Friday, March 07, 2008

Tools for enhancing returns

My previous post considered what in absolute terms would be an acceptable rate of return (6.7% pa in my case) and which asset classes would be best suited to providing that return (predominantly equities and real estate with some room for commodities).

There is more to achieving an acceptable rate of return than simply allocating capital to an asset or assets within a preferred asset class. Here are five tools that can be used to manage portfolios and, potentially, enhance returns:

1. risk concentration: when we think of long run returns on asset classes, we are usually thinking of the average returns over a lengthy period of time. However, returns for specific assets and for shorter time periods and for future time periods are unlikely to replicate the long run historical returns for a given asset class as a whole. Sometimes the returns for specific assets over a given future time period will be better than the historic class average and sometimes they will be worse. Diversification and lengthening your holding period will (or should) produce results which are closer to the average result for the asset class as a whole. In simple terms, if you want to achieve higher returns, one technique is to concentrate your investments in a narrower pool of specific assets within a class. However, in doing so you necessarily take on a higher level of investing risk (similar to stock picking - see below). As practical examples, at one end of the spectrum is Warren Buffett who became the world's richest man at least in part by avoiding excess diversification. At the less successful end of the investing spectrum are employees of companies like Enron who kept a disproportionately high percentage of their assets in the stock of one company;

2. market timing and stock picking: there is a lot of press about how hard it is to time the market and how hard it is to stock pick. The reality is that a lot of very successful investors do beat the market through timing and stock picking. The reality is that timing the market (like picking stocks) is very difficult. As a matter of statistical definition, for every share that beats the market there must be one that underperforms because collectively all investors will hold all the stocks (both good and bad) that comprise the market. Put differently, not all investors can beat the market and for every investor who does beat the market there must be one who underperforms. Underperformance based on stock selection can be avoided by simply buying the index. However, the same cannot be said for market timing. All investors to some extent or another must indulge in an element of market timing. Choosing when to invest, when to rebalance, deciding to stay in the market or to set up an automatic monthly payment to an investment fund are all examples of market timing. The question is not whether you will time your entry to and exit from the market but how you will do so. Some investors reduce the timing decisions to arbitrary rules (which reduces the scope for misjudging the market). Others will attempt to be more pro-active and make more thought out decisions. Risk and potential return tend to both rise as investors move away from relatively passive market timing systems to more judgement based approaches;

3. benchmarking against the market: investors (and fund managers) will often benchmark performance against the market. This is sensible for the simple reason that if you cannot beat the market you would be better off parking your money in low cost index funds and spending your time on other activities. That said, there are some issues with benchmarking. The first is deciding what index is an appropriate benchmark. Benchmarks are usually selected on the basis of being a comparable measure of performance for your portfolio. An investor who wants to measure the performance of an actively managed portfolio of US large cap stocks may benchmark against the S&P500 index. However, an investor who is investing in a broader range of asset classes should benchmark against a different index (or even create their own) if they wish to measure relative performance. Of course, investors seeking absolute returns can still benefit from benchmarking, but need to be careful not to be distracted from their chosen strategy by short term comparative divergences from the selected benchmark;

4. leverage: leverage is both a wonderful tool and a deadly poison. If it works for you, it can magnify returns significantly. If it works against you it can be financially fatal. It is no accident that many of the world's most successful investors (and most of the successful investors personally known to me) use a reasonable amount of leverage. Equally, it is no co-incidence that many investors who suffer catastrophic losses (including some well known hedge funds) do so because of the effect of leverage. My own rather conservative approach is to gear my real estate investments (no margin call issues and rents can meet mortgage payments) but not my investments in equities or commodities;

5. derivatives: much like leverage, derivatives can increase the risk and returns on your portfolio. I tend to use them very sparingly for a number of reasons. The first is the premium and the second is the roll over costs associated with longer term investing (as opposed to short term trading). As exciting as trading derivatives sounds, it is something which, in my view, is best left to the professionals (or at least people with more time to devote to their investments than I have).

All of the above are tools which investors can use if they wish to increase the returns on their capital. In doing so, investors will be accepting a higher degree of risk. A random look at wealthy investors is that most, if not all, of them (or at least the ones known to me) do not blindly put their money into index funds. They use all or some of the five tools mentioned above to improve investment performance.

At a personal level, I have used all of these at various times (these days I tend not to benchmark) and, although my returns have been volatile at times, on the whole the use of risk concentration, an element of market timing and leverage has been very worthwhile.

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