Weekly Digest

Be smart and enjoy your free lunch

Lorenzo La posta

12 March 2018

Anyone who has attended Finance 101 in their first year at university had one sentence imprinted on their mind: “Diversification is the only free lunch in investing”. I still remember my first day when my 40 year old, PhD in Economics, finance professor taught me the three pillars to bear in mind if you wanted to be a successful investor: diversification, diversification, diversification. Even though this is to a large extent true, this pill of wisdom could be more accurately stated as: “Smart diversification is the only free lunch in investing”.

According to the widely studied Modern Portfolio Theory set out by Harry Markowitz in 1952, a risk-averse investor can reduce risk in their portfolio by spreading investments across a large pool of lowly (preferably negatively) correlated assets. This is an extremely powerful yet simple principle. Whenever an asset is losing value, there is a high chance that a second asset in the portfolio - negatively correlated with the first - is offsetting this with gains, producing a less volatile return profile.

There is only one caveat: correlation is a backward looking and purely statistical measure. Thus, its value at any point in time is only an indication of how two securities moved together in the look-back period with little information on the underlying drivers of these movements. As a consequence, diversifying a portfolio only according to correlations works as a safety net as long as future market conditions are not too different from the past environment; this can be painfully false during short-term periods of high markets stress. In crisis periods a widespread flight to quality may add pressure to all risky assets whose returns would eventually show extremely high short-term correlation regardless of historical long-term values. In such situations historical correlations would be less meaningful and a Markowitz-efficient portfolio would strongly underperform a “smartly diversified” portfolio where diversification takes places at a risk-driver level rather than across a correlation matrix. A significant example of this phenomenon can be observed across global stocks and government bonds, which have historically shown a negative correlation (on average -42% in the five years from May 2008 to April 2013). However, in May 2013 the Federal Reserve’s chairman, Ben Bernanke, announced the FED would start tapering its asset purchase program and both asset classes sold off together for the following weeks. During the following three months their correlation topped to an unusually high value of +40% and diversification benefits faded away when most needed.

Here at Momentum we construct robust portfolios targeting high resilience and allocation efficiency. Each strategy that enters any of our portfolios is thoroughly analysed in all its components: experienced analysts are supported by sophisticated research tools to gain a complete understanding of each asset. Additional important factors are considered alongside the more traditional building blocks in the asset allocation process. This means embedding systemic risk checks, alternative risk factor exposures, tactical views and stress tests into the portfolio construction framework. Despite Markowitz’s idea of diversification as a simple, cost-effective shortcut towards asset allocation, only a deeper (yet real, with no over-engineering traps) and smarter asset returns decomposition would yield an efficient portfolio composition.

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