Independent Thinking®
The Value of Uncorrelated Returns
February 12, 2018
A well-diversified portfolio requires a defense against events unanticipated by the markets, such as a significant rise in inflation after nearly a decade of historic low rates, an unlikely but still possible event as discussed in the cover article of this issue and at length in the white paper (click here to download). Often, the best defense is not to hedge these events outright, but to add return streams to investor portfolios that are uncorrelated to traditional securities.
Risk-adjusted returns measure the return of a portfolio against the amount of risk taken to attain those returns. The most common measurement of risk-adjusted return is the Sharpe Ratio, a measurement that subtracts the risk-free rate from the return of an asset, and then divides the difference by the standard deviation of that asset.
In short, the Sharpe Ratio tells an investor if the manager achieved the investment’s return by employing shrewd portfolio management, or by taking on excessive risk. Implicitly, a higher Sharpe Ratio is preferable, as it suggests that the portfolio manager is achieving more return per unit of risk, a positive for a portfolio.
This is where uncorrelated return streams come into play. The risk-adjusted returns of a portfolio of 60% stocks and 40% bonds can be improved with the inclusion of assets with lower correlations, even when these new assets have the same expected return and standard deviation of the underlying 60%/40% portfolio.
How does that work? Since the assets with low correlation will theoretically not decline over the same time periods as the standard 60%/40% portfolio, their inclusion will lower the underlying volatility (as measured by standard deviation) of the portfolio that includes these uncorrelated assets. Assuming the returns are the same, a lower standard deviation will cause the Sharpe Ratio to rise. Again, that’s good news.
Working to improve risk-adjusted returns through uncorrelated assets is worthwhile even when the case for traditional asset class returns is positive. While investing in managers who have been able to outperform the markets with uncorrelated returns can be worthwhile, assuming their fees aren’t exorbitant, the Danish proverb reminds us that it’s difficult to predict, especially the future. The main focus should be on identifying asset classes in which the return stream itself is uncorrelated to traditional markets and returns 3%-5% above the traditional markets. Either passive or active investment vehicles may be appropriate.
Catastrophic reinsurance risk is a case in point. (See the interview with Pioneer ILS Interval Funds on page 5.) Premiums for catastrophic reinsurance risk should generate a reasonable annual return, net of investment fees. At the same time, the likelihood of having a good or bad return in reinsurance over a given period has nothing to do with how equity or bond prices are moving.
The Evercore Wealth Management Diversified Market Strategies asset class generally accounts for between 8% and 12% of balanced portfolios. It has contributed to the firm’s performance and risk exposures. The balanced composite has outperformed its benchmark since the firm’s inception in 2009, while the Sharpe Ratio has averaged 1.33, higher than any of the relevant benchmarks – including the global benchmark, the S&P 500 index, and a representative municipal bond index.1
This allocation to uncorrelated assets with an attractive return improves overall portfolio risk-adjusted returns and supports confidence in the broader asset allocation. This helps investors to hold onto more volatile investments, such as equities, during market downturns, instead of selling at the wrong time and realizing permanent portfolio losses.
Brian Pollak is a Partner and Portfolio Manager at Evercore Wealth Management. He can be contacted at [email protected].
A Bit on Bitcoin – John Apruzzese
The rapid appreciation of bitcoin this past year, along with the brand new phenomenon of initial public coin offerings, which has created hundreds of new so-called cryptocurrencies, has all the markings of speculative excess. This new space, which we think is more appropriately called digital assets, is neither big enough nor linked closely enough to the traditional financial markets to cause concern at this point but it does bear watching.
That said, we also think it is a mistake to dismiss out of hand this new phenomenon as nothing more than the equivalent of the famous tulip bulb speculative bubble of 1600s Amsterdam. There is an important kernel of unappreciated economic rationale behind the innovation of digital assets beyond the underlying blockchain technology, which is now generally accepted as a major innovation.
We will have more to say about this space in the future editions of Independent Thinking.
1 The performance results shown for the EWM Balanced Composite are based upon the returns of fully discretionary managed accounts with a designated investment objective of balanced and no investment restrictions. The EWM Balanced Composite’s benchmark consists of 50% MSCI All Country World Index, 30% BarCap Short-Intermediate Managed Money Index, 10% BofA Merrill Lynch 3-month Treasury Bill Index, and 10% Wilshire Liquid Alternative Index.