Stocks and bonds are sending opposite signals about whether US inflation will abate on its own, according to billionaire hedge fund founder Cliff Asness, who called the divergence his “biggest concern.”

Unlike stocks, the bond market is telegraphing that the Federal Reserve will make aggressive interest-rate cuts over the next year or two, Asness, co-founder and chief investment officer of AQR Capital Management, said on an episode of “Bloomberg Wealth with David Rubenstein.” That would trigger a recession that wouldn’t be mild, he said.

“If inflation stays sticky or it comes down because we enter a nontrivial recession —  it’s equities that I think are a scary place,” Asness, 56, said. “They’re not priced very consistently with bonds.” Still, he said, the US could see “immaculate” disinflation that doesn’t come at the cost of growth.

AQR, like other multistrategy funds, thrived last year as inflation spiked. Its longest-running strategy, Absolute Return, surged 43.5% after fees in 2022, its best performance since the firm’s inception and a change from poor returns in recent years starting in 2018. Asness — who has about 117,000 Twitter followers — pledged to stick to his strategy even as the Greenwich, Connecticut-based firm underperformed the market.

AQR is a quant shop, but its models famously incorporate the basic tenets of old-fashioned value investing and marry them with a momentum trading strategy. It’s an approach Asness defended in a series of soul-searching papers and in heated Twitter arguments during the strategy’s rough patch.

The resurgence of inflation — and rising interest rates — have since wreaked havoc on bloated valuations, and trend-following surged thanks to a sudden gust of volatility that blew in last year. With all of its strategies suddenly firing again, AQR’s patience was vindicated.

“The main thing we did, which was not so easy, was to stick with our process,” Asness told Bloomberg in the recent interview. “And then, it kicked in big-time in the last two years.”

After a stint at Goldman Sachs Group Inc., Asness founded AQR, which manages about $100 billion, with David Kabiller and John Liew in 1998.

Originally from Queens, New York, Asness described himself to Rubenstein as “a mathy, a nerdy kid.” He went on to earn an MBA and doctorate in finance from the University of Chicago, where he worked with Nobel Prize winner Eugene Fama, known as “the father of modern empirical finance.”

In his interview with Bloomberg, Asness described one of the scariest moments of his academic life under Fama and also spoke about the risks of private equity, value investing in the quant world and the best investing advice he ever received.

For more insights from the biggest names in investing, watch “Bloomberg Wealth With David Rubenstein.” Asness’s interview airs May 30 at at 9 p.m. ET on Bloomberg Television. The interview has been condensed and edited for clarity.

Last year, your longest-serving fund returned over 40% annualized. Why did it perform so well?

We did something fairly similar to what we do every year. We have a process that involves value investing, trend following, quality investing, looking for positive carry, looking for good momentum. That had suffered a lot from 2018 through 2020, all from the value component.

We analyzed that. We kept trying to prove to ourselves that, maybe value's never gonna work again. And we kept concluding, “No, it’s gonna work again. The world’s just gone crazy.” I think the main thing we did, which was not so easy, was to stick with our process. And then, it kicked in big-time in the last two years.

Is value investing the same in the quant world?

It’s related, but it is not the same. And this has caused no end of confusion. If I see a fire, I’m often more inclined to throw gasoline on it than water. Here's a case where I’ve actually tried to throw water on a fire and tell people, “You’re talking past each other.”

When I say "quants” —  I mean practitioners like me, and academics — it’s basically price to fundamentals, if something looks cheap, scaled by some fundamental. And the cheap tend to outperform the expensive long term. That is the famous academic value effect.

That is not the holistic measure of value a guy like Warren Buffett or any Graham and Dodd-style value investor would look at. In fact, they get quite annoyed sometimes. They go, “That’s not value. That’s just price. You’re just saying it’s cheap. Value is, ‘Is it cheap versus the growth opportunities, versus the moats around it, versus the safety of the stock, versus good things happening?’”

And if it ever gets this far, the quant should explain, “We believe in all those same things, just, semantically, we call those separate factors, and we add it up.” But that little miscommunication has caused a lot of differences.

You're not a big fan of some parts of private equity. Can you be specific about what you don’t like?

What I don’t like are the parts I’m very, very jealous of. In the piece I wrote — I admitted in the very beginning; no one quotes this part — that a fair amount of the motivation for this is admittedly professional jealousy. I think private equity investments have been great for people. I live in Greenwich, Connecticut. I meet a lot of private equity investors. They know more about how actual companies work and how to value them than I will ever dream of.

What I do worry about for the investors and, again, personally resent, is the reporting of risk and volatility. In a 20-some-odd percent down market last year, it was down 4%. And when you talk to the actual private equity people, to a man, to a woman, they agree, “Yeah, if we had to sell it, it would be down much more. But we don’t have to sell it.”

Private equity may still be a very good deal. But I can easily imagine — and I don't want you to yell at me — I could easily imagine its advantage being much smaller, or it could actually even go the other way if people so prized this ability not to market. If it makes you stick with something, that could be a better long-term outcome. But you could also be giving up more than you think. And if we hit that extremely rare, I would not forecast this, but the 10-year, 1930s-kinda bear market, you will discover you had more equities than you thought you had.

You were a research assistant for Eugene Fama. But you're now, every day, trying to beat the market. How do you square those two?

One of the scariest moments of my life, academically, was going to Gene Fama and saying, “I have a dissertation topic I’d like to write on. I want to study this thing called the momentum strategy.” Gene was fabulous about it. He used a phrase that has always meant a lot to me. He immediately said, “If it’s in the data, write the paper.” It’s the closest thing I've heard to a religious statement from him, which was really quite beautiful.

I actually think we agree on a ton more than we disagree. Gene works very closely with a fantastic firm, Dimensional Advisors. It’s not exactly the same. We believe in momentum more than Dimensional. They believe in what’s called the size effect more than we do. But we overlap a lot. They use momentum as part of their process, just not the entire thing. I think we’ve kinda met in the middle.

You started with $1 billion. Did you do reasonably well from the beginning?

About a year-and-a-half in, I would tell people when they’d ask similar questions, “Well, we raised $1 billion, and through diligence, hard work, and some good calls, we’ve turned that into half a billion dollars.”

The investors didn’t say, ‘Give me my money back’?

Some did. But many didn’t. And some gave us more. We started in August of 1998. That was the month Russia defaulted on its debt. The S&P was down about 18%. I always call that the crash nobody remembers. 18% is a crash. We were up that month. We were truly market neutral. The next 18 months as a whole were horrible for us.

The tech bubble, much like 2018 through 2020 — they always say history doesn’t repeat, but it does rhyme. I think these two are in between. I think it rhymes really well. It doesn’t perfectly repeat. We saw cheap stocks, as quants would define them in the simplistic way, be destroyed by expensive stocks. It wasn’t quality stocks doing well. It wasn’t safe stocks doing well. It was story stocks, what they call sometimes glamour stocks. That’s the tough environment for our process; 2018 through 2020 was a very similar environment.

But at the end of the day you go, “No, we think this is a giant dislocation. And we're gonna plant our feet and say, ‘All right, most of the time we try to make money the easy way. We’re gonna make even more money this time, but it’s gonna be the hard way.” That happened then and it happened now.

The Federal Reserve has been jacking up interest rates fairly steadily for more than a year or so. Do you think that's the right strategy?

I don’t think the Fed had much of a choice. I think they were slightly behind the curve. And inflation certainly was sticking around. Whether we have a hard landing or not, the only really good case is inflation just goes away on its own. That's a pretty good case. The world will do very well. My biggest concern and probably our firm's biggest concern is stocks and bonds seem to be taking a very, very different view.

Bonds, whether it’s a risk premium or a forecast of future interest rates — if it’s a forecast of future interest rates, what’s priced into the short term curve is multiple, severe cuts over the next year to two years. That is a recession, and not a mild one, in the forecast.

Equities are, I’m not saying it’s a graveyard, but they’re whistling past that. So that doesn’t mean bonds are right. Equities could be right. You could get what some people have called the immaculate deflation, where inflation comes down and growth doesn’t suffer. But if inflation stays sticky or it comes down because we enter a nontrivial recession — it’s equities that I think are a scary place. They're not priced very consistently with bonds. And we're gonna find out who's right in the next year.

What's the best investment advice you’ve ever received?

Pretty much every week, my wife tells me, “Stop looking at the screen. You’ll be a happier man,” and she’ll be a happier person married to a happier man.

This article was provided by Bloomberg News.