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The near-universal hunt for "smoother returns"
If you've spent any time thinking about investing, you've likely experienced an intuition that many share: that it would be great if there was a way to put money to work that produces mostly positive and more predictable returns over time, instead of just positive-on-average returns, but with painful drops throughout. In short: less volatile, "smoother" returns.
The intuitive appeal of "passive income"
In our work we hear a lot from clients about the desire for "passive income," which I've come to believe is largely a result of this wish.
People intuitively understand the difference between two theoretical investments, (1) that produces a specific amount of cash each month that you could either spend or reinvest, and (2) a different investment with the same "total return" on average over a long period of time, but in a less predictable and stable form, which one must sell to reap gains, but which sales will be difficult or impossible to time.
Many think of the S&P 500 Index as the latter: it has historically generated positive total returns over long periods of time when left alone, but not in any reasonably predictable way over any given shorter timeframe within.
Put Simply: Many people want to know how to accomplish long term growth goals while not being fully at the mercy of "the market" for massive downside in the interim.
Good News & Bad News: Getting to know the important investment concepts
The bad news first: we don't have a "holy grail" investment for you, the one you can safely put your money into and sit back while it prints high returns each month without losing market value. Anyone who presents that investment to you is likely either intentionally or unknowingly overlooking serious risks or drawbacks.
The good news is that there are a few concepts in investing that converge to form a picture of how to get closer to the outcome that so many people want. My goal here is to help you make sense of each of these and tie them together to understand what a process for achieving "smoother returns" could look like, and why it would actually make sense.
- Modern Portfolio Theory (MPT) and Post-Modern Portfolio Theory (PMPT)
- Factors and Factor Investing
- Alternatives & Private Investments ("Alts")
- Correlation, Negative Correlation, and No Correlation
1.(a) Modern Portfolio Theory (MPT)
Modern Portfolio Theory (MPT), developed by Harry Markowitz in the 1950s, revolutionized personal investing. MPT suggests that an investor can optimize the expected return of their portfolio for any given level of risk, through diversification by spreading assets across different classes to reduce volatility.
Put Simply: This field of research shows how combining lower-risk assets with higher-risk assets can actually decrease the risk of the collective whole, when done properly.
1.(b) Post-Modern Portfolio Theory (PMPT)
PMPT is basically that, except it evaluates risk differently by accounting for the difference between general "variance" as a proxy for risk and "downside risk" specifically, which is likely appropriate. It makes sense to care about mitigating large downside risks than more frequent but much smaller price variances.
Put Simply: The definition of "risk" you use matters. It's common in finance use the volatility of price moves up and down to mean "risk" - but in real life and for many investors, more meaningful definitions of "risk" include the possibility of an investment dropping in value a lot, or of catastrophic risks like going to zero and not coming back. PMPT is an attempt to be realistic about that.
2. Factors and Factor Investing
Traditionally, diversification has focused on asset class diversification, such as combining stocks, bonds, and cash. However, we can potentially do better by digging deeper to explore the benefits of factor diversification. Factors are specific characteristics or attributes that drive the returns of individual securities or asset classes, such as company size, value versus growth, profitability, quality, volatility, or momentum. By diversifying across factors, we can potentially enhance returns and reduce overall portfolio risk in a more comprehensive way.
Put Simply: Stocks and their underlying companies differ from each other in significant ways. The field of factor investing is an attempt to research and categorize these differences to enable investors to diversify along more fronts, and to determine how differing factors tend to perform compared to each other over time.
3. Alternatives & Private Investments ("Alts"): While factor diversification can provide significant risk reduction, incorporating alternative investment approaches can further enhance portfolio resilience. Alternative investments include strategies from hedge funds, private equity, real estate, private credit, and other non-traditional assets. These approaches can often have low correlation with traditional asset classes, offering additional diversification benefits.
Put simply: Just as stocks and companies in the public markets differ from each other, there are also investment structures and methods (often which appear in private markets) that make money in different ways, exposed to different environments and outcomes. For the purpose of this conversation, it's not necessary that they make money in "better" ways, just different ways at different times.
4. Correlation, Negative Correlation, and No Correlation: All of the above hinge around this idea. In short, when different assets (companies, investments, apartment buildings, etc.) make money in different ways, through different strategies, at different times, from different customers, in different geographic markets (and more), they become open to exhibiting lower or even negative correlation. This is the key. In order for a mix (or "portfolio") of assets to successfully provide for less volatile "smoother returns," buckets within that mix have to exhibit varying correlations, no correlation, or negative correlation. This is what allows the collection of investments to exhibit less variability than the individual categories within it.
Put simply: In order to put all of the above concepts to work and to benefit from enhanced diversification, ideally different holdings within a holistic mix will have low, zero, or negative correlation, meaning that they don't change values in tandem, and sometimes change value in opposite directions.
Below, I'll go into a little more (very helpful!) detail about each concept and how they apply in real life, but first, for the time-crunched, I'll address the question of what to do with all this information.
Why should I want this?
I've spent a bit of time so far explaining that I run into all sorts of people who value smoother return and less downside risk, but I haven't addressed an important question: should they want it? Is it really valuable or just a mirage?
I've encountered people who purport to see through the mystique about passive income and smoother returns, and to value the only thing that matters: total return. In essence, the idea is that accumulating the highest total amount of money before some future end date (arbitrary or otherwise) is all that matters, and that everything in between is just noise.
I'm not swayed by their opinions. For one thing, as with much of traditional financial planning, single-minded focus on long-term total return takes an assumption about timing and duration and then requires it to be true, or else. "Or else" in this case means, I guess, you don't have money when you need it, so I think that's worth avoiding.
In real life, where we work, flexibility is valuable in a plan. It may be fun for some people to imagine staring 40 or 50% losses in equities in the face, unfazed because they "know" they will get a 9% or 10% return over time - but in practice:
- Behaviors like holding for the long term are harder to execute under stress.
- They don't "know" any such thing about future returns (past performance does not guarantee future results!)
- No one I've ever met wants to see their net worth halved for an unknown time period, even if they won't be materially affected by it. Psychological results are real.
- Life gets in the way. Economic downturns, job loss, family changes, etc. may force a person's hand, and they may want access to their funds in the interim, at exactly the time of the down period they previously supposed that they wouldn't care about.
- The whole thing kind of falls apart when you transition from younger accumulation phases in the approach toward the distribution phase. The ability to wait out downturns is a luxury that tends to expire.
Finally, it just makes sense. A 50% decrease in value requires a 100% increase in value to follow in order to merely break even. $100k invested that drops to $50k in value, will need to return a full 100% ($50k more) to regain the original investment of $100k. The required future returns are much more reasonable for a portfolio that simply avoids massive short-term losses in the first place.
While most people believe it's good to buy low and sell high, this is not quite possible when the money you would have used to buy low must come from assets that are all down at the same time and which must in turn be sold low.
Rebalancing in a very well diversified portfolio has an easy explanation for the solution to this problem: if not all of your assets are down equally at the same time, and some are flat or up, you can rebalance the portfolio to its original allocation percentages seamlessly moving funds from assets that have maintained or increased in value into those that have since decreased in value.
Ok, so what am I supposed to do with this information, and how do I figure all of this out?
If there's one thing to take away from this piece, it's that the combined value of each of the four concepts taken together is much greater than the value of any of them individually.
- what makes sense to attempt to achieve
- mental frameworks through which to think about the challenges involved
- the breadth of tools available to address those challenges
...one can actually begin to determine how more reliable returns could be generated in the real world, over time.
As for how to go about it?
It's hard! It's really hard. Even determining what macroeconomic and specific factors your existing portfolio is exposed to is a heavy lift, let alone what alternatives could offset those exposures, how to access each of them and diversify within, and how to do all of that with proper vetting of risk.
It takes a lot of work, technology, and understanding, and even the best don't do it alone.
The right teams of people working on the hard problems combined with a thoughtful approach in the first place are a step in the right direction, if any of these goals appeals to you.
More Depth: How do these concepts apply in real life?
1. Modern Portfolio Theory (MPT & PMPT): More Depth
Modern Portfolio Theory (MPT), developed by Harry Markowitz in the 1950s, revolutionized the way we think about portfolio construction. MPT suggests that an investor can optimize their portfolio by reconsidering the relationship between risk and return. It emphasizes the importance of diversification, as spreading investments across different asset classes can help reduce volatility without necessarily sacrificing potential returns.
The big shift here is the counterintuitive idea that, for a conservative investor looking for a given low level of risk, one can actually include more risky assets in the mix to yield a higher expected return, than a portfolio consisting entirely of conservative assets. The goal here is to choose the optimal mix that maximizes expected return at whatever is determined to be the acceptable level of risk for a whole portfolio. The other important idea that may seem more intuitive, but that people overlook constantly, is that the important return is that of the entire mix as a whole, not the return of any particular subset within that mix.
PMPT is primarily important in that it helps to design this optimal mix by considering downside risk instead of just overall variance / volatility, since typically investors are trying to mitigate the risk of drastic losses, not so much the risk of "things moving." Again, maybe intuitive, but importantly different within the traditional world of finance and investing. Look around and you'll see many in this space using "risk" and "volatility" interchangeably, though you might not agree that you those are actually the same thing to you in real life.
There are a few reasons why I don't end the conversation here, but a big one comes down to systematic vs unsystematic or "specific" risk. MPT attempts to reduce the specific risk of individual securities through diversification, but it doesn't attempt to reduce systematic risk - essentially that the entire "market" or economy slows and shows losses that impact investments across the board. But why limit ourselves? Does it absolutely need to be true that a systematic downturn affects absolutely all possible investments and strategies, and that all investments must be positively correlated?
2. Factors & Factor Investing: More Depth
Traditionally, diversification has focused on asset class diversification, such as combining stocks, bonds, and cash. However, a more nuanced area of research encourages us to dig deeper and explore the benefits of factor diversification. Factors are specific characteristics or attributes that drive the returns of individual securities or asset classes. By diversifying across factors, we can potentially enhance returns and reduce overall portfolio risk, just as above, but in a deeper and more beneficial way.
Expanding on the discussion of what "risk" and "diversification" really mean, often risk has been simplified to be reflected only in the percentage of stocks vs. bonds. Beyond that, "stocks" is often represented primarily in the US by indexes like the S&P 500, which in turn represents only large US stocks. Put that way, it may seem obvious that there are more companies in the world than the largest US companies, and that maybe diversification can be more expansive than a simplistic view of stocks vs bonds.
A full discussion of factor investing won't be appropriate in this space, but the important point is that there is more to an investment than "is it an equity instrument?" (traditionally a stock) or "is it a debt instrument" (traditionally a bond)? Some examples of these factors are: company size (large, mid, small), quality (relates to a company's balance sheet, earnings stability, and margins), profitability (self-explanatory, and certainly not a given for all public companies), momentum (recent stock performance/inertia), geography, and volatility.
There have been many factors identified, and they all vary with regard to how well they:
- Explain returns, and why (market psychology, or business performance?)
- Perform vs the market (often referred to as the "return premium" of that factor)
- Persist over time and across periods.
- Survive publication (once everyone knows to look for it, does it still demonstrate return premium & explanatory value?
The research in this field is extensive, and fortunately a lot can be known (at least historically) about all of the above.
Finally, as in the MPT and PMPT discussion, certain factors may be riskier or more volatile in isolation, but contribute to less portfolio risk, taken as a mixed whole.
3. Alternatives & Private Investments ("Alts"): More Depth
Alternative investment approaches offer several advantages in comprehensive portfolio risk management. They can provide access to unique investment opportunities not readily available in traditional markets. They can offer potential for higher returns in certain market environments, downside protection, inflation hedging, and portfolio diversification beyond traditional asset classes. A common (but certainly not universal) objective is to achieve less downside than "the market" in "down years" at the potential expense of lesser gain in the "up years." The benefits of accomplishing that goal should be fairly obvious in the pursuit of "smoother" more predictable holistic returns.
Alternative and private investments are not monolithic. Within this universe, the objectives, risks, performance, and return profiles vary greatly. Even within the categories and strategies listed below, there are many further levels of variation and substrategies. That said, the following list at a high level should still be helpful in setting the tone for what we're talking about:
- Hedge Funds:
- Hedge funds are investment vehicles that most often aim to generate positive returns regardless of market conditions.
- They employ various strategies, such as long-short equity, global macro, event-driven, and arbitrage, to potentially generate alpha and provide downside protection.
- Even when they use public equities as instruments, they aim to do so in a way that profits by some mechanism other than "the market goes up" or "the market goes down."
- Desired return profile within a given fund or strategy may be "equity-like" returns to "fixed-income-like" returns, outside that range or in-between, .
- Private Equity (PE):
- Private equity involves investing in privately held companies or non-publicly traded assets.
- It offers the opportunity to participate in the growth and value creation of businesses that are not available on public stock exchanges.
- Private equity investments are typically held for the long term and can provide diversification and higher potential returns.
- Higher returns are never guaranteed, but when they do arise, they are often partly attributable to (1) focused business expertise and improvements driven by the PE investor owner, (2) the use of borrowing/leverage to enhance positive returns (with added risk when returns are negative), and (3) illiquidity - the investments often must be held longer-term by investors, which relates to expected/required returns and interim valuations in multiple ways.
- Real Estate:
- Real estate investments can include direct ownership of properties, real estate investment trusts (REITs), or real estate crowdfunding platforms.
- Strategies and categories vary widely, examples including: multifamily, office, hospitality, industrial, retail | development, opportunistic, value-add, core | Class A, B, C | global, domestic, regional | many levels of other variations.
- Real estate offers a tangible asset class that can provide income generation, capital appreciation, and diversification benefits to a portfolio.
- Much as with private equity, leverage, illiquidity, and sponsor expertise are often major factors.
- Private Credit:
- Private credit refers to investments in non-publicly traded debt instruments, providing financing to companies or individuals that may not have access to traditional bank loans.
- It primarily offers an alternative to traditional fixed income investments.
- Private credit investments can take various forms, including direct lending, mezzanine debt, distressed debt, or asset-based lending.
- These investments typically offer higher yields than public fixed income securities and can provide diversification, stable income streams, and potential downside protection.
- Private credit allows investors to participate in the financing and growth of businesses while potentially benefiting from less correlated returns compared to traditional fixed income assets.
- As with all of the investment strategies, enhanced return and diversification potential also come with attendant and different risks than traditional fixed income.
4. Correlation, Negative Correlation, and No Correlation:
Correlation is the central concept to diversification and Modern Portfolio Theory (MPT). In the investment context, it refers to the statistical relationship between the returns of two or more investment assets.
Positive correlation means that the assets tend to move in the same direction, meaning when one asset's return increases, the other asset's return also tends to increase. Negative correlation, on the other hand, indicates that the assets move in opposite directions. When one asset's return increases, the other asset's return tends to decrease. Zero correlation means that there is no linear relationship between the assets' returns. They may go up together, down together, in different directions, or one may stay flat while the other increases or decreases, in different combinations over time.
When assets within a mix are likely to move together, it can increase the overall risk of the portfolio: when one asset performs poorly, other positively correlated assets may also perform poorly, leading to greater losses. Negative correlation, on the other hand, provides diversification benefits. When assets have a negative correlation, they tend to offset each other's movements, helping to reduce overall portfolio risk. A total lack of correlation is also helpful in smoothing returns: if two assets have positive expected returns over time, and they don't have any particularly strong likelihood of moving down at the same time, the whole portfolio's expected downside during each period is more limited, statistically speaking.
Beta, often used in constructing investment portfolios, measures the sensitivity of an asset's returns to the returns of the overall market, usually represented by a benchmark like the S&P 500. A beta greater than 1 indicates that the asset is more volatile than the market, while a beta less than 1 suggests lower volatility. In the context of MPT and diversification, investors often aim to combine assets with different betas to optimize their portfolio's risk-reward profile. By including assets with low or negative correlations and adjusting their weightings based on beta, investors attempt to create better-diversified portfolios that aim to maximize returns for a given level of risk, aligning with the core principles of Modern Portfolio Theory.
While the beta between stocks in public markets is considered extensively, by now it should be obvious that it can be limited. While many individual stocks have betas of greater or less than 1, in practice, finding diversified investments with a beta of zero or a negative number is unlikely. Most stocks have a positive beta, moving to at least some degree in tandem with the rest of the market.
Further, beta is a largely historical number, describing what has happened: it can just as easily have or lack explanatory value for *why* it should happen, and thus its usefulness is limited in coming up with reliable expectations for the future.
This material is intended for educational purposes only. References to specific securities, asset classes and financial markets are for educational purposes only and do not constitute a solicitation, offer, or recommendation to purchase or sell a security.