The Strategy Portfolio Approach To Investing

Includes: MRK, PFE
by: Jonathan Kinlay


Research by Harry Markowitz in the 1950's provides the basis for much of the corpus of modern portfolio theory.

In this framework, portfolio construction is highly dependent on asset correlations to diversify portfolio risk.

But assets correlations are notoriously unstable and tend to rise during periods of market stress, reducing portfolio diversification at times when it is most needed.

An alternative approach, discussed in this article, is to construct portfolios of strategies rather than portfolios of assets.

This enables broadly diversified portfolios to be constructed, comprising assets that may normally be highly correlated.

For many decades the principles of portfolio construction laid out by Harry Markovitz in the 1950s have been broadly accepted as one of the cornerstones of modern portfolio theory (as summarized, for example, in this Wikipedia article). The strengths and weakness of the mean-variance methodology are now widely understood and broadly accepted. But alternatives exist, one of which is the strategy portfolio approach to portfolio construction.

The essence of the strategy portfolio approach lies in the understanding that it is much easier to create a diversified portfolio of equity strategies than a diversified portfolio of the underlying assets. In principle, it is quite feasible to create a basket of strategies for highly correlated stocks that are uncorrelated, or even negatively correlated with one another. For example, one could combine a mean-reversion strategy on a stock like Merck & Co. (NYSE:MRK) with a momentum strategy on a correlated stock such as Pfizer (NYSE:PFE), that will typically counteract one another rather than moving in lockstep as the underlying equities tend to do.

In fact this approach is widely employed by hedge fund investors as well as proprietary trading firms and family offices, who seek to diversify their investments across a broad range of underlying strategies in many different asset classes, rather than by investing in the underlying assets directly.

What is to be gained from such an approach to portfolio construction, compared to the typical methodology? The answer is straightforward: lower risk, which results from the lower correlation between strategies, compared to the correlation between the assets themselves. That in turn produces a more diversified portfolio, reducing strategy beta, volatility and tail risk.

What are the drawbacks to this approach to portfolio construction? One major challenge is that it is much harder to create strategy portfolios than asset portfolios. The analyst is obliged to create (at least) one individual strategy for each asset in the universe, rather than a single strategy for the portfolio as a whole. This constrains the rate at which the investment universe can grow (it takes time to research and develop good strategies!), limiting the rate of growth of assets under management. So it is not an approach that I would necessarily recommend if your goal is to deploy multiple billions of dollars; but AUM up to around a billion dollars is certainly a feasible target.

From a risk perspective, the chief limitation is that we lack the ability to control the makeup of the resulting portfolio as closely as we can with traditional approaches to portfolio construction. In a typical equity long/short strategy the portfolio is constrained to have a specified maximum beta, and overall net exposure. With the strategy portfolio approach we are unable to guarantee a specific limit on the net exposure, or the beta of the portfolio. We may be able to quantify that, historically, the portfolio has an average net long exposure, of, say, 25% and an average beta of 0.2; but there is nothing to guarantee that a situation may not arise in future in which all of the strategies align to produce a 100% net long or net short exposure and a beta of +1/-1, or greater. This is extremely unlikely, of course, and may never happen even in geological timescales, as can be demonstrated by Monte Carlo simulation. What is likely, however, is that there will be periods in which the beta and net exposure of the portfolio may fluctuate widely.

Is this a problem? Yes and no. The point about constraining the portfolio beta and net exposure in a typical long/short strategy is to manage portfolio risk. Such constraints decrease the likelihood of substantial losses - but they cannot guarantee that outcome, as has been demonstrated during prior periods of severe market stress such as 2000/01 and 2008/09. Asset correlations tend to increase significantly when markets suffer major declines, often undermining the assumptions on which the portfolio and its associated risk limits were originally based.

Similarly, the way in which we construct strategy portfolios takes a statistical approach to risk control, using stochastic process control. Just as with the traditional approach to portfolio construction, statistical analysis cannot guarantee that market conditions may not arise that give rise to substantial losses, however unlikely such circumstances may be.

For a demonstration of how this approach works, see this post on the Systematic Strategies Quantitative Equity Strategy.

More on modern portfolio theory

More on genetic programming

More on applying stochastic process control to investment strategy

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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