The diversification benefits of adding systematic strategies to a traditional portfolio

Nov 25, 2022 | Education

Investment management processes are constantly increasing in sophistication in line with improvements in technology and the professionalisation of the industry. Few remaining managers concentrate on pure return targeting with significant attention now paid to the risk of each individual investment. However, sophisticated investment professionals also regularly consider the interplay between a single asset and the remainder of the portfolio in order to determine the additional contribution (beyond risk and return) of each individual element.

Appraising the performance of an asset in a portfolio

Given the wide range of investment choices available, assets that do not form part of the ‘core’ asset allocation are under greater levels of scrutiny to justify their role in the portfolio. This means that they have to bring something different to the table, often in the form of a diversifying source of return. In future articles we will discuss the important topic of portfolio construction in greater detail, which it merits. However, in this short introduction to the subject, we demonstrate quite simply the power of diversification in a portfolio.

Whilst risk and return targets are two of the cornerstone objectives of an investment manager, there are many more nuanced metrics that can be used to appraise the performance of a portfolio. In a previous article we introduced the concept of drawdown – that measures the cumulative losses from ‘peak-to-trough’ of an asset – and explained its importance. In a similar vein, metrics that measure risk-adjusted performance such as the Sharpe Ratio assess whether or not the expected return from an investment is commensurate with the additional risk taken by investing into it.

Using metrics such as these can be an effective method for judging both individual assets and an entire portfolio. Therefore, by comparing the impact upon these metrics of a portfolio after the addition of a new investment, we can begin to develop a clearer picture of how additive it was to the portfolio as a whole.

Uncorrelated strategies can be highly additive to the performance of a portfolio

To demonstrate our point clearly, let us take an investment that is highly diversifying when compared to traditional assets. Table 1 shows the correlation of monthly returns of an index of systematic strategies to equities, bonds and a 60/40 combination of the two – often referred to as the “market” (or traditional) portfolio. The systematic strategies are shown to be highly uncorrelated to equities, bonds and the combined market portfolio.

Table 1: Correlation of systematic index to traditional assets [1]

Studying the returns in more detail helps us to understand the importance of uncorrelated sources of return. In Figure 1 we focus on the 10 worst months for equities and compare to how the systematic index performed at the same time. Not only did the systematic index not experience simultaneous steep declines, it also managed to generate a positive return on average. This clearly demonstrates the benefits of diversification, especially during times of market stress. Therefore, should we add an allocation of systematic strategies to our traditional portfolio, we could potentially expect a significant improvement in performance.

Figure 1: Comparison of systematic index to equities during times of market stress [1]

Table 2 demonstrates precisely that. Whilst there is a small reduction in the expected return, this is more than compensated for by the significantly reduced risk of the new portfolio. The noticeable improvement in the Sharpe ratio clearly indicates that the addition of systematic strategies means that the portfolio should now expect a greater return on investment for every additional unit of risk that it takes. In fact, if we wished to generate the same expected return as the market portfolio, we could simply lever the portfolio to the required degree and the result would be a reduction in risk compared to our initial allocation. Finally, and perhaps most pertinently, there is a very large reduction in the maximum drawdown of the new combined portfolio.

Table 2: Improvement in portfolio performance following the addition of systematic strategies [1]

The results above clearly demonstrate the powerful effects of diversification on a traditional portfolio. The challenge is therefore to find alternative sources of return that are sufficiently uncorrelated to an investor’s portfolio and still provide some attractive upside of their own, like the systematic index above. Potentially, such investments can smoothen the return profile, improve risk-adjusted returns and minimise our drawdown in times of market stress.

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[1] Systematic strategies are represented by the Barclays BTOP50 Index, global equities by the MSCI AC World Index, global bonds by the Barclays Global Aggregate Index and the traditional portfolio consists of 60% equities and 40% bonds, rebalanced monthly. For the calculations in Table 2, we allocate 70% to the traditional portfolio and 30% to systematic strategies. Calculations are based upon the monthly total returns for the period January 2000 to April 2022. Source: Bloomberg.