By most accounts, 2018 brings predictions of continued market growth and economic expansion. Recently, the Dow Jones industrial average closed over 26,000 for the first time. A new, pro-business tax bill was signed at the close of 2017, and more like-minded policies are expected to push an already all-time-high equities market even higher. But what happens if the opposite happens? Can your portfolio weather such a storm?
To achieve success in investing in the long term, one must structure a portfolio that can withstand all market environments, can mitigate risk and drawdowns, and provide more stable returns over time. To achieve this, investors must leverage the power of diversification in a portfolio.
In 1990, Harry Markowitz won the Nobel Memorial Prize in economic science for having developed the theory of portfolio choice in the 1950s. Markowitz’s pioneering work demonstrated that by optimally investing in assets which differ in expected risk and return in uncertain conditions, investors can reduce the overall risk. As famously stated by Markowitz, diversification is “the only free lunch in finance.”
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His theory was not based on studies, but proven by mathematics. If you combine two uncorrelated return streams that each have a return of 10 percent and a volatility of 10 percent, the value of the two return streams is calculated by summing the two together, which is 20 percent. To calculate the combined volatility, however, you must take the square root of the sum of the variances. In this case, the volatility is just over 14 percent. Compared to the increase in the combined return (20 percent) which was aggregated, the overall volatility was reduced.
The idea is that by diversifying, an investor gets the benefit of reduced risk at no loss in returns. This concept became known as the Markowitz Efficient Frontier, which is the set of all portfolios that will give the highest expected return for each given level of risk.
Many investors have not fully adopted the groundbreaking work developed by Markowitz. For decades, the 60-40 portfolio (60 percent allocation to stocks and 40 percent allocation to bonds) has remained the standard moderate-risk portfolio used by financials planners and asset managers. Because equities and fixed income are typically uncorrelated, investors recognize some benefits of diversification, including more consistent returns over various market environments.
But the problem with the 60-40 portfolio model is that it misses most of the benefits of diversification. With this model, the optimally balanced portfolio as described by Markowitz has largely been replaced by a model that is massively over-allocated to equity risk. Unfortunately, many retail investors suffered unnecessarily because of this allocation model, like in 2008, which only provides minimal diversification benefits.
A portfolio designed to fully leverage the benefits of diversification requires multiple uncorrelated strategies, not just equities and fixed income. Using Markowitz’s mathematical models, one can see that the return per unit of risk in a portfolio improves by over 41 percent when the portfolio consists of two uncorrelated strategies, such as the 60-40 portfolio. However, this return per unit of risk improves dramatically as the number of uncorrelated strategies increases: plus 73 percent for three, 100 percent for four, 123 percent for five, and so on.
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Implementing diversified, uncorrelated systematic alpha strategies is the key to harnessing the power of diversification in a portfolio. Systematic alpha strategies refer to sources of return for risk taken that are systematically accessible, beta neutral and persistent. The strategies categorized today as systematic alpha come in many shapes and sizes. Examples include volatility strategies, momentum models and commodities, currencies and rates carry strategies.
For years, sophisticated institutional investors have relied on systematic alpha strategies to defend portfolios from devastating drawdowns. This concept has started transitioning to more retail-oriented investors and asset managers, as the pendulum swings from the 60-40 model toward the models developed by Markowitz long ago.
Systematic alpha strategies have been developed and implemented by BNP Paribas, a pioneer in these strategies. For example, the BNPP CASA Index leverages seven systematic alpha strategies exhibiting low correlation to both traditional assets and each other. Through the power of diversification, the index has achieved positive returns every year since 2002 and has generated a 21 percent annualized return, a 11.2 percent volatility level and a maximum drawdown of only minus 13.5 percent, as of Dec. 31, 2017. Because the seven strategies provide alternative exposure, their combined risks are not simply added together, they counterbalance each other and diminish the overall risk.
Ray Dalio, the founder of Bridgewater Associates and one of the most successful investors, highlighted the need for a portfolio of uncorrelated strategies in his book, “Principles.” Dalio described the concept of implementing a portfolio of multiple uncorrelated return streams as the “holy grail of investing.”
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When considering a portfolio allocation, ask whether it provides enough diversified, uncorrelated sources of return. Meaningful allocations to systematic alpha strategies can help investors reap the benefits of spreading risk systematically, improving risk-adjusted returns and smoothing out portfolio returns over time.
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Why the Best Portfolios Rely on Diversification originally appeared on usnews.com
