The basic premise for building a diversified portfolio is that uncorrelated or – better yet – negatively correlated assets and strategies will add up to produce higher risk-adjusted returns. These returns can then be leveraged up or down to suit individual risk tolerance. I want to think independently about which amount of capital exposure is optimal for my purpose, so I use the term leverage in a general way to describe portfolio exposure. For example using 0,5 times leverage means that only half your capital is invested or two times leverage implies the use of margin to invest twice the available capital, requiring twice the stomach for tolerating the ensuing volatility. Through volatility adjusted exposure, a very volatile, high return asset or strategy can be scaled down to perform a useful function in a portfolio or an asset with meagre returns, but small volatility can be levered up.
I don´t judge the use of leverage, I think of it as a tool. It is important to be aware that leverage scales risk just as much as return.
To reach higher returns and avoid leverage, it is common practice to overweight volatile assets like equities in a traditional portfolio. But it makes more sense to create a well balanced portfolio (risk parity or equal weighted) with a higher risk-adjusted return and then lever it up to the desired level of risk and return, if this doesn’t involve high costs. A moderately leveraged, highly diversified portfolio is considerably less risky than an unleveraged, non-diversified one.
Apart from correlation, the return distribution of different strategies is the second important factor. Skew describes the return distribution in comparison to a normal distribution. Most of the time skew is negative with more outlier events (fat tails) at the left side of the distribution, meaning that you will experience more extreme losses than normally distributed probabilities would lead you to expect.*
Positively and negatively skewed strategies behave very complimentary. One exhibits many small losses interspersed with infrequent high winners, the other delivers many small wins interrupted by few but large losses.
Positive skew strategies are quite hard to find and provide great diversification. A good example are trend following strategies that provide net positve crisis alpha – one of the few strategies with great returns in 2008-2009. Most asset classes and short volatility strategies deliver a negatively skewed return distribution, that usually shows large losses coincidental with bad times in the market. Which means, that correlations for most assets and strategies tends to move towards 1 (everything is getting more and more correlated) in a crisis – just when diversification is most needed.
Bonds are the classic diversifier to an equity portfolio working as a safe haven in a crisis. Unfortunately this negative correlation is not dependable – in inflationary times like the 1970s both stocks and bonds showed large losses. In such times real assets like real estate, gold and other commodities deliver diversification
Holding cash can play an important role in the portfolio as a dependable diversifier and because it leaves all options open. One avoids falling prey to the endowment effect: people ascribe more value to things merely because they own them.
As the base pillar of my portfolio, I put together a globally diversified asset allocation, which exposes it to the basic risk premia of all asset classes.
This can be done at low cost with ETF – most simply with a single Global Asset Allocation ETF or by using a robo- advisor. With several individual ETF it can be structured and easily customized, sourcing ideas from any of a plethora of asset allocation models. For example the Endowment Model, Permanent Portfolio, All Weather Portfolio or others
– low cost is more important than the exact asset mix. The most common ways are to equally weight or volatility weight the individual parts.
I use several individual index ETF to be able to easily implement a tactical allocation in the next step – to scale the exposure of the different parts of the allocation model up or down according to changing market conditions. It also makes it easy to include alternative assets, e.g. timber or other commodities, specific countries or global sectors.
There are plenty of ETF for implementing different factors available, but research is required to determine just how big the factor exposure of the ETF actually is and how it is implemented.
The Global Asset Allocation has historically yielded between 8,5% – 9,5% a year on average with a volatility of about 8% and a Sharpe ratio of 0,6-0,8. This is twice as good as a pure equity portfolio because the Global Asset portfolio´s volatility is only half and the Sharpe ratio double that of an equity portfolio with similar return expectations. Theoretically (if it can be done in a cost efficient way) it would be possible to reach the same volatility and drawdowns as an equity portfolio with twice the return (17%-19%) by leveraging the portfolio two times. We are entering the league (in terms of risk-adjusted returns) where the all time best investors are playing – for example Warren Buffets Sharpe ratio
is only 0,76 even if his returns have been a bit higher due to the leverage and use of float he employs.
Up to now our investment approach could still be called a largely passive buy and hold portfolio. A yearly rebalancing of the allocation would be sufficient to keep it running. It is a solid, sophisticated solution that even the world´s largest hedge fund Bridgewater uses as a basis for their highly successful funds.**
But some of the most lucrative alternative risk premia are hard or overly risky to harvest in a passive manner and recent studies suggest, that risk-adjusted returns can be improved by a systematic, active approach.
To me the best complimentary strategy, to counterweight the negatively skewed return characteristics of the Global Asset Allocation, are trend-following managed futures.**** As one of the few profitable positive skew strategies, they provide dependable, alternative crisis protection, great diversification and a long history (from the 1970s) of high returns above 10% with low volatility and a Sharpe ratio of 0,6-0,9. The inherent leverage in futures also makes for a cost effective way to boost the portfolio´s exposure if wanted.
The main drawbacks are the complex implementation and the high capital requirements to trade such a strategy – about a minimum $1million portfolio size is necessary to run the strategy as part of a portfolio at acceptable risk levels. An easier way is the access via fund vehicles provided by major CTAs (very high fees, alas) or newer ETF with very short track records (do they deliver what is promised?).
Nonetheless, I allocate a size of one third to one half the Global Asset Allocation portion of the portfolio to trend following strategies.
I concentrate on a small handful of additional strategies to keep the portfolio simple enough to be able have an overview of all positions and allocations to its different parts in a spreadsheet in less than a minute. Otherwise it gets too confusing and costly mistakes tend to creep in.
***** ranks as my number one alternative strategy. It is very lucrative, but also has a lot of pitfalls and non-obvious risks as well as the problem of becoming a quite crowded strategy in 2017.
What it basically does, is selling financial catastrophe insurance and lottery tickets to other investors for a premium.
It captures the volatility risk premium (a bit of an abstract concept): the expected (implied) volatility is – on average – consistently higher than the volatility that actually materializes in the market´s movements (realized volatility). The premium is the spread between the two.
The basic strategy in academic papers systematically sells monthly index options on the S&P 500. Strategy statistics going back to 1990 (not a very long history, but spanning several market cycles) come up with numbers very much like long term equity performance (annual return 8%; Sharpe ratio 0,35). This passes the base rate test of delivering sufficiently long term positive returns in its least sophisticated form even after a devastating crisis that wiped out a decade of cumulative returns in 2008. The CBOE has information and indices for different strategy variations on its website
Volatility selling returns are very negatively skewed: long periods of extraordinarily consistent returns (that are in practice easily scalable to very high levels) are interspersed by large losses (that will wipe you out just as easily, if your leverage is too high). A good indication of that is the very high Sharpe ratio (for a risk premium) for volatility selling before the financial crisis – from 1990-2007 – of 1,3. That´s three times as high as the pure equity risk premium. An explanation for this might be, that selling financial catastrophe insurance demands especially high risk premia, because extraordinarily large losses come at the worst time.
In practice a short volatility strategy needs great attention to detail and good risk control to keep the inevitable losses in check. I try to accomplish this by finding ways to run the strategy in favorable conditions and to scale it down when conditions deteriorate. It can provide big, smooth returns and portfolio leverage at no cost (selling options uses no money in your account, only collateral needs to be provided for margin).
Two approaches look very promising to me:
- Selling out of the money put options on indices (insurance) and selling far out of the money call options on individual securities (lottery tickets). These carry the highest premia as investor demand for these options is highest and they systematically overpay for them. Studies show that it also works well to combine index short puts and short calls into systematic strangles, that make a portfolio more market neutral. This type of strategy captures the volatility risk premium while avoiding to make a directional market bet.
- Trading volatility directly through VIX futures, options and ETP. Volatility ETP like VXX are some of the most efficiently value-losing securities out there and the opportunity lies in taking the other side. The danger lies in the vicious spikes these securities can have to the upside.
Despite (or because of) it´s dangers, being short volatility has been very profitable for me and I allocate as much to it as to the Global Asset Allocation. To calculate the allocation you need to use the actual exposure you have to the underlying securities not the value of the options. With a margin account you can easily employ a lot of leverage, so it is important to be aware of how big your exposure actually is. For example, you could be fully invested in different ETF and sell options on 2-3 times that amount on top of it resulting in leverage of up to four times – very dangerous! The upside is that controlled leverage comes at no cost, as you don´t actually borrow money.
The portfolio looks a bit lopsided now, with too much tail risk exposure and could be balanced by a strongly positively skewed hedging strategy to feather some of the risk of being short volatility. An idea could be an asymmetric bet, buying long term far out of the money put options on struggling stocks and indices. This may be a strategy with a negative long-term expectation, but a strong benefit to portfolio diversification at low cost, with a strong upside when markets turn south.
As the returns of this strategy are very asymmetric, it doesn´t require a lot of capital. 2%-6% of our capital can hedge a good part of the portfolio (the exposure to the underlying is a proxy for the size of your hedge). Using yearly options, the most this strategy can possibly cost is your invested capital – a tolerable loss considering the protection it buys. Implementing some adaptive allocation rules has the potential to turn this strategy net positive.
When you have found strategies, you want to include in your portfolio, write down the exact rules of entry, exit and position size. Define the strategies role and allocation size in your portfolio.
Important note: all strategy statistics always concern the past – it is easy to forget that the future may bring very different results indeed.
I arrived at using the strategies I talk about here through a long process of trial and error, but there are countless other methods and ways to go about investing. Whatever you do, I suggest to concentrate a lot on the process of building strategies and portfolios – the desired outcome will follow over time. Research in depth to really understand and make each strategy your own, otherwise it may be very difficult to consistently implement it.
*on concepts like skew and kurtosis read “Skewing Your Diversification“ by Mark S. Shore which gives insights on the advantages of combining short option and trend following managed futures with a traditional portfolio.
**The hedge fund AQR
has done very interesting, openly available research on this.
*** In the 1990s Ray Dalio of Bridgewater wrote a paper about asset allocation called “ENGINEERING TARGETED RETURNS & RISKS“ which also deals with the subject of using leverage as a tool; more recent papers and articles I found at ReSolve,
Alpha Architect or others.
**** Examples for good books are “Trend Following with Managed Futures: The Search for Crisis Alpha“ by Alex Greyserman and Kathryn Kaminski, “Following the Trend“ by Andreas Clenow or “Systematic Trading“ by Robert Carver.