We continue to identify applications in the U.S. and the international defense markets that we were seeking strategic relationships with potential servicing partners. Our third target market is offshore oil and gas and applications include communications, equipment monitoring and seismic mapping to support early exploration and reservoir management. Our value proposition is enabling access to deepwater resources in a cost effective manner. We continue to develop our technologies for applications, which require high power output through a combination of scaled-up PowerBuoy design, enhanced mooring systems and array technologies. Finally, the offshore wind industry continues to be very exciting for us. So, our objective and value proposition is to become the preferred integrated solution delivering up to 50% or more lifecycle cost savings over incumbent solutions. Near-term addressable market opportunities include multiple stakeholders across scores of sites in the U.S. and Europe over the next three years. We continue to see significant market interest in our PowerBuoy and we are discussing potential applications with stakeholders using our APB-350 as the power solution platform. To address all of these market segments, we are collaborating with potential users, as well as progressing toward agreements for further application development and demonstrations. With that, I will turn it over to Mark who will review our financial results for the fiscal first quarter 2016. Mark Featherstone Thanks George and good afternoon everyone. I will now briefly review results for the first fiscal quarter of 2016 before we open up the call for questions. For the three months ended July 31, 2015, OPT reported revenue of $0.1 million as compared to revenue of $1.5 million for the three months ended July 31, 2014. The decrease in revenues compared with the prior year period was primarily related to the completion of our WavePort contract with the European Union and decreased billable costs on our project with Mitsui Engineering & Shipbuilding or MES. The MES project is currently undergoing a stage-gate review with its project stakeholders. The net loss for the three months ended July 31, 2015 was $4.1 million as compared to a loss of $3.3 million for the three months ended July 31, 2014. The increase in net loss is primarily due to higher product development costs associated with the development of our legacy PB40 device and due to the redesigned APB-350. Subsequent to the end of the quarter, we retrieved the PB40 and deployed the APB-350. During the three months ended July 31, 2014, we recovered product development costs from prior periods under our cost sharing contract with the European Union for our WavePort project in Spain. This increase in product development cost recovery was offset by a favorable change of $0.4 million in our gross loss over the prior year quarter. The prior year quarter included a gross loss due to a change in estimated cost for the MES project. In addition, selling, general and administrative expenses were $1.2 million lower in the first quarter 2016 than in the prior year quarter, primarily due to reduced legal fees, decreased site development expenses, decreased patent amortization costs, as well as lower third-party consultant fees. These decreases were partially offset by increased employee-related costs. Turning now to the balance sheet, as of July 31, 2015, total cash, cash equivalents and marketable securities were $14.2 million, down from $17.4 million on April 30, 2015. As of July 31, 2015 and April 30, 2015, restricted cash was $0.5 million. Net cash used in the operating activities was $3.1 million during the quarter ended July 31, 2015, down slightly from the $3.2 million for the quarter ended July 31, 2014. As discussed in our last conference call, we have taken a number of steps over the last several months to reduce our cash burn rate, while also increasing our technical, operating and business development resources. As such, we continue to project that our operating cash burn in fiscal 2016 will be lower than that in fiscal 2015 despite increased deployment activity in fiscal 2016. We have also substantially increased our proposal efforts and remain active in pursuing commercial partnerships and other alliances with potential customers. As a result of these actions, we remain confident in our cash position and we expect to have sufficient cash to maintain operations into at least the third calendar quarter of 2016. With that, I will turn back to George before we open the call for questions. George Kirby Thanks Mark. Before we move to questions, I want to take a minute to reiterate a few compelling reasons to consider OPT. Number one, we believe we are the technology leader in wave energy conversion for offshore applications. We are seeing that our technology provides a critical solution for offshore distributed power generation for a number of industries discussed earlier. We have a clearly defined technology roadmap which focuses on driving down costs, improving reliability and durability and broadening commercial applications and we currently have and continue to develop significant intellectual property around our technologies and applications. Number two, we are targeting large addressable markets, including ocean based communication and data gathering, security, defense and offshore oil and gas. We are executing multiple PowerBuoy deployments, which we believe will further advance our product validation and will serve as near-term market catalyst. We are also engaging potential customers to develop PowerBuoy applications which can lead to solution demonstrations and market launch. And number three we have a solid leadership team in place at both the executive management and the Board levels. So in summary, we remain laser focused on launching our PowerBuoys into offshore market applications, where reliable and cost-effective power is critical. And we are very excited about the progress that we have made in advancing our core technologies toward achieving this goal. As we accelerate our technology development, we continue to receive very positive market feedback, as we expect our PowerBuoys to demonstrate cost-effective alternatives to incumbent solutions, which generally use less reliable and more costly sources of power. We continue to engage with potential partners for joint development projects as part of our commercialization efforts. We are very encouraged by the opportunities that are opening in front of us and we look forward to announcing further progress in the near future. So thank you for your time today. And operator, we are now ready to take questions. Question-and-Answer Session Operator George Kirby Okay. Given that there are no more questions, I want to thank everyone again for attending today’s call. If there are any other questions, please don’t hesitate to contact us in the future. And we look forward to providing you with further updates next quarter. Thank you everyone. Operator Ladies and gentlemen that concludes today’s conference. Thank you very much for your participation. You may now disconnect. Have a great day. Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. 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4 Important Lessons From Psychology For Investors

Summary Beware of overconfidence – your predictions may be incorrect, prepare yourself. Don’t neglect competition – don’t fall prey to what-you-see-is-all-there-is. Avoid loss aversion/sunk costs – only hold stocks because you believe will outperform. Anchoring and adjustment – Ignore useless information as much as you can when valuing a stock. Humans are not fully rational beings. Most of the time, this irrationality serves a useful evolutionary purpose, but for investing, it can be devastating. The pitfalls laid out below are well-known concepts in behavioral economics. To get a better grasp of how they affect your investment decisions, they are illustrated with my personal experience. Beware of overconfidence Duke University conducts annual surveys among CFOs. Among other things, the CFOs are asked for an estimate range of the S&P 500 returns over the following year. They were asked to provide a value of which they were 90% sure it was too high and another that they would be 90% sure of that would be too low. This would provide a range of 80% accuracy. The findings are shocking: only one in three was correct, versus the 80% one would expect with such a prediction. Their range was too narrow and they were too overconfident. With many decisions that rely on estimates, this overconfidence can be dangerous. Being aware of overconfidence can help a lot. To the credit of the CFOs, they are not in a position where they can give a realistic 80% accurate forecast (which would be between -10% and +30%) because they are seen as experts and look clueless when they provide a very wide range. The best professional forecasters are aware of the low value of their predictions and share less of the overconfidence bias. One of the best sell-side analysts of the Netherlands told me once about analyst estimates: ‘we know one thing for sure: actual earnings won’t match the estimates.’ Don’t neglect competition Colin Camerer and Dan Lovallo observed that often in decision making people ignore competing possibilities and coined the term ‘competition neglect’. It can be illustrated with an example of eBay (NASDAQ: EBAY ). Many sellers let their auction end during peak-visit hours in the evenings to increase the price of the item they try to sell. They neglect the fact that normally auctions should have the same distribution as bids, and therefore bids per auction should not differ. Even worse, they ignore the fact that many people (competitors) use the same strategy. The consequence of neglecting this competition is a lower price obtained for the item as well as a lower probability of a sale ( this is a link to that study ). Investors can learn from this. Every time you study a business, be aware of the most obvious things the market will see. If people like IBM (NYSE: IBM ) because Warren Buffett invests in it, you should be aware that this is already reflected in the stock price. On a deeper level, it pays to see what the competitors of the business you study are doing. It is easy to get optimistic about a company when you only see the competitive landscape from its own perspective. One of such examples is R&D spending at GM’s (NYSE: GM ) competitors. GM has been lagging in R&D expenditure growth as I point out in this article . Not taking into account the increased competitive pressure from other automakers, will create a lot of room for disappointment. Avoid loss aversion/sunk costs The loss-aversion theory explains that people generally are more sensitive to losses than they are to gains. For investors, the relevant part of this theory is often closely related to the sunk-cost theory. After making a bad investment that turns out worse than expected Philip Fisher has described this in his book Stocks and Uncommon Profits as: “More money has probably been lost by investors holding a stock they really did not want until they could ‘at least come out even’ than from any other single reason.” In my case this stems from anticipated regret. I know that if I sell a stock that is down over 30% and it rebounds thereafter that I will experience a great deal of regret. It is very hard to ignore this anticipated emotion. One way to deal with it is to just sell the stock and never look at it again, or sell half of the position to mitigate future underperformance. What I did in one case was going short on other stocks in the same industry that were overvalued compared to the stock I owned. Beware of anchoring and adjustment In making decisions in uncertain environments decision makers frequently make an initial estimate and then adjust this estimate when new information arrives. Anchoring can be the result of anything. Even when answering a simple question like ‘how many people live in Luxembourg?’, hearing a completely unrelated statement like ‘there are a billion butterflies in New York’ can influence you answer. For investors the question is ‘how much is stock X worth’ and the information we should avoid is the stock price in the market. I too often fall prey to this type of thinking. In this article on ING (NYSE: ING ), I remained conservative on my assumptions on growth, ROE, and discount rate in order to keep the target price closer to the market price. I now believe the same stock is worth over €15.50, versus €12.40 then (the +25% is roughly in line with the stock price appreciation since then), while operationally, the company is almost the same as it was 10 months ago. Hedge, always hedge This one is not directly related to any psychological concept, but it does have ties with overconfidence and ignoring what is out there. Never gamble when you don’t have to. Both of my two worst investments of the past two years could have been hedged. The first one is Ensco (NYSE: ESV ). I knew oil price was a risk but confident in fact that I had no idea where the oil price would go, I thought it would be a prudent thing to assume the futures market showed was the most accurate forecast. Perhaps it was, and of course it is not unreasonable to assume an efficient market when it comes to commodities. What I should’ve done, however, is recognize that the oil price was such an important part of the investment case that I was unfit to make that call without a view. Alternatively I could have chosen to hedge the risk, but instead I took a hit of over 50% on the investment. Luckily, I later started to hedge this risk and prevented much worse by doing so. In another case, I discovered that the ArcelorMittal (NYSE: MT ) mandatory convertible notes ( prospectus ) could be proxied by a bond and a long put and short call option on MT stock. My conclusion was that the note was undervalued compared to prevailing interest rates and options that would mitigate any exposure to Arcelor’s stock price. In fact, I saw an arbitrage opportunity. Instead of buying the notes and purchasing a put option while selling a call, I only bought the notes because I found the spreads on the options painfully high, and was tempted by the upside. Again, this investment turned sour and I suffer a loss of over 40%. If the spreads on the options really were too big, I should’ve refrained from buying the notes. How to cope with these behavioral issues? As the behavior is natural, it is hard to overcome. It is perhaps even impossible to overcome all of them. But knowing and acknowledging it affects you is half the battle and helps to put yourself back on the track of rationality when you need it most. Disclosure: I am/we are long MT, IBM, ESV, ING. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

AQR Style Premia Alternative I, AQR Style Premia Alternative LV I, September 2015

By Samuel Lee Objective and strategy AQR’s Style Premia Alternative, or SPA, strategy offers leveraged, market-neutral exposure to the four major investing “styles” AQR has identified: Value , the tendency for fundamentally cheap assets to beat expensive assets. Momentum , the tendency for relative performance in assets to persist over the short run (about one to twelve months). Carry , the tendency for high-yield assets to beat low-yield assets. Defensive , the tendency for low-volatility assets to offer higher volatility-adjusted returns than high-volatility assets. To make the cut as a bona fide style, a strategy has to be persistent, pervasive, dynamic, liquid, transparent and systematic. SPA offers pure exposure to these styles across virtually all major markets, including stocks, bonds, currencies, and commodities. It removes big, intentional directional bets by going long and short and hedging residual market exposure. As with all alternative investments, the goal is to create returns uncorrelated with conventional portfolio returns. SPA sizes its positions by volatility, not nominal dollars. In quant-speak, risk is often used as shorthand for volatility, a convention I will adopt. Of course, volatility is not risk (though they are awfully correlated in many situations). SPA’s strategic risk allocations to each style are as follows: 34% each to value and momentum, 18% to defensive, and 14% to carry. Its strategic risk allocations to each asset class are as follows: 30% to global stock selection, 20% each to equity markets and fixed income, and 15% each to currencies and commodities. There is a bias to the value and momentum styles, perhaps reflecting AQR’s greater confidence in and longer history with them. Risk allocations drift based on momentum and “style agreement,” where high-conviction positions are leveraged up relative to low-conviction positions. The strategy’s overall risk target falls in steps in the event of a drawdown and rises as losses are recouped. These overlays embody some of the hard-knock knowledge speculators have acquired over the decades: bet on your best ideas, cut losers and ride winners, and cut capital at risk when one is trading poorly. SPA targets a Sharpe ratio of 0.7 over a market cycle. AQR offers two flavors to the public: the 10% volatility-targeted AQR Style Premia Alternative Fund Inst (MUTF: QSPIX ) and the 5%-vol AQR Style Premia Alternative LV Fund Inst (MUTF: QSLIX ). Adviser AQR Capital Management, LLC, was founded in 1998 by a team of ex-Goldman Sachs quant investors led by Clifford S. Asness, David G. Kabiller, Robert J. Krail, and John M. Liew. AQR stands for Applied Quantitative Research. The firm’s bread and butter has long been trading value and momentum together, an idea Asness studied in his PhD dissertation at the University of Chicago. (Asness’s PhD advisor was none other than Eugene Fama, father of modern finance and one of the co-formulators of the efficient market hypothesis.) When the firm started up, it was hot. It had one of the biggest launches of any hedge fund up to that point. Then the dot-com bubble inflated. The widening gap in valuations between value and growth stocks almost sunk AQR. According to Asness , the firm was six months away from going out of business. When the bubble burst, the firm’s returns soared and so did its assets. The good times rolled until the financial crisis shredded its returns . Firm-wide assets from peak-to-trough went from $39.1 billion to $17.2 billion. The good times are back: As of June-end, AQR has $136.2 billion under management. The two near-death experiences have instilled in AQR a fear of concentrated business risks. In 2009, AQR began to diversify away from its flighty institutional clientele by launching mutual funds to entice stickier retail investors. The firm has also launched new strategies at a steady clip, including managed futures, risk parity, and global macro. AQR has a strong academic bent. Its leadership is sprinkled with economics and finance PhDs from top universities, particularly the University of Chicago. The firm has poached academics with strong publishing records, including Andrea Frazzini, Lasse Pedersen, and Tobias Moskowitz. Its researchers and leaders are still active in publishing papers. The firm’s principals are critical of hedge funds that charge high fees on strategies that are largely replicable. AQR’s business model is to offer up simplified quant versions of these strategies and charge relatively low fees. Managers Andrea Frazzini, Jacques A. Friedman, Ronen Israel, and Michael Katz. Frazzini was a finance professor at University of Chicago and a rising star before he joined AQR. He is now a principal on AQR’s Global Stock Selection team. Friedman is head of the Global Stock Selection team and worked at Goldman Sachs with the original founders prior to joining AQR. Israel is head of Global Alternative Premia and prior to AQR was a senior analyst at Quantitative Financial Strategies Inc. Katz leads AQR’s macro and fixed-income team. Frazzini is the most recognizable, as he has the fortune of having a last name that’s first in alphabetical order and publishing several influential studies in top finance journals, including ” Betting Against Beta ” with his colleague Lasse Pedersen. Unlisted is the intellectual godfather of SPA, Antti Ilmanen, a University of Chicago finance PhD who authored Expected Returns , an imposing but plainly-written tome that synthesizes the academic literature as it relates to money management. Though written years before SPA was conceived, Expected Returns can be read as an extended argument for an SPA-like strategy. Strategy capacity and closure AQR has a history of closing funds and ensuring its assets don’t overwhelm the capacity of its strategies. When the firm launched in 1998, it could have started with $2 billion but chose to manage only half of that, according to founding partner David Kabiller . Of its mutual funds, AQR has already closed its Multi-Strategy Alternative, Diversified Arbitrage and Risk Parity mutual funds. However, AQR will meet additional demand by launching additional funds that are tweaked to have more capacity. As of the end of 2014, AQR reported a little over $3 billion in its SPA composite return record. Given the strategy’s strong recent returns, assets have almost certainly grown through capital appreciation and inflows. Because AQR uses many of the same models or signals in different formats and even in different strategies, the effective amount of capital dedicated to at least some components of SPA’s strategy is higher than the amount reported by AQR. Management’s stake in the fund As of Dec. 31, 2014, the strategy’s managers had no assets in the low-volatility SPA fund and little in the standard-volatility SPA fund. One trustee had less than $50,000 in QSPIX. Collectively, the managers had $170,004 to $700,000 in the SPA mutual funds. Although these are piddling amounts compared to the millions the managers make every year, the SPA strategy is tax inefficient. If the managers wanted significant exposure to the strategies, they would probably do so through the partnerships AQR offers to high-net-worth investors. But would they do that? AQR, like most quant shops, attempts to scarf down as much as possible the “free lunch” of diversification. The managers are well aware that their human capital is tied to AQR’s success and so they would probably not want to concentrate too heavily in its potent leveraged strategies. Opening date QSPIX opened on October 30, 2013. QSLIX opened on September 17, 2014. The live performance composite began on September 1, 2012. Minimum investment The minimum investment varies depending on share class, broker-dealer and channel. For individual investors, a Fidelity IRA offers the lowest hurdle: a mere $2,500 for the I share class of the normal and low-volatility flavors of SPA. Or you can get access through an advisor. Otherwise, the hurdles are steep: $5 million for the I class, $1 million for the N class, and $50 million for the R6 class. Expense ratio The I class for the normal and low-volatility versions cost 1.50% and 0.85%, respectively. The N classes costs 0.25% more and the R6 classes costs 0.10% less. The per-unit price of exposure to SPA is lower the higher the volatility of the strategy. QSPIX targets 10% vol and costs 1.5%. QSLIX targets 5% vol and costs 0.85%. Anyone can replicate a position in QSLIX by simply halving the amount invested in QSPIX and putting the rest in cash. The effective expense ratio of a half QSPIX, half cash clone strategy is 0.75%. Comments Among right-thinking passive investors who count fees by the basis point, AQR’s SPA strategy elicits revulsion. It’s expensive, leveraged, complicated, hard to understand, and did I mention expensive? To make the strategy easier to swallow, some passive-investing advocates argue SPA is “passive” because it’s transparent, systematic, and involves no discretionary stock selection or market forecasting. This definition is not universally accepted by academics, or even by AQR. The purer, technical definition of passive investing is a strategy that replicates market weightings, and indeed this definition is used by the venerable William Sharpe in his famous essay, ” The Arithmetic of Active Management .” I do not think SPA is passive in any widely understood sense of the word. In fact, I think it’s about as active as you can get within a mutual fund. And I also happen to think SPA is a great fund. Regardless of my warm feelings for the strategy, I consider SPA suitable only for a rare kind of nerd, not the investing public. Though SPA is aggressively active, its intellectual roots dig deep into the foundations of financial theory that underpin what are commonly thought to be “passive” strategies, particularly value- and size-tilted stock portfolios (DFA has made a big business selling them). The nerds among you will have quickly caught on that what AQR calls a style is nothing more than a factor, a decades-old idea that sprung from academic finance. For the non-nerds: A factor, loosely speaking, is a fundamental building block that explains asset returns. Most stocks move together, as if their crescendos and diminuendos were orchestrated by the hand of some invisible conductor. This co-movement is attributed to the equity market factor. According to factor theory, a factor generates a positive excess return called a premium as reward for the distinct risk it represents. It is now widely agreed that two factors pervade virtually all markets: value and momentum (size has long been criticized as weak). AQR’s researchers – including some of the leading lights in finance – argue there are two more: carry and defensive. They’ve marshalled data and theoretical arguments that share an uncanny family resemblance with the data and arguments marshalled to justify the size and value factors. The SPA strategy is a potent distillation of the factor-theoretical approach to investing. If you believe the methods that produced the research demonstrating the value and size effects are sound, then you have to admit that those same tools applied to different data sets may yield more factors that can be harvested. OK, I’ve blasted you with theory. On to more practical matters. Who should invest in this fund? Investors who believe active management can produce market-beating results and are willing to run some unusual but controllable risks. How much capital should one dedicate to it? Depends on how much you trust the strategy, the managers, and so on. I personally would invest up to 30% of my personal money in the fund (and may do so soon!), but that’s only because I have a high taste for unconventionality, decades of earnings ahead of me, high conviction in the strategy and people, and a pessimistic view of competing options (other alternatives as well as conventional stocks and bonds). Swedroe, on the other hand, says he has 3% of his portfolio in it. How should it be assessed? At a minimum, an alternative has to produce positive excess returns that are uncorrelated to the returns of conventional portfolios to be worthwhile. However, AQR is making a rather bold claim: It has identified four distinct strategies that produce decent returns on a standalone basis and are both largely uncorrelated with each other and conventional portfolios. When combined and leveraged, the resulting portfolio is expected to produce a much steadier stream of positive returns, also uncorrelated with conventional portfolios. So far, the strategy is working as advertised. Returns have been good and uncorrelated. In back-tests, the strategy only really suffered during the dot-com bubble and the financial crisis. Even then, returns weren’t horrendous. Is AQR’s 0.7 Sharpe ratio target reasonable? I think so, but I would be ecstatic with 0.5. What are its major risks? Aside from leverage, counterparty, operational, credit, etc., I worry about a repeat of the quant meltdown of August 2007. It’s thought that a long-short hedge fund suddenly liquidated its positions then. Because many hedge funds dynamically adjust their positions based on recent volatility and returns, the sudden price movements induced by the liquidation set off a self-reinforcing cycle where more and more hedge funds cut the same positions. The stampede to the exits resulted in huge and sudden losses. However, the terror was short-lived. The funds that sold out lost a lot of money; the funds that held onto their positions looked fine by month-end. AQR is cognizant of this risk and so keeps its holdings liquid and doesn’t go overboard with the leverage. However, it is hard for outsiders to assess whether AQR is doing enough to mitigate this risk. I think they are, because I trust AQR’s people, but I’m well aware that I could be wrong. Bottom line One of the best alternative funds available to mutual-fund investors.