The best free lunch in town

Many asset managers are scored based on the returns they provide to investors relative to each unit of risk incurred. A portfolio that can achieve the same return with less volatility (i.e. less risky) is seen as superior. Similarly, a portfolio that can achieve a greater return for the original level of risk is also seen as beneficial to the investor. As expected, investors are seeking to maximise returns whilst minimising risk.

Finance’s holy grail is to find two assets that are expected to increase in value over the longer term, with a perfect negative correlation in the short term. In the short term when one asset falls in value, this fall is perfectly offset, plus a small positive margin, by the gain in the other. Your capital slowly grows over the long term, with next to zero risk in the short term. Akin to a savings account at the bank, each day your account slowly ticks up.

In reality these market scenarios very rarely occur. Whilst the saying goes ‘there is no free lunch’, a more apt assessment might assert ‘there is no free buffet’ – although with adequate planning and preparation, there are some free ‘sandwiches’. '

So how does one acquire the most discussed free lunch in finance, diversification?

Investors can compare a fund's historical performance (noting that historical performance is not necessarily an indicator of future performance) by determining each level of return achieved for the level of risk taken. For example, say Fund 1 historically achieves a 3% return having a 4% risk profile (i.e. a ratio of 0.75), whereas Fund 2 achieves a 6% return with a 6% risk profile (i.e. a ratio of 1.00). It is evident that historically Fund 2 has achieved the superior outcome for each unit of risk taken.

Although an investor might not be willing to take on a risk profile of 6% and is only seeking out a 3% return on investment – does this preclude the investor from investing in Fund 2? Not necessarily when considered from a portfolio perspective. This investor has two choices for their $100 investment:

• Option 1 - Invest the full $100 into Fund 1, anticipating a 3% return with a 4% risk profile
  
• Option 2 - Invest half (i.e. $50) into Fund 2, and ‘invest’ half (i.e. the other $50) in a safe spot ‘under the bed’, anticipating a 3% return overall, with a 3% risk profile.

Option 2 targets the same return, with a historically lower risk profile than Option 1.

Similarly, this process can be reversed for investors seeking a higher return profile. Say there is a third fund, Fund 3, that historically achieves a 12% return having a 15% risk profile. For investors seeking a 12% return, what choices do they have?

• Option 1 -  Invest $100 into Fund 3, anticipating a return of 12% with a risk profile of 15%
  
• Option 2 - Borrow $100 (which, for the purposes of this example, remains interest free), and invest $200 into Fund 2, anticipating a 12% return on the $100 of non-borrowed funds, with a 12% risk profile.

Again, Option 2 targets the same return profile for the $100, with a historically lower risk profile than Option 1.

Asset allocation matters

The risk-return payoff is important because it allows investors to strategically allocate funds within their portfolios. So for a portfolio manager, how can a better risk-adjusted portfolio be achieved? How can a fund seek to drive up returns whilst lowering the level of risk taken? One possible answer could be by using diversification to the portfolios advantage.

Diversification acts to slow volatility in the following way: Say we have $100 to invest and purchase Stock A, which moves upwards 1% (+$1) one day and then downwards 1% (-$1.01) the next day, ending the period at $99.99.

In an alternate example, using the same $100, we construct a portfolio containing only $50 of Stock A, and invest the remaining $50 into Stock B. Importantly, Stock B has a historical correlation of 50% to Stock A. In this example, Stock A moves upwards 1% (+$0.50) (with Stock B anticipated to increase 0.5% (+$0.25)) on the first day. On the second day, Stock A moves downwards 1% (-$0.505) and Stock B is anticipated to decrease by 0.5% (-$0.25125). Overall, the portfolio is anticipated to be valued at $99.99375.

Not only was the portfolio return slightly higher in this example than it was in the first, the volatility, or degree to which the portfolio rose and fell was also less aggressive.

This strategy can be applied further by adding additional stocks to the portfolio which have a (historical) correlation of less than 100% to the existing portfolio, thereby intending to reduce the volatility of the portfolio via introduction of the third stock, the fourth, the fifth and so on…

Generally speaking, a carefully constructed portfolio of 20-40 positions maintains a balance of diversification, which whilst it is not a buffet, still makes for a great free sandwich. 

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