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Rockstead Portfolio Construction Framework – Part II

In Part I of this article, we have briefly discussed the need for a framework to measure, evaluate, and compare the performance of an investment portfolio or investment fund. At Rockstead Capital, we also use this framework to objectively evaluate and improve the performance of our clients’ investment portfolios and in-house funds.

In this part of the article, we will discuss the importance of an investment portfolio to deliver stable and well-distributed positive returns, and how to construct such high performing portfolios.

STABILITY

The stability metric measures the consistency of positive returns, and there are multiple ways to define it. One straightforward way is to simply measure the percentage of months in which a portfolio managed to generate positive returns over a given period. A slightly more complex approach is to compute the number of consecutive positive monthly returns of the portfolio.

Regardless of the method used, the value of investing in a stable portfolio can be appreciated by observing the three hypothetical portfolios below. The stable Portfolio C generates positive returns that are evenly distributed across all time frames.

A stable portfolio is obviously more desirable because its returns over any time frame are predictable, which makes financial planning easier and helps investors avoid prolonged periods of underperformance.

HOW TO CONSTRUCT A HIGH PERFORMING PORTFOLIO

After discussing the various metrics for measuring portfolio performance, one may wonder how to construct a superior, high-performing portfolio. Our answer: strategy diversification and smart utilisation of leverage。

Strategy Diversification

Every piece of investment advice starts with a discourse on diversification. The idea is to invest in asset classes that demonstrate little or no correlation with one another to enhance diversification and reduce portfolio volatility. This was sensible advice 20+ years ago. However, since 1973, stocks and bonds have been positively correlated nearly 70 percent of the time.

The problem is that as we, collectively as investors, have piled into various “uncorrelated” asset classes, we have created an unwanted but predictable consequence: the correlations across markets and asset classes have risen, reducing the benefits of diversification. In addition, numerous academic and practitioner studies show that correlations between assets tend to increase during periods of market downturn, precisely when diversification is expected to protect a portfolio. Therefore, diversification today is a lot more difficult than it was a few decades ago and sticking with the old playbook of “hold more diverse asset classes or foreign stocks” will no longer do the trick.

Given the limits of asset class diversification as an effective hedge, one approach to constructing a superior portfolio is to use a variety of anti-correlated investment strategies. These investment strategies can include trend following, momentum, reversal, carry trades, and volatility trading, among others. The key is to focus on strategy diversification rather than just asset diversification。

Anti-correlation & Leverage

Artemis Capital, based in Austin, published a research paper [1] about the macro shifts in long-range economic and monetary environments. One observation in the paper is that anti-correlation is an effective defensive component for a long-term, resilient portfolio. To recap and paraphrase this insight:

Suppose an investor is given the option to buy two out of three possible asset choices: Assets A, B, and C. The first two assets (A and B) are highly correlated, and both generate positive returns: 15 percent and 13 percent respectively. Asset C, on the other hand, produces a slightly negative yield of -5 percent but is countertrend to assets A and B. In other words, asset C makes the most substantial gains during periods when the other two assets (A and B) suffer drawdowns.

Which two assets produce the best portfolio? Counterintuitively, combining assets A and C produces a portfolio that generates superior, risk-adjusted returns (10 percent returns and -5 percent drawdown) even when one of the assets (C) generates a negative yield.

Given the much higher return-to-drawdown ratio of Portfolio A + C, one can simply apply leverage to the A + C portfolio to achieve higher returns with lower risk than either Portfolio A + B or holding any individual asset.

Though simple yet effective, many investors (and portfolio managers) have yet to fully appreciate or understand the immense value that a defensive asset brings to a long-term portfolio. As summarised by the Artemis research team, anti-correlation is more valuable than excess returns. Put simply, because the market is unpredictable, anti-correlation is key to negating nasty surprises and protecting wealth.

THE ROCKSTEAD PORTFOLIO CONSTRUCTION FRAMEWORK

Before implementing any investment portfolio, the framework dictates that we check the portfolio for sufficient diversification across asset classes, strategies, sources of alpha, and geographical exposure.

Considering various types of diversification should result in an investment portfolio that produces high risk-adjusted returns that are highly stable, have low downside correlation to global equities, and recover quickly from losses when they occur.

From our experience, strategy diversification probably has the largest impact on the stability and risk-adjusted benefits of an investment portfolio. We suspect that most portfolio managers do not discuss strategy diversification as often as asset class diversification because strategy diversification is extremely difficult to achieve.

To achieve effective strategy diversification, the portfolio manager must possess technical expertise in developing quantitative investment models that utilise a diverse pool of financial instruments, including derivatives, to trade various asset classes. An individual portfolio manager rarely has the expertise to develop investment strategies across all asset classes.

Furthermore, even if the portfolio manager is highly knowledgeable in strategy development, implementing these strategies often requires significant investment in infrastructure, technology, and people to manage operational risk. Such investment is usually out of reach for mid-size or small asset management companies or hedge funds.

Due to the size and scale of our firm, we have managed to establish a direct partnership with the structuring or financial engineering teams of top-tier reputable investment banks. These teams have proven records of strong strategy development and trade execution capabilities.

Such partnerships allow us to jointly design investment portfolios for our clients, enabling us to gain access to a diverse pool of proven investment strategies and obtain a level of diversification that most boutique hedge funds cannot achieve. Hence, the firm’s ability to scale and remain well-diversified is not limited by the size of our in-house trading and investment team.

DISCRETIONAL PORTFOLIO MANAGEMENT (DPM)

Family office clients can access high-performing investment portfolios through our Discretionary Portfolio Management (DPM) service. Our family office clients typically have a substantial amount of investment funds to deploy, allowing us to tailor their portfolios to their investment objectives and risk appetites. These discretionary portfolios are implemented in separate managed accounts, and assets from other clients are never commingled with these portfolios.

To further customise the risk-return profiles of clients’ discretionary portfolios, we can arrange with our banking partners to “wrap” selected strategies or baskets of strategies with a CPN (Capital Protected Note), Leveraged Notes, options, or warrants. Such wrappers or structures prove to be extremely helpful for clients who wish to protect their capital, set hard limits on losses, or gain leverage on their investments.

For accredited investors who wish to invest relatively small amounts, they can simply purchase either the Rockstead Quant Fund or Rockstead Resilience Fund. Both Funds are designed based on the same diversification principles and evaluated using our portfolio construction framework.

For more information on Rockstead Capital family office services and fund offerings, please contact any of our relationship managers or email familyoffice@rockstead.com.

References:

[1] The Allegory of the Hawk and Serpent – How to Grow and Protect Wealth for 100 Years, published in 2020

Rockstead Portfolio Construction Framework – Part I

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