- The expected risk-adjusted return over the long-term: this is defined by excess returns and volatility, expressed most commonly by the Sharpe ratio
- The correlation between different strategies and assets, taking a special look at correlations in crisis periods
- The return distribution characteristics of the different elements of the portfolio
Uncorrelated performance of assets in a portfolio often does not feel very good. Diversification implies that there will always be parts of your portfolio that underperform or even lose while others excel. We take disproportional notice of these laggards and instinctively want to avoid them – the benefit over time (as leaders and laggards continuously change) is very abstract and counterintuitive as it isn’t visible in daily portfolio performance.
Combining return and risk gives us the risk-adjusted return. If we divide excess return by volatility (as an expression of risk) we get the Sharpe ratio. In general the higher its Sharpe ratio, the better the strategy or portfolio is.
As the Sharpe ratio depends on the assumption of returns being independent of each other and normally distributed, which poorly reflects the properties of real markets, it always has to be taken with a grain of salt. It is also very sensitive to the time period it looks at, because realized returns often differ dramatically over different periods in history. As it is widely used, it is still the best measure to compare different strategies when our information comes from different resources.
Diversifying across different asset classes with low correlation to each other, raises the portfolio´s Sharpe ratio – that is investing 101, but it is amazing how concentrated many individual investors´ portfolios are.
I have even gone so far as to free myself from the idea of having to select individual stocks altogether to beat the market – the chance of picking outperformers is simply too small as about 65% of stocks underperform their market average and a small percentage of extraordinary performers carry the majority of market gains. I simply invest in broader market ETF, which makes it much easier to structure a portfolio.
Global Asset Allocation
Risk Parity and Leverage
Because correlations between asset classes are constantly changing and somewhat unreliable (especially during a crisis they tend to move towards 1, which means they can be completely correlated at the worst possible time), it will pay off to incorporate alternative, systematic return sources with low correlation to other asset classes. This is what a lot of hedge funds do – termed “alternative beta”. These strategies target systematic risk premia, which is what I mostly concentrate on in my research.
- Return Factors: long-only factor exposure (value, momentum, carry, low beta, quality, etc.) has been added to he standard toolbox for portfolio construction in recent years under the buzzword “Smart Beta”.
Selecting securities according to these return factors has historically outperformed a market cap weighted portfolio.
Because they are especially pronounced and robust, I mainly integrate the value and momentum factors in my portfolio. These two factors display the rare quality of often being negatively correlated, which boosts their combined Sharpe ratio enormously. Whenever value lags, momentum usually outperforms and vice versa – which leads to a much smoother equity curve as each factor can underperform the market for years on end.
A new avenue I am researching and looking at implementing at least partly via a short option strategy is long/short factor exposure. A domain of hedge funds, this method targets the pure outperformance of factors by going long the stocks displaying the factor most strongly and simultaneously going short the stocks showing the factor most weakly. This yields great Sharpe ratios and a low correlation to other assets specifically during a crisis, because it is independent of market direction. But is very hard to implement for the individual investor as it requires shorting a large number of stocks and employing very high levels of leverage (around 8x to 10x). It can be accessed through mutual funds – usually for substantial fees.
- Trend-following Managed Futures: even though relatively widely used as a tiny part of institutional portfolios, this strategy is still under the radar for most individual investors, because it is difficult and expensive to implement. It has shown to be one of the best diversifiers in the past, because of its propensity to deliver positive returns in times of crisis – termed crisis alpha. I have a considerable allocation to managed futures in my portfolio (between 15% and 40% depending on the market environment). Until the end of 2017 I accessed the strategy exclusively through mutual funds and ETF, increasing the allocation continuously as the equity bull market is getting longer and managed futures have underperformed in recent years. Both are likely to regress to their mean returns in the future. One ETF that looks good in theory (but unfortunately has not yet performed well) is WisdomTree Managed Futures Strategy ETF WTMF. Mutual funds are specific to the part of the world you reside in, but in general large CTAs have proven to be effective. In Europe it is fairly easy to access the MAN AHL, Winton or Transtrend programs via UCITS funds, if you are willing to pay the high fees.
Starting in 2018, I have begun to trade my own managed futures strategy, finally overcoming numerous practical hurdles – e.g. the high amount of capital required to run it at a tolerable risk level. This was a very important step for me, as the history of the strategy gives me confidence that I will be able to generate positive returns in a market crisis.
- Volatility risk premium and carry: these are highly correlated to each other, but both offer very substantial, reliable alternative risk premia. Because of their correlation, I mostly concentrate on the volatility risk premium – I have found it to be a superior source of outsized returns: 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 which is positive on average. Its basic concept is to sell catastrophe insurance to other investors for a premium. The strategy is rising in popularity (and therefore crowdedness) because it has recently had very high Sharpe ratios (above 5 for many strategies), but is not (yet) considered an independent asset class. It can capture reliable income streams in sideways- (that´s great, because these are often frustrating and test investor´s patience) and up- markets, but is exposed to rare, but large losses in down markets, when volatility is likely to shoot up suddenly. This risk definitely has to be very strictly controlled. Such a return distribution is called negatively skewed, a property that is shared by many asset classes and strategies. Being essential for portfolio construction return distribution needs to be addressed in detail.
For a holistic view of portfolio construction I analyze the typical return distribution of different strategies in more detail – specifically their skew: at what times and how strongly are they likely to out- or underperform.
- Negative skew: you can expect many small wins and few, but very large losses. The high win rate feels very good and makes long strings of losses less probable. It is possible create an income stream that is very constant and reliable 70% to 80% of the time by writing options, for example. A single large, infrequent loss on the other hand can wipe out a long string of winners at once. Owning equities or writing options have been net positive strategies on average, but you have to make sure you can survive the drawdowns without abandoning the strategy. A way to actively handle the risk and exploit these strategies in good times, while reducing or shutting them down in bad times might be to use an adaptive asset allocation and to balance them with positively skewed portfolio elements.
- Positive skew: you can expect many small losses and few, but large winners. The very real possibility of experiencing long strings of losses and consequently spending a lot of time in a drawdown are hard to tolerate for any length of time, but this psychological hurdle can be mitigated by combining such a strategy with a negatively skewed, constant return stream. The harder part is to find such strategies, that have a positive expected return at all – the rare winners have to be bigger than the accumulated small losses.
Investors greatly value a way to make money in a crisis, that doesn’t cost them an arm and a leg in good times. For example, a positively skewed strategy that has historically been very expensive, with negative average returns, is buying protective puts for a portfolio. It still is attractive for many investors, because it provides a certain protection against deep drawdowns in bad times.
Trend-following managed futures to me is the most promising positively skewed strategy and it has a high allocation in my portfolio, but I also hedge my portfolio through asymetric bets by buying far out of the money puts in areas of the market that show weakness or extreme overvaluation. Explicitly going long volatility, either through protective puts or using volatility instruments directly usually has very low odds and doesn’t pass my strategy criteria, unless it is part of an overall positive strategy (for example a strategy that is short volatility the majority of the time), that employs these protective measures only when it perceives massive breakdowns with the market going into full crisis mode. Again that is a role an adaptive asset allocation can play.
I use a matrix that gives me a birds eye view of my portfolio´s basic elements and their place and function in it. With that in mind I can dive into the details of balancing them.
In “A Barbell Portfolio Strategy” I dive deeper into the benefits of balancing extreme strategies for less risk and high return.