Originally published in the Brandywine Asset Management Monthly Report.
You see that in these reports we compare our performance to both the BTOP50 CTA index and the S&P 500 Total Return index (which includes dividends). While it may make some sense for us to compare ourselves to other CTAs (after all, we are a CTA), we provide the comparison to the S&P 500 TR index not because there’s any relevance to the comparison, but because it is expected of us (investors seem to compare every investment to the S&P 500). In reality, however, it’s really neither sensible nor fair for us to compare our performance to the S&P 500.
It’s not sensible because the S&P 500, despite the “500” in its name, is a narrowly focused index, whose returns are powered by a limited number of “return drivers.” Mike Dever explains this (and discusses return drivers) at length throughout his best-seller, Jackass Investing: Don’t do it. Profit from it. In particular, in the opening chapter of his book, he shows how the S&P 500 index price is dominated by two primary return drivers. In the short-term, defined as less than 20 years (which for most people would be considered long-term), it is driven by changes in people’s enthusiasm for owning stocks. Longer-term, growth in corporate earnings is the dominant return driver. In stark contrast, Brandywine’s performance is driven by dozens of return drivers acting across more than 100 global financial and commodity markets.
It is this stark difference in the diversification between the S&P 500 TR index and Brandywine’s Symphony program that also makes a comparison of the two unfair. Over time, the S&P 500 TR index will be unable to compete on a risk-adjusted basis with the returns earned by Brandywine. This is already becoming apparent. While past performance is not necessarily indicative of future performance, since the inception of Brandywine’s Symphony program in July 2011, both the program and the aggressively-traded Brandywine Symphony Preferred Fund have produced risk-adjusted returns that exceed those of the S&P 500. This is despite the fact that Brandywine has slightly underperformed expectations and the S&P 500 has produced strong returns (relative to its historical returns) over that period.
The basis for making the statement that the S&P 500 TR index will underperform Brandywine on a risk-adjusted basis is one of simple math. Brandywine’s Symphony program incorporates dozens of trading strategies that are each based on a sound, logical return driver capable of producing positive returns over time. While any single one of them may approximate the risk-return profile of the U.S. stock market (such as a 10% expected return with the probability of an occasional 50% drawdown), in combination they produce those returns with much reduced risk. As summarized in the final chapter of Mr. Dever’s book, this is due to the fact that the returns earned by any single trading strategy in Brandywine Symphony’s portfolio are unrelated to the returns earned by the other trading strategies. When one is losing, there is the potential that another is profiting.
This is the basic concept behind portfolio diversification and Modern Portfolio Theory. Unfortunately, the way MPT is taught and practiced by most people is not true investing; it’s gambling. That is because their portfolios may contain as much as 20%, 30% or even 60% long stock exposure. By creating portfolios that are dominated by long stock exposure, they are gambling their money on a single return driver (people’s enthusiasm for stocks). Brandywine’s Symphony program is also exposed to global stock markets, but as we practice ‘true’ portfolio diversification, this sector represents just 17% of the portfolio, and that portion is dynamically allocated both long and short among the stock indexes of dozens of countries. The remaining 83% of Brandywine’s portfolio is allocated to trading strategies taking positions in the currency, interest rate, metals, energy and agricultural commodity markets.
If, over time, many of these trading strategies have a positive return, then over time Brandywine’s Symphony program will produce those returns, but with substantially reduced risk. In fact, because Brandywine’s drawdowns are smaller than those of a less diversified portfolio (such as one dominated by long stock exposure), the return can actually be greater than the average return of each strategy, as the portfolio spends more time producing new profits, rather than recovering from past losses. This is how we are able to produce such high absolute returns (such as the 20%+ annualized returns of the Brandywine Symphony Preferred Fund) and risk-adjusted returns.
We find that many people allocate their money based on fear. Interestingly, the fear of missing out is often greater than the fear of losing. Because of the overwhelming focus on the “stock market,” many people fear missing out on its potential returns, when in fact they could actually exceed those returns, with less risk, by investing in a truly diversified portfolio.