Originally published in the Brandywine Asset Management Monthly Report.
Brandywine is well known for the diversity of trading strategies we have developed over the past 30+ years and continue to employ today in Brandywine’s Symphony program. It is this strategy diversity that provides us with the opportunity to profit across a variety of market conditions and, although past performance is not predictive of future performance, to increase the probability that future returns will approximate past returns.
While Brandywine’s specific trading strategies and portfolio allocation model (which determines the allocation to be made to each trading strategy and market in the portfolio) is somewhat complex, the underlying concept upon which we base our investment philosophy is quite simple. That is, we create a portfolio that is balanced across a wide range of trading strategies, each based on a sound, logical return driver capable of providing positive returns over time. Properly employed, this approach will create a portfolio that produces greater returns with less risk than a less-diversified portfolio.
To illustrate this let’s look at a simple example using two actual trading strategies.
The first strategy is a “tail-risk” strategy designed to perform especially well during periods of financial and commodity market disruption. It has produced the following risk-return profile since the end of 1998 (the end of trading in Brandywine’s Benchmark program and the start of the simulations for Brandywine’s Symphony program ).
Annualized Return: 5.0%
Annualized Volatility: 23.3%
Maximum Drawdown: -44.2%
Return-to-Vol Percentage: 21%
The second strategy, in contrast to the first strategy, benefits from favorable financial market conditions.
Annualized Return: 3.7%
Annualized Volatility: 15.7%
Maximum Drawdown: -51.0%
Return-to-Vol Percentage: 24%
No one in their right mind would employ either of these two strategies as a standalone strategy in their portfolio; they’re too risky. To receive single-digit returns while risking half your money is akin to gambling. But each strategy is based on a reasonably sound return driver that would permit it to be allocated a small part (perhaps a few percent) of a portfolio. And because those return drivers are truly independent of each other, allowing one strategy to profit while the other is losing, by combining the two we get the following, much more favorable, performance:
Annualized Return: 10.3%
Annualized Volatility: 22.5%
Maximum Drawdown: -27.9%
Return-to-Vol Percentage: 45%
The tremendous benefits of “true” portfolio diversification can already begin to be seen with just these two truly independent trading strategies combined into a balanced portfolio. The annualized return of the two-strategy portfolio is more than twice as good as that of the best-performing strategy and with just half its volatility. The maximum drawdown is also significantly lower than that of either of the two strategies.
Now multiply this effect by the dozens of trading strategies incorporated into Brandywine’s Symphony program and you can understand how we achieve the ACTUAL performance results shown in these reports – where the risk-adjusted return is five times better than the average of the two strategies.
We understand that not everyone can replicate what Brandywine has built over its 30-year history. But what we can’t understand is why people would choose to gamble with their money. We say that because the second strategy shown in the above example is actually the S&P 500 total return index. Yes, the strategy that no one in their right mind would employ as a standalone strategy is the dominant strategy employed by most people in their portfolios!
Portfolio diversification is often preached but virtually never employed. Concentrating a portfolio in stocks (as well as stocks and bonds, but that’s the subject of another article) is not investing, it’s gambling. In addition to the tremendous benefits of true portfolio diversification, what this simple example shows is that the vast majority of people have been taught to gamble with their money. Instead of investing – by truly diversifying their portfolios to earn better returns with far less risk than they are taking – they choose to let substantial portions of their portfolios ride on one highly risky bet. Even if you think stocks are a good buy, why wouldn’t you find other opportunities to diversify your portfolio and reduce risk? As Brandywine has discovered, there are dozens of equally or even more compelling trading strategies that can be employed in your portfolio.
Don’t gamble – invest.
(1) Since the performance of the first strategy shown in these examples is based on back-tested (hypothetical) performance, the following disclaimer is required:
HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS ACHIEVED BY ANY PARTICULAR TRADING PROGRAM.
ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS.