Misunderstanding Buffett

In November 2013, Connecticut-based money management firm AQR published a paper considering how to construct a quantitative model emulating the way Warren Buffett has selected his investments and generated attractive long-term returns. As we believe AQR’s conclusions do not represent how Buffett actually invests, we considered how we might build a "Buffett model" in a different way.

Long Short

AQR’s quantitative approach to Buffett-style investing

AQR’s Buffett model builds on a long lineage of research initiated by Eugene Fama and Kenneth French. The starting point of their work was the capital asset pricing model (CAPM) and the hypothesis that, because markets are efficient, greater returns can only be achieved by taking on greater risk. Risk in the CAPM — and to efficient-market adherents — is defined as beta, or the volatility of investment returns when compared to the market.

Fama and others noted outperformance in certain investment strategies that could not be explained solely through the use of beta, and so they searched for other factors that helped explain their observations. One of their findings was called the "value factor," which showed that by weighing companies with high ratios of book value (shareholders’ equity) to market value (market capitalization), one could explain a large portion of the excess returns. Another finding was that smaller companies tended to deliver higher returns than larger companies and that these excess returns could not be explained using beta alone.

Fama and others augmented the CAPM with the value and size factors to create a new "three-factor" model to better explain historical market returns. In their minds, there should be very few sustainable sources of outperformance against a benchmark constructed using these three factors.

One substantial challenge to their views, however, was that Buffett’s returns and the returns delivered by certain other value investors from the Graham-Dodd school of investing were persistently stronger than could be explained by the three-factor model. As a result, researchers at AQR attempted to augment the three-factor model to see if they could explain Berkshire Hathaway’s historical performance.