Beta The One Trick Unicorn
Galway Investment Strategy
By Liam Molloy, Bethany Carlson
November 27, 2012
For a long time investors have been told the only free lunch is diversification. In a hurry to buy into the mythical free lunch investors jumped in without asking enough questions, like what is diversification. Instead everyone hurried to fill buckets and cover the style boxes with about as much thought as someone filling out a March Madness office bracket. Investors confused lots of buckets as being the same as having many sources of return. Instead investors had climbed aboard a one trick unicorn, as in the end the myth of style boxes gave way to reality of many versions of the same source of return, Beta. Investors learned the painful lesson that a lot of one source of return really is not diversification.
As the S&P 500 declined almost 51% from the fall of 2007 to early 2009 many of the other buckets filled in the name of diversification were down even more. The problem is during times of crisis like 2007- 2009 and the tech wreck of 2000 – 2002, correlations dramatically increased. The negatives of a portfolio dominated by a single source of return become magnified. The harsh truth of that math lesson is costly, as to just get back to zero after the recent crisis requires a 104% return. Investors must stop measuring diversification by how many buckets are filled and look at how many and how diverse the sources of return are.
True Diversification, Curiously Strong
The term “alternative investments” has become a catch-all for a variety of strategies outside the realm of the long only style box so many have been indoctrinated into. The investments can vary from low volatility to high volatility but they all attempt to add more Alpha than Beta as a return source. Their power is in their ability to be agnostic (to an extent) of the overall market and access superior talent. The chart on the following page shows how just dedicating 15% of a portfolio to a blind basket of these strategies significantly improves risk adjusted performance, not just for aggressive investors but for investors across the entire risk spectrum.
Again it comes down to having many sources of return so the goal is to create a mix of Alpha and Beta strategies. Some strategies will thrive when volatility is lower and others such as global macro, and managed futures, thrive in volatile markets. Managed futures have almost zero correlation with the S&P 500 and have thrived in times of crisis. The S&P 500 has had 5 quarters this past decade when it declined by more than 13%. In four of those quarters global macro has achieved positive returns. Long/short equity strategies will have some underlying Beta exposure but can provide a steady source of Alpha. Again the key for investors is blending variety of strategies and exposures to create a more reliable and efficient portfolio. True diversification is not a myth but it does require more art and science than filling of buckets. The results are worth the work.
Two Horned Curious Unicorn
Buying a broad basket of “alternative investments” does improve risk adjusted return, but true diversification with varied Alpha sources is a more complicated creature. SCS Financial is a Boston based investment firm with unique hedge fund insight. T heir CIO Ken Minklei pointed out that true Alpha is as rare as a two horned unicorn species from Borneo. It does not stop Ken from being curious and searching for it anyway. This never ending quest for this rare creature has led to an expert knowledge of the complexities of constructing a truly diversified portfolio. Understanding not just how much of a risk budget a strategy will use, but how it uses its allocated risk permits superior construction.
The goal is to manage the composition of risk to create true diversification by dissecting how a strategy correlates to the market and other strategies, what risk factors are being accepted, portfolio sizing limitations, and a clear understanding of how a manager adds value. In the world of alternatives a great steward of capital adds significant value via their ability to perform thorough operational due diligence (just ask any “investors” in Madoff). It is an additional challenge that many who are from a long only perspective often minimize to their own peril. The value of having an expert guide in the search for this fabled creature is significant in so many aspects. Even in one of the most common of alternative strategies such as long/short equity potential value is evident. In 2008 HRFI data shows that the average of all long/short equity managers was down almost 20% while the average return of the top quartile was almost up 11%. In the following year the average of all the long short managers was up a strong 32% but the average of the top quartile was 82%. So the value of this two horned curious unicorn is significant in many ways, and investors would be wise to seek expert advice in their own quest.
The fact that diversification via checking the style boxes is a myth does not mean this fairy tale has a bad ending. It just means you simply cannot ride many forms of Beta to get there. Attempting to add agnostic return sources will give you a better chance of achieving true diversification. The journey of curious types such as Ken who continually search for the mythical true Alpha can help investors achieve a happy ending. The discovery of the one source of true Alpha becomes less important than the lessons the search itself provides investors. The lunch is not free and traditional long only portfolios will need a hand from those Don Quixote types. Their lessons are invaluable to all investors searching for that happy ending.
As always, we are proud to be your partners in riding unicorns, and chasing true diversification without compromise.
Liam Molloy, CFA
Bethany Carlson, CFA
(c) Galway Investment Strategy