Accessing Uncorrelated Returns

We just love high returns, it’s a fact, and we love anything that goes up. We simply love when our portfolio, whether due to our own analysis or simply luck just goes up. We get an even bigger high if the portfolio actually beats the market (or an index), this is the ultimate gratification. Of course there is no free lunch and when the portfolio goes downs, it usually follows that same index in the same direction.

We should not be surprised that our portfolio is linked “somehow” to an index or more specifically to a benchmark. In fact, whenever we look at our portfolio returns, it seems like our portfolio acts as if it was connected through a rubber band to that index. The movement is never identical, but direction of both the portfolio and the market (index) is pretty much always the same. That effect we can broadly call correlation.

In fact, in the finance world, through the famous Capital Asset Pricing Model (CAPM) this can be looked at as beta. Basically beta tells us how sensitive the movement of our portfolio is to the movement of the market. In other words if the beta of our portfolio is 1, then our portfolio movements will be identical to the movements of the chosen index. The opposite is true as well, with beta equal to -1, our portfolio will move inversely proportional to that index. Or if the beta of our portfolio is 1.5, then for every 1% movement of the index, our portfolio will move 1.5%. On the average that is.

Clearly we like when we outperform the market, but don’t like it when our portfolio suffers in line with the market. So what’s the answer? The answer is “uncorrelated returns”, or as some finance books call it the “holy grail”. The reason is it so sought after, again based on classical finance theory, is that if we have investments that are uncorrelated to the market we can diversify our portfolio and reduce risk. Which is a very prudent advice indeed!

Ok, sounds good, but how can you do it. There are several ways of achieving uncorrelated returns. The basic tenet is diversification. More specifically this diversification can be achieved through the following four methodologies: Portfolio Exposure, Asset Classes, Geographical Exposure, or Portfolio Construction. Or a combination of any of the above.

Portfolio Exposure refers to having financial instruments from different sectors or industries. Asset classes refer to different types of financial instruments, such as equities, fixed income, cash. Geographical exposure refers to investing into different countries and regions. Portfolio construction implies having long and short positions. These are what I call the Four Horsemen of the uncorrelated returns.

A good example of Portfolio Construction would be to buy sectors that typically move in the opposite direction. For example, you could buy Consumer Discretionary sector (XLY) and Consumer Staples sector (XLP). If the economy is doing well, the Consumer Discretionary will boom and do very well, while the Consumer Staples will lag behind. If the opposite is true, Staples will be a defensive sector and will typically outperform the Discretionary sector.

I already spoke about Asset Classes in my previous article; this is a classic case of, for example, 60/30/10 allocation, referring to keeping 60% in equities, 30% in fixed income instruments and 10% in cash.

Geographical Exposure makes intuitive sense as well. Just look at our economy relative to the Chinese economy. I am not making any predictions going forward, but clearly the Chinese economy did really well past several years, while we suffered. The salient point here is that if you had SPY for the US economy and FXI for the Chinese economy, you would have done much better for the past several years.

The last, but certainly not least, is the Portfolio Construction. I am referring to having significant positions in Longs as well as in Shorts. If the picks are good, you can potentially make money on both the long and short sides. An interesting example is GRV, this is a dollar neutral (all longs equal all shorts) portfolio. Although it is still a young fund and this month’s performance has suffered, this is an excellent potential example of a portfolio with uncorrelated returns.

The four methods above are listed from the least to the most in overall potential for uncorrelated returns.

That’s the start, there are many interesting and viable combinations of the Four Horsemen of the uncorrelated returns.