Investment Enhancement Modern Portfolio Theory

Investment Enhancement

Modern portfolio theory holds that a fully diversified portfolio will have no firm-specific risk. International diversification addresses the issue of country-specific risk. A portfolio that is fully diversified in one country is still going to fluctuate based on the performance of that market, and of that currency. International diversification offsets the risk associated with one country with risk that is associated with another country.

International diversification is made possible because the correlation coefficients of most developed market pairings are relatively low. However, full international diversification may not be easy to achieve, because most of the world's major markets bear some degree of correlation, as global markets become more integrated. Yavas (2007) found that the correlations between the DAX, the S&P 500 and the Nikkei were statistically significant, meaning that is would be difficult for an investor to achieve full international diversification with a portfolio built from those three major exchanges.

While in theory international diversification should insulate the portfolio from country-specific risk, de Santis and Sarno (2008) showed that it is better to hold a portfolio consisting of assets from a subset of countries, rather than seeking full international diversification. They argue that international diversification is only effective to the extent that returns in different markets are not correlated. Yavas showed that there is significant correlation between the world's major markets.

De Santis and Sarno identified the reasons why international diversification is imperfect. They cite the Euro has having an impact, as it wipes out the currency risks that would previously have decreased the comovements of different stock exchanges. What the authors find is that while there is some opportunity for diversification, those opportunities are limited as a result of the risk-arbitrage relationships between major markets.

Driessen and Laeven (n.d.) found that the benefits from international diversification are greatest for investors in developing countries, which are more likely to have a lower degree of correlation with major developed markets. As well, most benefits are likely to come from outside of the region of the country. It is reasonable to conclude then that the value of international diversification increases the less integrated the foreign country is with the home country's economy.

A fully diversified domestic portfolio will still be subject to all of the fluctuations inherent in the domestic market. In theory, international diversification will reduce that volatility. However, the world's most important and liquid markets are highly correlated, which reduces the benefits of international diversification. Even economies as different as the U.S., Japan and Germany have a significant degree of comovement. It is important to consider, then, that to the extent that true international diversification is possible, it is only possible when emerging markets are included. It would require carefully study to determine if emerging markets, with their high rates of volatility, are an appropriate way to reduce risk in a portfolio. Emerging markets are subject to illiquidity and have at times been correlated with Western markets, such as during the recent economic downturn.

2. In developing a portfolio, there are a number of alternative investment vehicles that can offer benefits to the portfolio, reducing the dependency on bonds and equities. Some of the many alternative investments are real estate, precious metals, hedge funds, commodities, derivatives. Technically, one could consider collectibles to be alternative investments, including fine art and vintage wine. Some may consider different equity forms such as private equity or venture capital to be alternative investments (Schweizer, 2008).

These different investment forms can serve an important function in the portfolio. The first function that they perform is diversification. Some markets, such as real estate or oil, can be loosely tied to the equity or debt markets, but will have a low level of correlation with the market overall. Some commodities, such as precious metals, have a low level of correlation or an inverse correlation to the broad market. Some commodities, such as coffee, are subject to conditions that are largely unrelated to the broad market.

Other alternative investments have a deliberately inverse correlation with the market -- many hedge funds for example -- and therefore serve key role in insulating the portfolio from downside risk. Hedge funds are also poorly correlated with the markets because they often have limited investments, and few rules. They have different return drivers than do the bond or equity markets (Schweizer, 2008). As such, they are used to offset market fluctuations.

In addition, private equity, venture finance and hedge funds also have another impact on the portfolio in that they typically provide a long-term time horizon. These types of investments are often illiquid, so the investor needs to view them as long-term investments. However, the lack of liquidity also means that for the most part they have low levels of correlation with the broad market.

Derivatives are another possibility, and their potential impact on the portfolio will be discussed in the next question. They can either increase risk or decrease risk, depending on the type of derivative and how it is used.

Overall, the impact of alternative investments is to reduce the degree to which the portfolio is subject to the equity and fixed income markets. Alternative investments are often used as an ancillary component of the portfolio, to reduce the portfolio's overall volatility but with the hopes that returns will not suffer as a result.

3. Derivatives can be used for a couple of different purposes in a portfolio. The first is to increase leverage (risk), thereby delivering greater returns or losses than otherwise would be acquired for the money. The second use of derivatives is to limit the downside risk of a portfolio. They can also be used for asset allocation and diversification purposes.

The latter two purposes are simple -- derivatives are a different asset class and therefore represent a means by which an investor can increase his or her holdings not only of the derivatives class but eventually the underlying asset class as well.

An uncovered derivative increases the risk associated with the portfolio significantly. The investor is able to purchase or sell more of a security than would otherwise be possible, which increases the leverage and volatility of the portfolio. This tactic can be used sparingly in a portfolio to come effect but is largely gambling.

The covered derivative can be used to limit the downside risk to the security owner. Such a derivative strategy requires the portfolio to pay for the privilege of limiting downside risk -- essentially selling that downside risk to another party for a profit. The counterparty may use the same strategy to gain extra income from his or her portfolio.

According to the efficient market hypothesis, enhancing returns through derivatives should not be possible if the derivatives are fairly priced. However, in practice this is not the case (Lhabitant, 2000). One possible explanation is that derivative markets are less liquid than equity markets, which results in arbitrage opportunities. There are also biases built into derivatives markets that can be exploited as well, as these biases bring the price of the derivatives away from equilibrium.

Lhabitant (2000) shows that the Sharpe ratio for a covered call is higher when the exercise price is just out of the money, especially in long options. The author does not indicate why this is the case, but it could be speculated that the market is slightly irrational at this point, with buyers seeing a slightly out-of-the-money call as being a good value buy relative to other option positions. For the portfolio, the implications are clear -- that there are superior returns to be had by writing covered calls just out of the money.