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This is the final article in our series written exploring the myths in popular investing as exposed in Michael Dever’s new book, “Jackass Investing.” In the book, Dever uses experience from three decades of hedge fund management to explore how the conventional wisdom in investing and portfolio management preaches little more than gambling.

By Mario Mainelli

The focus of this article will be what Dever refers to as “the free lunch.” The free lunch he is referring to is an increased portfolio return without a simultaneous increase in risk. Such a free lunch would leave investors salivating, with an eager knife and fork in hand. However, we have been trained to believe that expected return cannot be increased without increasing the risk, putting a kybosh on the metaphorical free lunch. Does this free lunch actually exist? The answer is both yes and no. Yes because, for an optimal and properly diversified portfolio, it is true that the only way to increase your expected return is to increase your risk tolerance. No because most investors do not have such an optimal, properly diversified portfolio; conventional wisdom has guided them to create what Dever refers to as a non-diversified “poor-folio.” Because of this they can increase expected return without increasing risk through proper diversification. We will return to the free lunch concept after a brief discussion on the risk/return relationship.

Modern Portfolio theory has taught us that there is a near-linear relationship between risk and return. For each level of risk, there will be various levels of returns from different portfolios and an investor should obviously choose the highest return for a given level of risk. It becomes immediately evident that some of these portfolios are not optimal. For example, if portfolio A has a standard deviation of 10% (standard deviation is a representation of risk) and an expected return of 12%, while portfolio B has a standard deviation of 11% and an expected return of 12%, all else being equal, portfolio B is inferior to asset A. Why take a higher risk to achieve the same expected return? Dever considers standard deviation to be an inadequate expression of the true risk of the portfolio for reasons we described in a prior article.

An inevitable conclusion here is that to obtain a higher expected return, we need to increase our risk tolerance. The theory itself is correct; the problem, however, is the way investors apply the theory. The theory of needing to increase risk to increase return, as mentioned above, refers to optimal, properly diversified portfolios. The average investor will use a conventional portfolio, which creates the illusion of diversification, but is not truly diversified. The author gives an example of such a conventional portfolio, which holds more than 3,000 stocks, 8,000 bonds, and thousands of real estate properties from over 40 countries. The returns from the conventional portfolio over the last 30 years are displayed below:

(Click charts to expand)

Despite the vast number of securities involved, the portfolio’s performance is driven by only three return drivers: corporate earnings growth, a doubling of the P/E ratio (which powered the stocks), and a dramatic decline in interest rates (which powered the bonds and real estate). To quote the author, “a dependence on just three return drivers not only results in unnecessary risk, but also ensures that past performance is not indicative of future performance, regardless of the length of that past performance.”

If one of those three return drivers fails, the return of the entire portfolio will suffer dramatically. This has already happened with the P/E ratio, having reverted back to its long-term average of 16 from the unsustainable level of 44 reached at the peak of the bull market in 2000. Furthermore, we cannot expect the historical returns from the bond portion of this portfolio to continue. At the beginning of 1981, the return on 5-year government bonds was 13.25%, leaving this rate nowhere to go but down (powering the returns of bonds over the period); the 2010 year-end rate for those same bonds was 1.93%, leaving much less room for a decrease and a higher likelihood of an increase. Considering the failure of two of the three return drivers, we can venture a guess at what the future performance of this portfolio will look like.

How can we remedy the shortcomings of the above portfolio? We need a portfolio that is exposed to more than just three return drivers. The action section for this article shows a truly diversified “free lunch” portfolio that is exposed to many return drivers. The returns for the free lunch portfolio are shown below, compared with the conventional portfolio.

As can be seen, the free lunch portfolio outperforms the conventional portfolio at every point in the thirty year span. I’ve included a modified version of the free lunch portfolio below, consisting of seven components: WisdomTree Managed Futures (WDTI), CANSLIM trading strategy, iShares International Inflation-linked bonds (ITIP), SPDR Dow Jones Industrial Average (DIA), Vanguard Emerging Markets (VWO), and iShares Dow Jones Select Dividend (DVY). Despite only seven total components, the portfolio is exposed to dozens of return drivers, which is far superior to the conventional portfolio`s exposure to only three. More importantly, the components of this portfolio contain positions that are more independent of one another than what we saw in the conventional portfolio. I’ve given each security an approximately equal allocation of 14.3% (100/7= 14.3).

The WisdomTree Managed Futures Fund that I have included seeks a positive return in any environment; it has allocations to energy, livestock, grains, metals, various currencies, treasuries, and derivatives.

The CANSLIM is a strategy that has been discussed in a previous article of mine that selects small-cap growth stocks that have enjoyed favourable growth in recent periods and are viewed as undervalued.

The SunAmerica fund offers exposure to a vast number of fixed income and managed future funds and seeks an absolute gain by utilizing and actively managed quantitative investment process.

The SPDR Dow Jones Industrial Average provides exposure to relatively-safe blue chip US equity, which has upside value if (and hopefully when) the US stock market rallies further.

The Vanguard Emerging Markets Fund invests in up-and-coming markets such as Russia, Brazil, China, and Korea. This is the riskiest portion of the portfolio, but it has great upside potential.

The iShares Diversified Alternatives Trust holds a variety of long and short positions in currency forwards and exchange-traded futures. The fund seeks to earn absolute returns with a low historic correlation to traditional asset classes

Lastly, the iShares Dow Jones Select Dividend Fund will provide some steady income in the form of dividends. For further information on dividend investing, please refer to one of our previous article, Playing Dividends.

I’ve compared the portfolio’s performance against the NASDAQ for the 3 month, 6 month, and 1 year time frame, with the corresponding graphs below:

Some simple trend analysis will prove the diversification benefits at play. Although the difference in total returns is minimal (my portfolio is 2.52% and the NASDAQ is 2.48%), my portfolio is considerably less volatile than the NASDAQ throughout all three time periods. A longer time frame analysis would have been beneficial, but this was not possible as some of the funds in the portfolio were created less than two years ago. I hope you have enjoyed this insight into portfolio diversification. Please keep some of these concepts in mind before creating your next portfolio strategy!

Source: The 'Free Lunch' Portfolio

Additional disclosure: This series has been written on a contracted basis with the book's author. The opinions expressed in the article are those of Efficient Alpha and not necessarily those of the book's author. Efficient Alpha has been contracted to describe strategies and concepts used within the book but not to promote or recommend any strategies, the author, or the author's services.