This paper explores the value of low-statistical-dependence risk premia building blocks and their role in improving investment outcomes. Low statistical dependence is frequently underestimated both as a mechanism for controlling risk and as a potential source of additional return. While the underlying mathematics of volatility, correlation and portfolio outcomes are well established and relatively well known, it is frequently the case that investors lack a visceral intuition for just how powerful these statistical features are in contributing to desirable investment outcomes.
Example Pension Fund Allocation
U.S. Pension funds are some of the largest and most sophisticated investors in the world, we have chosen to complete a cross section analysis between an average 60/40 stock bond portfolio, the average pension fund according to a publication by JPMorgan, the typical U.S. public pension plan has approximately 52% of its assets in equities, 28% in fixed income, 5% in real estate and 14% in total alternatives (confusing, grammatically-incorrect sentence – please simplify and clarify what you’re trying to say and break down this sentence down into smaller pieces – Dave). In order to analyze the merits of this typical allocation, we have attempted to realistically design a proxy for it by selecting a broad collection of related indices as depicted in Exhibit 1 below. Based on a typical institutional asset allocation, the equity exposure was created with the following style and regional allocations: U.S. large cap (21%), U.S. small cap (5%), non-U.S. developed equities (21%) and emerging markets equity (5%). Likewise, the fixed income exposure was further broken down as follows: short-duration fixed income (3%), core fixed income (20%) and TIPS (5%). Due to a lack of an appropriate passive benchmark, the Russell 2000 Growth Index represented the private equity exposure with a quarterly lag.
Exhibit 1: Example Pension Fund Asset Allocation
The portfolio is hypothetical and used for illustrative purposes only.
Portfolio Return Analysis
When reviewing the performance of the three different portfolios over the recent period, we notice a clear difference in one key area, risk, compounded annual returns are very similar in fact the differences between the top returning 60/40 & All Weather asset allocation is small as All Weather achieves over 90% of the return, however, at the same time as taking 24% less risk (confusing and grammatically incorrect sentence – clarify and break up into smaller pieces, possibly with the first of them ending at “risk” – Dave). The worst performing asset allocation is the average pension fund on all fronts and as shown in the table, and what is most interesting is the diversified asset allocation is almost perfectly correlated to the U.S. Stock Market despite being invested in a large variety of assets.
The Efficient Frontier
The efficient frontier says the provided portfolio (All Weather) is very close to the theoretical efficient portfolio for maximizing investor’s risk/return trade off on a diversified portfolio.
Just how diversified is this average portfolio based on an
average pension fund allocation? From a purely qualitative perspective, it appears to be a sensible asset allocation. It is diversified across asset classes, geographies, market caps, maturities and even includes a healthy dose of alternatives. A more rigorous inspection, however, reveals a very different reality. The inclusion of highly correlated assets actually does not help diversify your portfolio, as they all effectively perform the same. First, most portfolios invested in multiple asset classes may be diversified in name only, which may result in risk exposure concentrated in one or two risk factors. Second, diversification based on statistically independent risks can be effective for both reducing risk and enhancing returns. Thus, building a portfolio of low-correlated, well-defined, independent risk premia can potentially enhance performance outcomes to an extent that goes beyond many investors’ intuitive expectations.
The Moral of the Story
First, most portfolios invested in multiple asset classes may be diversified in name only, which may result in risk exposure concentrated in one or two risk factors. Second, diversification based on statistically independent risks can be effective for both reducing risk and enhancing returns. Thus, building a portfolio of low-correlated, well-defined, independent risk premia can potentially enhance performance outcomes to an extent that goes beyond many investors’ intuitive expectations.
Special Thanks to Our Contributor
Vidal Wills
alpha@wptfunds.com
WPT Funds Management is focused on understanding how the world works. By having the deepest possible understanding of the global economy and financial markets and then translating that understanding into a great portfolio and strategic partnerships. We are building a distinct track record of success. We aim to do this by having great people operate in a culture of radical truth and radical transparency.