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AQR C A P I T A L
M A N A G E M E N T
AQR Capital Management, LLC I Two Greenwich Plaza, I Greenwich, CT 06830 I T : 203.742.3600 I F : 203.742.3100 I www.aqr.com
Andrea Frazzini, Ph.D. March 2013 Vice President AQR Capital Management
Ronen Israel Principal AQR Capital Management
Tobias J. Moskowitz, Ph.D. Fama Family Professor of Finance Booth School of Business, University of Chicago Research Associate National Bureau of Economic Research
Robert Novy-Marx, Ph.D. Assistant Professor of Finance Simon School of Business, University of Rochester Faculty Research Fellow National Bureau of Economic Research
A New Core Equity Paradigm Using Value, Momentum, and Quality to Outperform Markets
1 Throughout this paper, we will interchangeably use the terms “quality” and “profitability”, also references to returns, risks, out-performance, etc. are based on a hypothetical analysis and not an actual portfolio or account. Any statement about returns is also subject to the caveat that past performance is not a guarantee of future returns. Please see below for additional details on this analysis and important disclosures at the end of this paper.
We would like to thank Cliff Asness, William Cashel, April Frieda, Marco Hanig, Antti Ilmanen, Sarah Jiang, Bryan Johnson, David Kabiller, John Liew, Mark McLennan, Alex Sanborn, Laura Serban and Dan Villalon for helpful comments and suggestions, and Jennifer Buck for design and layout.
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Introduction
2 Note, there are other well-known styles, including the “size” and “low-beta”
effects. In this paper, we focus on value, momentum, and profitability, since these styles are the most applicable for long-only investors seeking to outperform core benchmarks. Throughout the paper, references to “core benchmarks” shall mean the Russell 1000 for U.S. large cap, Russell 2000 for U.S. small cap and MSCI World Ex U.S. for International large cap.
Motivation
3 Fama and French (1996, 2008, 2012), Jegadeesh and Titman (1993), Asness
(1994), Asness, Moskowitz, and Pedersen (2012), Israel and Moskowitz (2013). 4 See Asness, Moskowitz, and Pedersen (2012), among others.
5 Graham (1973).
6 Grant (1838): “…when a member possessed a stock, and prices were rising, he
ought not to sell until prices had reached their highest …” 7 Most prominently Fama and French in a series of papers: Fama and French
(1992), Fama and French (1993), Fama and French (1996), Fama and French (2004), Fama and French (2008), Fama and French (2012).
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8 Berger, Israel, and Moskowitz (2009).
9 Novy-Marx (2012a, 2012b) and Asness, Frazzini, and Pedersen (2013).
10 Frazzini, Kabiller, and Pedersen (2012).
11
Novy-Marx (2012a) shows that incorporating profitability measures yields dramatic improvements to the performance of value strategies based on book-to-price. 12
Of course, any single stock may not be attractive on all criteria; it is the characteristics of the portfolio that we ultimately care about.
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Economic Intuition
13
Ball (1978), Berk (1995). 14
Lakonishok, Shleifer, and Vishny (1994).
15
Many of these explanations are based on the Nobel-prize winning work of Daniel Kahneman and Amos Tversky. See, for example, Kahneman and Tversky (1979). 16
Bernard (1992), Michaely, Thaler, and Womack (1995), and Chan, Jegadeesh, and Lakonishok (1997). 17
Research in behavioral finance shows a strong tendency for retail investors, and even mutual fund managers, to exhibit the disposition effect. See Odean (1998) and Grinblatt and Han (2005) for retail investors and Frazzini (2006) for fund managers.
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Implementing the Styles
18
Although these market corrections can lead to short-term losses for momentum, our research suggests that equity momentum strategies do not have larger or more frequent periods of underperformance than other equity styles (value, growth, and the market). 19
Frazzini, Israel, and Moskowitz (2012). 20
See Israel and Moskowitz (2013).
21
All of our value measures scale a measure of firm fundamentals by a measure of the share price using the most up-to-date market information, which significantly improves the performance of value strategies that are combined with momentum portfolios. See Asness and Frazzini (2011) and Appendix B for details. 22
See Novy-Marx (2012a) and Asness, Frazzini, and Pedersen (2013). 23
See Chan, Jegadeesh, and Lakonishok (1997) which also documents earnings announcement-based momentum and post-earnings announcements drift.
Exhibit 1: Composite Style Measures
Value Profitability Momentum
Measures Book-to-price Total profits over assets Prior 1-year return (skipping last month)
Earnings-to-price Gross margins Return around earnings announcements over prior year
Forecasted earnings-to-price Free cash flow over assets
Cash flow-to-enterprise value
Sales-to-enterprise value
Source: AQR.
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24
The universe of countries include: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Hong Kong, Italy, Israel, Japan, Netherlands, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and United Kingdom. In addition, stocks from all markets (including the U.S.) must meet certain other criteria based on company type (e.g., which excludes REITS, ETFs, closed end funds, LPs, SPACS), liquidity (e.g., minimum liquidity requirement of three month median daily trading volume of at least $0.1 MM.), exclusion of firms with less than 12 months of public trading, and exclusion of firms announced as a current takeover or merger target. 25
Note as well regarding the weighting scheme, our version of value uses current price as in Asness and Frazzini (2011) and thus is actually somewhat more
value/contrarian than the standard versions that use lagged prices (see Appendix B for a more detailed discussion). 26
Appendix A details the benefits of our approach.
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27
The information ratio is defined as excess returns divided by tracking error. 28
It may come as a surprise to some that in U.S. large cap, simple cap-weighted book-to-price value, delivers only small, positive outperformance, but this is consistent with other data studies (see Israel and Moskowitz 2013) and underscores the need for more themes, more diversified measures and a slightly more aggressive weighting scheme than cap weighting.
Exhibit 2: Performance of Value, Momentum, Profitability Strategies
Source: AQR. Returns are gross of transaction costs and fees. Performance is hypothetical, and is not based on an actual portfolio or account, See important disclosures relating to hypothetical results at the end of this paper.
Simple
value Value Momentum Profitability VMP
Simple
value Value Momentum Profitability VMP
Simple
value Value Momentum Profitability VMP
Return 12.6% 16.7% 15.2% 14.7% 17.3% 16.1% 18.8% 17.6% 17.5% 20.7% 8.5% 11.9% 7.7% 8.4% 11.2%
Volatility 17.2% 18.1% 20.6% 16.8% 16.6% 20.2% 21.7% 23.9% 21.5% 19.9% 18.4% 18.7% 17.5% 15.8% 15.7%
Sharpe Ratio 0.45 0.65 0.50 0.58 0.74 0.55 0.64 0.53 0.58 0.79 0.28 0.46 0.25 0.32 0.50
Excess Return 0.6% 4.7% 3.2% 2.7% 5.3% 4.0% 6.8% 5.5% 5.5% 8.6% 2.4% 5.8% 1.6% 2.3% 5.1%
Tracking Error 8.0% 8.4% 10.3% 5.4% 5.8% 8.2% 10.3% 8.7% 5.2% 5.2% 7.4% 7.9% 7.9% 4.7% 7.0%
Information Ratio 0.08 0.56 0.31 0.51 0.91 0.49 0.65 0.63 1.06 1.67 0.32 0.74 0.20 0.49 0.72
U.S. Large Cap, 1980 - 2012 U.S. Small Cap, 1980 - 2012 International, 1990 - 2012
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29
Asness (2011).
Exhibit 3: Style Performance Relative to Core Benchmark, Total Excess Returns (U.S. Large Cap)
Source: AQR. See important disclosures about hypothetical results at the end of this paper.
Exhibit 4: Style Performance Relative to Core Benchmark, Cumulative Underperformance
(U.S. Large Cap)
Source: AQR. See important disclosures about hypothetical results at the end of this paper.
100%
1000%
10000%
19
80
19
82
19
84
19
86
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88
19
90
19
92
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94
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96
19
98
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00
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02
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04
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08
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10
20
12
Cum
ula
tive E
xcess R
etu
rns
(log s
cale
d)
Simple Value ValueMomentum ProfitabilityVMP U.S. Large Cap
-40%
-30%
-20%
-10%
0%
19
80
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82
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84
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86
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88
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12
Cum
ula
tive E
xcess R
etu
rns
Simple Value Value
Momentum Profitability
VMP U.S. Large Cap
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30
Note that some of the relatively lower (negative) correlation between value and momentum in our international sample is due to the fact that we are allowing country over-weights and under-weights. Keeping the portfolio country neutral relative to the core benchmark increases the magnitude of the negative correlation.
Exhibit 5: Performance of Integrated Value, Momentum, and Profitability (VMP) Strategies
U.S. Large Cap, 1980 - 2012
U.S. Small Cap, 1980 - 2012
International, 1990 - 2012
VMP
VMP
VMP
Return 17.3% 20.7% 11.2% Volatility 16.6%
19.9%
15.7%
Sharpe Ratio 0.74 0.79 0.50
Excess Return 5.3%
8.6%
5.1% Tracking Error 5.8%
5.2%
7.0%
Information Ratio 0.91 1.67 0.72
Net Returns 15.6%
18.3%
10.3% Net Sharpe Ratio 0.64
0.67
0.44
Total Trading Costs 1.7% 2.4% 0.9%
Turnover (1-sided) 136%
102%
125% Beta 1.0
1.0
0.8
Worst Cumulative Underperformance -11% -13% -17%
% of Rolling 3-year Underperformance 4.7%
4.7%
13.2% % of Rolling 5-year Underperformance 0.0%
0.0%
2.9%
% of Rolling 10-year Underperformance 0.0% 0.0% 0.0%
Source: AQR. Net returns are after estimated transaction costs but gross of fees. Performance is hypothetical and is not based on an actual portfolio or account, See important disclosures relating to hypothetical results at the end of this paper.
Exhibit 6: Correlation of Monthly Excess Returns of Value, Momentum, and Profitability Strategies
U.S. Large Cap
U.S. Small Cap
International
Momentum Profitability
Momentum Profitability
Momentum Profitability
Value -0.48 -0.39
-0.56 0.14
-0.09 -0.16 Momentum 0.38 0.18 0.45
Source: AQR. See important disclosures about hypothetical results at the end of this paper.
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Exhibit 7: Annual Excess Returns of Value, Momentum, and Profitability Strategies and VMP
Strategies (U.S. Large Cap)
Source: AQR. See important disclosures about hypothetical results at the end of this paper.
Exhibit 8: Rolling Outperformance of Integrated Value, Momentum, and
Profitability Strategy vs. Traditional Value Strategy (U.S. Large Cap)
Source: AQR. See important disclosures about hypothetical results at the end of this paper.
Exhibit 9: Cumulative Performance of Integrated Value, Momentum, and Profitability (VMP) Strategies
Source: AQR. See important disclosures about hypothetical results at the end of this paper.
-30%
-20%
-10%
0%
10%
20%
30%
40%
50%
19
80
19
82
19
84
19
86
19
88
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90
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92
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94
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19
98
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00
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02
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12
Value Momentum Profitability VMP U.S. Large Cap
-15%
-10%
-5%
0%
5%
10%
15%
19
84
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86
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88
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90
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92
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94
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95
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97
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99
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01
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03
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05
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08
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10
20
12
Simple Value VMP U.S. Large Cap
$0
$1
$10
$100
$1,000
19
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90
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12
Gro
wth
of
$1 (
log s
cale
d)
Total Return vs. Core Benchmark
VMP U.S. Large Cap Russell 1000
VMP U.S. Small Cap Russell 2000
$0
$1
$10
$100
19
90
19
91
19
92
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93
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94
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95
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96
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97
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00
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01
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20
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09
20
10
20
11
20
12G
row
th o
f $1 (
log s
cale
d)
Total Return vs. MSCI World Ex U.S.
VMP International MSCI World Ex U.S.
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Misconceptions
31
See, for example, Lesmond, Schill, and Zhou (2003) or Korajczyk and Sadka (2004). 32
See Keim (1999).
Benefits of Integration
33
Israel and Moskowitz (2012). 34
Israel, and Moskowitz (2012), Fama and French (2012). 35
Asness, Moskowitz and Pedersen (2012) and Israel and Moskowitz (2012). 36
Novy-Marx (2012a).
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37
Thus, running the integrated strategy at higher tracking errors is another added benefit that can be extraordinarily valuable to investors. For example, at higher tracking error an investor essentially pays lower fees per unit of style exposure and per unit of excess returns they expect to receive.
38 Israel and Moskowitz (2012) and Frazzini, Israel, and Moskowitz (2012).
39 Frazzini, Israel, and Moskowitz (2012) discuss trading costs in value, momentum,
and other equity strategies. 40
Israel and Moskowitz (2012).
Conclusion
41
Israel and Moskowitz (2012) and Frazzini, Israel, and Moskowitz (2012). See Israel and Moskowitz (2012) for a discussion of effective tax rate computations.
Exhibit 10: Effects of Trading Costs and Taxes For Value, Momentum, and Profitability (VMP) Strategies
Excess Returns
Gross
After Trading Costs
After Trading
Costs and Taxes
Turn- over
(1-sided) Effective Tax Rate
U.S. Large Cap, 1980-2012 4.1% 3.6% 2.1% 64% 9.5%
U.S. Small Cap, 1980-2012 6.7% 6.0% 3.9% 54% 11.4%
International, 1990-2012 4.6% 4.1% 3.1% 70% 10.0%
Source: AQR. See important disclosures about hypothetical results at the end of this paper.
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References
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Appendix A: Impact of Specific Design Choices
41
Note that the “simple value” portfolio in Exhibit A1 is based on the top 50% of stocks with the highest book-to-price while the exhibits in the main text use the top 25% of stocks. In Exhibit A1 we start with the top 50% to demonstrate the benefits of concentrating and using a more aggressive weighting scheme in portfolio (4).
0.00
0.10
0.20
0.30
0.40
0.50
0.60
0.70
0.80
0.90
1.00
Simple value portfolio(top 50%)
Use current price Multiple measures ofvalue
Concentrate inhighest ranking (top25%) and blend capand signal weighting
Add momentum Value, momentumand profitability
Info
rmati
on
Rati
o
Exhibit A1: Impact of Specific Design Choices
Portfolio Description Excess Return
Tracking Error
Information Ratio
Worst Rolling 5-year Underperformance
(1) Simple value portfolio (top 50%) 0.3% 5.3% 0.05 -47.3%
(2) (1) + use current price 0.8% 5.9% 0.14 -34.1%
(3) (2) + use multiple measures of value 1.7% 5.8% 0.29 -18.3%
(4) (3) + concentrate (top 25%) and blend of cap-signal weighting 4.7% 8.4% 0.56 -11.1%
(5) (4) + add momentum 4.4% 6.3% 0.70 -18.3%
(6) - VMP (5) + add momentum and profitability 5.3% 5.8% 0.91 0.0%
Source: AQR. See important disclosures about hypothetical results at the end of this paper.
Value Value +
Momentum
VMP
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Appendix B: Momentum Screens
42
Asness and Frazzini (2011).
Exhibit B1: Performance of Momentum Screens, 1980 – 2012
Portfolio Description Return Volatility Sharpe Ratio
Excess Return
Tracking Error
Info. Ratio
Turnover (1-sided)
HML Loading
UMD Loading
(1) Simple value portfolio (top 25%) 12.5% 17.2% 0.44 0.6% 8.0% 0.07 63% 0.65 -0.10
(2) (1) + momentum screen 12.8% 16.8% 0.47 0.9% 7.1% 0.12 58% 0.61 0.05
(3) (1) + current price + some momentum 13.1% 16.8% 0.49 1.2% 7.1% 0.17 56% 0.65 0.06
(4) (1) + current price + momentum 14.2% 16.8% 0.56 2.3% 6.1% 0.38 57% 0.31 0.25
Source: AQR. See important disclosures about hypothetical results at the end of this paper.
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Appendix C: Academic (Fama and French) Factor Exposures
Exhibit C1: Factor Exposures of Simple Value and VMP Portfolios
U.S. Large Cap, 1980 - 2012
U.S. Small Cap, 1980 - 2012
International, 1990 - 2012
Simple value VMP
Simple value VMP
Simple value VMP
Alpha -1.38% 2.68% 1.06% 5.56% 0.65% 1.78%
(-1.75) (3.64) (1.21) (6.07) (0.48) (1.51)
MKT 1.07 1.04
1.05 1.04
0.91 0.87
(71.3) (74.3) (63.1) (59.8) (41.1) (44.8)
SMB 0.02 0.12
0.81 0.83
-0.16 -0.11
(0.8) (5.9) (33.6) (32.9) (-3.30) (-2.48)
HML 0.65 0.22
0.75 0.42
0.63 0.45
(28.2) (10.1) (29.6) (15.7) (11.2) (9.3)
UMD -0.10 0.20
-0.18 0.01
-0.16 0.20
(-7.52) (15.4) (-11.70) (0.8) (-5.37) (7.6)
R2 94% 94% 94% 94% 89% 89%
Source: AQR. See important disclosures about hypothetical results at the end of this paper.
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Disclosures
This document has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer or
any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual
information set forth herein has been obtained or derived from sources believed by the author and AQR Capital Management, LLC
(“AQR”) to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a
representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information
serve as the basis of any investment decision. This document is intended exclusively for the use of the person to whom it has been
delivered by AQR, and it is not to be reproduced or redistributed to any other person. The information set forth herein has been
provided to you as secondary information and should not be the primary source for any investment or allocation decision. This
document is subject to further review and revision. Past performance is not a guarantee of future performance.
This document is not research and should not be treated as research. This document does not represent valuation judgments with
respect to any financial instrument, issuer, security or sector that may be described or referenced herein and does not represent a
formal or official view of AQR.
The views expressed reflect the current views as of the date hereof and neither the author nor AQR undertakes to advise you of any
changes in the views expressed herein. It should not be assumed that the author or AQR will make investment recommendations in the
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The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or
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nor is it to be relied on in making an investment or other decision.
There can be no assurance that an investment strategy will be successful. Historic market trends are not reliable indicators of actual
future market behavior or future performance of any particular investment which may differ materially, and should not be relied upon as
such. Target allocations contained herein are subject to change. There is no assurance that the target allocations will be achieved, and
actual allocations may be significantly different than that shown here. This document should not be viewed as a current or past
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The information in this document may contain projections or other forward‐looking statements regarding future events, targets,
forecasts or expectations regarding the strategies described herein, and is only current as of the date indicated. There is no assurance
that such events or targets will be achieved, and may be significantly different from that shown here. The information in this document,
including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be
superseded by subsequent market events or for other reasons. Performance of all cited indices is calculated on a total return basis with
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The investment strategy and themes discussed herein may be unsuitable for investors depending on their specific investment
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Hypothetical performance results (e.g., quantitative backtests) have many inherent limitations, some of which, but not all, are described
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trading program in spite of trading losses are material points which can adversely affect actual trading results. The hypothetical
performance results contained herein represent the application of the quantitative models as currently in effect on the date first written
above and there can be no assurance that the models will remain the same in the future or that an application of the current models in
the future will produce similar results because the relevant market and economic conditions that prevailed during the hypothetical
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implementation of any specific trading program which cannot be fully accounted for in the preparation of hypothetical performance
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anomalies. This backtest’s return, for this period, may vary depending on the date it is run.
Diversification does not eliminate the risk of experiencing investment losses.
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