Modern Portfolio Theory: Diversification Increases Risk-Adjusted Returns
Markowitz’s Nobel Prize-winning theory proved that portfolio construction is not just about the return and risk characteristics of individual asset classes. The behaviour of those asset classes relative to one another was a key component in addressing the risk and return of a portfolio.
Markowitz found that combining assets with non-perfect correlations can improve risk-adjusted returns, that is, by holding a diversified portfolio of assets, investors reduce overall portfolio risk. The lower the correlation between assets, the greater the benefit to a portfolio. A portfolio is said to be ‘efficient’ if it produces the highest rate of return at a given level of risk.
Each line on the graph is the ‘efficient frontier’ for that combination of asset classes: the portfolios that achieve highest rate of return for a given level of risk, or alternatively, the lowest level of risk for a given return.
When considering portfolios on the efficient frontier, while all portfolios will be ‘efficient’, there is just one optimal portfolio mix that provides the highest risk-adjusted return. This theoretical portfolio is called the ‘market portfolio’ or otherwise known as the ‘super-efficient portfolio’.
James Tobin (1958) introduced the concept of the Capital Market Line (CML), which is the rate at which you can borrow or save cash, and lies tangential to the efficient frontier at the point of the market portfolio. By taking the optimal portfolio mix, and blending this portfolio with cash to reduce risk, or borrowings to increase risk, the investor moves along the CML as opposed to the efficient frontier. All portfolio combinations on the CML will lie above the efficient frontier, therefore suggesting higher returns for each marginal increase in risk.
Source: Frontier Capital Management LLP
Frontier’s multi asset funds encompass the work of both Markowitz and Tobin. The funds invest across eight asset classes, offering superior “efficiency” compared to pure equity portfolios, or portfolios with two (e.g. equities and bonds) or three (e.g. equities, bonds, and property) asset classes over the longer term. Frontier is unique in its use of leverage rather than different asset class allocations to cater to different risk return profiles, utilising the CML to try to achieve greater risk adjusted returns than those found along the ‘efficient frontier’.
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