WE highlighted two weeks ago that portfolio optimisation can be perceived as the “free lunch in investments,” as you gain additional expected returns without taking on more risk or by minimising risk for a given level of expected returns. In order to fully appreciate the optimisation concept, investors need to be familiar with concepts such as risk or volatility and risk-adjusted returns, asset correlation and the efficient frontier.
We explained the risk and risk-adjusted returns concept previously. To recap, risk or volatility is the quantifiable likelihood of loss or lower-than-expected returns. It measures the uncertainty of expected return using a statistical measurement called standard deviation. Risk adjusted return measures the return an investment makes in relation to the amount of risk it takes on.
Well, we are half way through to making ourselves that free lunch. In this article, we will highlight the remaining investment concepts to build an optimum portfolio. They are asset correlation and the efficient frontier.
What is the quality of your diversification?
Risk is inherent in any investments. Part of investment risk can be mitigated through diversifying or “not putting all your eggs in one basket.” One can diversify “between asset classes” i.e. bond versus equity and “diversification within an asset class,” i.e. small cap stocks versus large cap stocks.
A word of caution for investors: Not all diversification is effective in lowering risk. The benefits from spreading your eggs into a few baskets to reduce risk of them all breaking at the same time only works if all your baskets don’t fall together.
Think about correlation as the strings that tie investors’ baskets together. The trick is to ensure that you minimise baskets that are all on the same strings, a fund manager added.
How do investors know if their baskets were on the same string, i.e. whether it would all fall at the same time? This is where asset correlation comes in and plays a crucial role in the diversification process.
How to achieve quality diversification? Ensure that the assets you hold have zero or negative correlation.
Correlation between assets falls within the number range of –1 to +1. Typically, large cap stocks and medium cap stocks very often move in the same direction and have correlation greater than 0.75. Bond and equity tend to move in opposite directions or negatively correlated with correlation below 0.
The less the strings are attached to each other (which means the lower the correlation), the lower the risk that all your eggs will break at once. So correlation is important for investors because it serves as a checking mechanism on the quality of diversification. “The higher the quality of diversification, the lower the risk of your investments,” an investment expert said.
Let’s highlight the correlation concept using data compiled from independent fund analysis firms as an example (see table).
Eva has RM10,000 in bond fund B and is considering to diversify her portfolio. Having read Citibank’s advisory on “diversification between asset classes” and “diversification within an asset class,” she planned to invest a further RM5,000 into balanced income fund A and RM5,000 into bond fund A to diversify. Eva went to consult her advisor, Siti, to clarify.
“Eva, correlation between bond fund A and B is moderate at 0.347 so if A falls 10%, B only dips 3.47%, so adding bond fund A adds value to the quality of diversification within an asset class for your portfolio. Balanced income fund A moved in opposite direction with bond fund A; hence adding the fund also improves diversification between asset classes of your portfolio. Looks like you've made a good choice,” Siti said.
“But if you invest RM10,000 equally into highly correlated funds like equity growth fund and KLCI tracker fund today and the KLCI falls 10% next month, the price of equity growth fund is likely to fall almost as much or -9.38%. Thus holding highly correlated funds does not add much value to diversification.
“Investing in funds that are so highly correlated (above 0.9) is like holding one big fund anyway,” Siti added.
In a nutshell, if investors select assets with relationship below +1, it adds to the quality of diversification (which reduces overall portfolio risk), and as we move from positive correlation to negative correlation, the benefits of adding that asset for diversification increases further.
Efficient frontier and
Modern portfolio theory tells us that there is an efficient frontier for any portfolio of assets. It is a combination of assets in a portfolio that give us the maximum expected returns, for a certain level of risk.
The first step in developing an efficient frontier is to calculate the average expected return versus the volatility for all investment products. This data is then plotted onto a linear graph, which represents the efficient frontier.
Let’s look at an example and the chart below. Farah’s current portfolio A’s expected return and risk are 6% and 10% respectively. Her advisor Gopal said, “Your portfolio is considered suboptimal as it is below the efficient frontier.”
He continued: “Miss Farah, if you can still stomach a 10% risk, you are better off selecting portfolio B. By optimising or maximising the portfolio A to portfolio B, you are likely to gain an extra 6% return or free lunch without additional risk.”
The goal of portfolio optimisation is to search for such “free lunch.”
Farah said, “I may retire soon and feel that my current portfolio A and your suggested portfolio B are too risky. But is there a portfolio for me to maintain the 6% return but lower my risk exposure?”
Gopal happily replied, “Yes, optimisation could still add value by suggesting portfolio C, which provides the same 6% return but at 5% risk instead of 10% before optimising.”
Therefore, before using the efficient frontier, you must ask yourself: how much returns am I looking for based on my investment and, how much risk can I accept?
A conservative investor may be seeking annualised returns of 5% while an aggressive investor may want 10% annualised returns. The latter would assume a higher degree of risk for greater returns.
Once you have determined your return goals and risk-taking ability, you can identify an investment product that fits your investment criteria.
Bear in mind that there may be instances where you may not find the right combination between risk and returns. For example, you may not be able to find an investment product that gives you high returns and very little risk.
Or you may have invested in products that do not fall onto the efficient frontier. The solution then is to find a portfolio that is as optimal as possible.