Ampersand Portfolio Solutions has published the third part of its white paper entitled The Risk Contribution of Stocks.
The firm writes that part three provides a path for mitigating the significant risk of over allocating to stocks as identified in its prior white paper, The Risk Contribution of Stocks, Parts 1 &2. In the new and final instalment of the three-part series, Ampersand introduces a way to diversify beyond stocks and bonds without having to sell the stock/bond portfolio holdings.
The firm writes that its white paper clearly illustrates the riskiness of a 60/40 stock/bond portfolio, showing that 92 per cent of the risk is contributed by stocks. Diversifying the portfolio by adding another asset class such as managed futures yields improvements, Ampersand says.
Among the scenarios presented in the first paper, a portfolio with 20/50/30 allocations to stocks/bonds/managed futures provided the highest Sharpe Ratio among portfolios whose allocations to the three asset classes were constrained to add up to 100 per cent.
“However, in the real world, it’s extremely rare to find portfolios with a 30 per cent allocation to managed futures. How can investors gain the benefits of diversification without having to sell their stocks or bonds in order to allocate to another asset class like managed futures?”
Key highlights from The Risk Contribution of Stocks, Part 3 reveal that Ampersand’s hypothetical scenarios showed that a 20/50/30 stock/bond/managed futures portfolio provides the highest reward-to-risk ratio and could be considered the optimal allocation strategy.
The firm writes that the fact remains that it’s extremely rare to find portfolios with allocations to alternatives as high as 30 per cent. In fact, in most portfolios stocks continue to be the main source of risk, often exceeding 90 per cent.
The main reasons for under-diversification are the historical lack of available diversifying strategies and, when available, the opportunity cost of utilizing them. With few exceptions, investors who do have access to diversifying strategies tend to allocate only small amounts to alternatives, so stocks remain their largest source of risk. In addition, the traditional way to diversify is to sell stocks or bonds in order allocate to a diversifier such as managed futures.
The portion allocated to the diversifier (managed futures) forces an investor to choose between stocks and bonds OR managed futures. In the end, however, this OR decision may result in giving up the returns that the relinquished stocks and bonds might have continued to earn.
Ampersand proposes a new theory. “There is no need to sell stocks and bonds to diversify into managed futures. How is this possible? These programs can be accessed by using 10 per – 25 per cent margin or collateral, and the stocks/bonds in an investor’s 60/40 portfolio can themselves be posted as collateral. This is an ‘overlay’ approach, where the alternatives are overlaid on top of the stock/bond portfolio without the need to sell any stocks or bonds.
“The potential benefits of this ‘enhanced’ diversification include: eliminating the opportunity costs of meaningful diversification; better balanced portfolio construction; and higher potential returns for investors with higher risk tolerance,” the firm concludes.
