Do you worry about risk?
Then a new white paper by Ampersand Portfolio Solutions, Enhanced Portfolio Diversification: The Power of & might be for you. The new paperprovides an in-depth look at the details associated with structuring overlays as a way to hedge equity-related risk. In prior white papers, The Risk Contribution of Stocks, Parts 1-3 and Looking Under the Hood, Ampersand introduced a concept to diversify beyond stocks and bonds without having to sell the stock/bond portfolio holdings. The latest paper delves deeper and illustrates how equity risk can be managed or mitigated using creative enhanced diversification solutions. Ampersand Portfolio Solutions, a division of Equinox, collaborates with select asset managers to construct bespoke investment solutions.
Ampersands white paper, Enhanced Portfolio Diversification: The Power of &, the fifth in a series, recaps the risks associated with a 60/40 stock/bond portfolio, showing that 92% of the risk is contributed by stocks. Diversifying the portfolio by adding another asset class such as managed futures, other alternative investments, or hedge fund strategies can help to mitigate risk, provide a smoother ride for investors, and enhance performance.
Here are some key highlights from Enhanced Portfolio Diversification:
- One of the few strategies that provides the benefits of non-correlation and has stood the test of time in terms of providing reasonably good risk-adjusted returns over multiple market cycles (including the Global Financial Crisis of 2008) is managed futures.
- By creating a variety of hypothetical portfolios using allocations to stocks/bonds/alternatives, the papers illustrative charts reveal that an investment of 30% equities, 20% bonds, and 50% managed futures handily outperforms all other portfolios on all metrics. The worst drawdown (loss) is about half as deep as an example using a 48/32/20 ratio. In fact, the 30/20/50 portfolio is very close to the efficient frontier as defined by Modern Portfolio Theory.
- In the real world, it is extremely rare to find investment portfolios with allocations as high as 50% to alternative strategies. Most portfolios continue to be significantly under-diversified.
- Ampersand analyzes extended diversification which allows for diversifiers to be added without selling any stocks and bonds in the original portfolio. This is possible through an overlay approach, where the alternatives are overlaid on top of the stock/bond portfolio, without the need to sell any stocks or bonds.
- Using the power of & an investor can continue to have a 60/40 exposure to stocks and bonds as well as adding 50% (or even higher) to alternatives and truly harness greater benefits of diversification as espoused by Modern Portfolio Theory. The 60/40/50 portfolio provides a much higher return, higher reward/risk ratio, and shallower drawdowns. Detailed examples of how this solution works using allocations to managed futures ranging from 0% to 100% are provided in the paper with striking visuals.
- The dominance of the & portfolios over traditional portfolios (in which the allocation to stocks, bonds, cash, and managed futures adds up to exactly 100% is remarkable. For any level of risk from around 4% to 15%, significantly higher returns may be achieved using an & approach.
- For example: a 22/78/47 portfolio has a return of about 9.3% for 6.9% risk level, about 170 basis points better than a traditional 30/20/50 portfolio which offers a return of about 7.6% at that risk level.
- Another portfolio using a 48/52/127 & approach has the same risk level as the S&P 500 Index (about 15%) but a return of about 16.75% versus about 9.7% or 700 basis points higher.
- Using an increasingly larger overlay, it is possible for investors who are less risk averse to take on greater risk in the hope of earning higher returns. For example: a 67/33/183 & portfolio has a risk level of about 20.8% higher than the historical risk of the stock market and a return of about 22%.
- By using the overlay approach to gain extended diversification, investors gain the ability to reduce market risk and smooth drawdowns while potentially improving the portfolios risk-adjusted return. Investors can diversify without having to sell their core stock and bond holdings and they can choose a level of risk suitable for their needs. That, in short, is the power of &.
For the white paper described herein: https://equinoxfunds.com/sites/default/files/Insights_Enhanced-Diversification_0.pdf
