“There’s no such thing as a free lunch.” It’s a phrase most of us learn early in our education, and it’s grounded, of course, in the idea that you can’t get something for nothing. Milton Friedman helped popularize the saying in finance in the 1970s, but it was another Nobel Prize–winning economist, Harry Markowitz, who came to the conclusion that this most durable of adages may in fact be wrong. According to Markowitz’s research, there is a free lunch in finance, and it comes from one place: diversification. Specifically, owning assets that exhibit a low correlation to one another.
One way to eat that free lunch is by taking advantage of liquid alternatives, or strategies that harvest alternative risk premia. But before we get to that, let’s whet our appetites with a review of the basics.
What does correlation mean?
Broadly speaking, in an investing context it means the way in which one asset tends to perform with respect to another. S&P 500® Index futures provide a handy, if extreme, example. If you’re shorting S&P 500® futures, you’re betting against the broad equity markets. So mathematically we could express this short position as having a –1 correlation to equities. At the other end of the spectrum, a long position with respect to the S&P 500® would have a correlation of 1.
A correlation of zero would be akin to a coin flip—roughly half the time you’d expect the asset to move in tandem with another asset, and the other half of the time you’d expect it to move in the opposite direction. This means an asset with zero correlation to, say, the equity market could move in the same direction as equities in any given short-term period. So in a one- or two-month time frame, that asset could produce a 0.5 correlation to the market. But over the long term it should smooth out back to zero.
What’s the advantage of low correlation?
Most investors intuitively understand the value of low correlation, perhaps most commonly illustrated in the classic diversified portfolio of 60% stocks to 40% bonds. Bond performance typically has a low correlation to that of stocks, providing investors with a counterbalance if equity prices fall. Owning fixed-income assets therefore reduces risk.
But why stop there? Blending additional low-correlated assets with similar positive expected returns further enhances diversification, reduces portfolio risk, and increases the odds of better and more consistent performance—all without requiring you to spend any more than you would have otherwise in the course of investing. This is what Markowitz meant when he called diversification “the only free lunch in finance.”
The chart below makes it plain to see that a portfolio’s risk declines—and thus its Sharpe ratio improves—as you add low-correlated assets with similar expected returns.
Source: Parametric. For illustrative purposes only.
Adding other types of asset classes—not just equities and fixed income but also currencies and commodities (assets that fall into the broader category of liquid alternatives)—and optimizing them across a variety of factors such as carry, value, and momentum helps investors achieve a superior risk-adjusted return.
Sounds fantastic. What’s the catch?
Critics point out that many liquid alternative strategies have underperformed during some periods of market volatility, as we experienced in early 2018. These strategies tend to advertise low to near-zero correlations to traditional asset classes, but, as we discussed above, zero correlation means these blended assets will move opposite the market only half the time. So in any given time period there’s a 50% chance (assuming a zero correlation, with a higher-percentage chance as the correlation creeps higher) that they move with the market.
An investor who wants certainty that an asset provides protection when equity markets drop needs assets with a –1 correlation to equity markets. Those assets, however, are very, very expensive. As a result, we believe in the elevated benefits of a systematic, model-driven, patient approach to liquid alternatives. Investors gain positive excess returns while having low correlation to traditional asset classes.
The bottom line
Liquid alternatives offer an additional way to reduce portfolio risk, keep costs low, and drive returns over the long run. If that isn’t quite something for nothing, it’s awfully close.
Tom Lee, CFA, Managing Director, Investment Strategy & Research
Mr. Lee leads the investment team that oversees investment strategies managed in Parametric’s Minneapolis and Westport Offices. In his current position, Tom directs the research efforts that support existing strategies and form the foundation for new strategies. He is also chair of the Investment Committee that has oversight of these strategies. Tom has co-authored articles on topics ranging from liability driven investments to the volatility risk premium. Prior to joining Parametric in 1994*, Tom spent two years working for the Federal Reserve in Washington, D.C. He earned a B.S. in Economics and an MBA in Finance from the University of Minnesota. He is a CFA charterholder and a member of the CFA Society of Minnesota.
*Reflects the year employee was hired by The Clifton Group, which was acquired by Parametric Portfolio Associates® LLC on December 31, 2012.
The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss.