Going Back To First Principles

Constructing the optimal portfolio

Originally published in the May 2012 issue

In January 2012, investment advisory firm, Capital Generation Partners, launched its First Principles Diversification research, which examines the effectiveness of the traditional methods of diversifying a portfolio. The paper asserts that at a fundamental level, there are only three asset classes: debt, equity and cash. On that basis, hedge funds cannot be considered an asset class and only when they are considered from the bottom up, with a deep appreciation of the underlying assets and strategies concerned, can they bring powerful diversification to a portfolio and help reduce risk.

Capital Generation Partners argues that investors have to understand this basic principle before they can construct the optimal portfolio which captures growth on the upside and protects on the downside.

Ever since Harry Markowitz unveiled his Modern Portfolio Theory, diversification has been at the heart of portfolio construction. Markowitz showed that a diversified portfolio reduces volatility over an undiversified portfolio and that portfolio construction should take into account correlations between securities as well as the returns of individual securities. Thus began the evolution of diversification techniques, starting with the addition of equities to formerly bond-dominated portfolios. This was the genesis of the 60:40 portfolio, with newer diversification theories adding private equity, real assets and hedge funds to the mix.

By 2008, most sophisticated portfolios were broadly diversified across all these asset classes and investors felt reassured that they had taken the appropriate steps to protect their portfolios. But this approach to diversification ran into a brick wall in the aftermath of Lehman when portfolios diversified along this model collapsed in value as assets devalued in tandem with each other. Clearly the standard model of diversification failed the 2008 test. As advisers with an interest in building robust portfolios, Capital Generation Partners wanted to understand how such widely accepted diversification techniques had failed investors at the crucial moment. This was the genesis of First Principles Diversification.

The research started with an examination of asset classes as the building blocks of diversification and concluded that the traditional classification of six asset classes (equity, bond, private equity, hedge funds, real assets and cash) did not fully reflect the fundamental distinctions between asset classes. The core observation of First Principles Diversification is that there are in fact only three types of asset into which one can invest: one can own a share of an asset (equity), one can own cash which is fungible into other assets (cash and commodities), or one can lend (debt). These three types of asset represent the core assets available to investors – other asset classes are merely different strategies or vehicles for investing in these fundamental assets.

Having identified these three underlying assets, the study went on to classify all investment approaches that can be applied to the three underlying assets along two spectrums. Investors can take a directional or arbitrage approach to their assets and they can take a discretionary or systematic approach to their assets. Thus a directional equities investor might seek to capture price movements by going short or long a particular stock whereas an arbitrage investor seeks to capture differentials between pricings, regardless of direction. The same options are also open to cash or debt investors. Investors must also choose whether to apply discretionary techniques, using individual judgement to decide on investments, or whether to apply a systematic strategy – formalising and automating the investment process.

Thus an active equities manager would be classified as a directional, discretionary equities strategy whereas a FTSE 100 tracker is a directional and systematic equities strategy. Of course there are additional styles or techniques which can be utilised on top of these strategies – geography, sector, use of leverage, and so forth – but these sit on top of the classifications outlined above.

Creating a set of three matrices to illustrate these classifications allows us to see which strategies fit into which of the 12 buckets. To illustrate the point further, it is clear that a long/short equities hedge fund appears in the same quadrant (equities, directional, discretionary) as a private equity fund. Meanwhile a fixed income arbitrage fund would appear in the debt, arbitrage, systematic quadrant. It follows that the long/short hedge fund and the fixed income arbitrage fund have little in common beyond their hedge fund vehicle structure.

Having identified these categories, from first principles, the study went on to examine the correlations between the assets and strategies identified. The study selected a 10-year period (2000 – 2010) and, using returns data for each of the 12 strategies, analysed the performance of the portfolio. No portfolio optimisation techniques were used in this process – an equal allocation to each strategy was used. The resulting portfolio was then compared with portfolios representing the 60:40 model and the enhanced diversification portfolio (incorporating private equity, real assets and hedge funds). In total, analysis was run on 30,000 portfolios and the results are shown below.

What underpins this result is the fact that the first principles approach to diversification employs uncorrelated asset classes and strategies. As the heat map in Fig.3 shows, the enhanced diversification approach inadvertently uses some highly correlated strategies as diversifiers and unsurprisingly, in extreme circumstances such as the 2008 crash, these tightly correlated assets react in the same way as each other and fall in value at the same time.

Thus the first conclusion of First Principles Diversification is that private equity, real assets and indeed some types of hedge fund are not useful diversifiers for a 60:40 portfolio because they will essentially behave the same way as the equities they are supposed to diversify from.

The problem then, with those 2008 portfolios was that investors used real assets, private equity and perhaps some long/short equity hedge funds to diversify their equity-heavy portfolios. A 60:40 portfolio might have moved to a portfolio of 40% equities, 30% fixed income, 8% real estate, 8% private equity, 7% hedge funds and 7% commodities. But adding up these allocations according to our new classification gives an equity allocation of at least 56% – or more depending on the hedge funds selected. This hardly represents a diversification from the original 60:40 portfolio.

The second conclusion is that hedge funds should not be viewed as a single asset class. Hedge funds vary by underlying asset, and by strategy. The result is that they can be highly uncorrelated with each other – it makes no sense then for investors to make a single allocation to hedge funds and to expect this to diversify from the rest of the portfolio. A better approach is to crack open the category of hedge funds and to reallocate hedge funds across the 12 buckets we have identified. In doing this it becomes clear that certain systematic CTAs (systematic and arbitrage) will have a fundamentally different impact on portfolios than certain global macro hedge funds (cash, discretionary, directional) and this in-principle understanding is demonstrated again with the evidence from the correlation heat map which shows that the two are highly uncorrelated. Clearly these two very distinct approaches do not constitute a coherent asset class – what hedge funds have in common with each other typically is a mindset and a structural similarity rather than any behavioural similarity.

Having shown that hedge funds do not make sense as an asset class, it follows that hedge funds of funds are problematic for investors seeking to use the First Principles Diversification approach. Investors using the hedge fund of funds approach will typically have allocated 5-10% of their portfolio to this strategy and may use just one or two hedge funds of funds to cover this allocation. But this approach will not allow for careful calibration of the strategies employed to diversify from other assets in the portfolio and in any case the size of the allocation will probably be insufficient to diversify from a typical equities-heavy portfolio.

Taking these conclusions to their logical extension, an equal allocation to each of the 12 buckets we have identified may result in portfolios which, compared to traditional portfolios, feature a much bigger allocation to hedge funds and a much larger number of individual hedge funds in the portfolio. But this in itself is not a cause for concern – as hedge funds are not an asset class in themselves this does not reflect an “overweight” allocation or an excessive concentration of risk. As we have demonstrated, hedge funds are a diverse group, united by structure and mindset rather than by underlying asset and strategy.

First Principles Diversification also highlights the need for portfolio investors to monitor managers closely for style drift. In this approach to investment, managers are chosen for their ability in a very specific strategy. Funds which drift into other strategies will demonstrate different levels of correlation with other funds in the portfolio than was intended when the portfolio was constructed and this could impair the portfolio’s ability to withstand difficult economic conditions.

Managing a much larger allocation to hedge funds – and finding the right managers in each of the very distinct hedge fund strategies – can be a real barrier to this sort of investing. We do not claim that this method of investing is a panacea as it is not open to all investors; typically only very large portfolios will have the resources and the research expertise to allow for such an approach. The shortcut presented by hedge funds of funds is clearly a temptation but we do not think that hedge funds of funds can offer the degree of tailoring that is required to make this approach work.

Our conclusion is that there is no shortcut to diversification. Modern Portfolio Theory began the process of alerting investors to the power of diversification but recent experience has demonstrated that traditional routes to diversification are inadequate and that creating truly diversified portfolios cannot be done quickly and easily. The challenge for today’s investors is to find diversification tools which work. For now, we believe that for large, sophisticated investors willing to explore new approaches, there is scope for introducing the techniques of First Principles Diversification into their portfolios. Focused work on asset allocation, manager selection and on portfolio monitoring – all of which take time and resources – are key to the creation of truly diversified portfolios which allow investors to enjoy more robust returns with less volatility.

Charlotte Thorne is a founding partner of Capital Generation Partners. She has a degree in PPE from Oxford. She began her career at HM Treasury where she advised on corporation tax and pensions policy and spent time in the Diplomatic Service working with the European institutions. She also worked at the FSA on European and consumer policy.