Derivatives have their risks. Used properly, however, derivatives can increase the probability that an investor will achieve his or her goals. That is how they are being used in the new portfolio strategies and how they are likely to enhance portfolios in the future.
With the long-only portfolio, it is difficult for an investor to achieve true diversification. As we learned in Chapter 4, a portfolio is properly diversified only if there are assets that have little or no correlation with each other. In the traditional long-only portfolio, the investments tend to be fairly closely correlated with each other and with major economic factors such as interest rates, inflation, and economic growth. The portfolios tend to rise and fall in line with the major stock and bond indexes. Derivatives allow an investor to seek investment positions that are not correlated with long-only investments or that depend on the movements of the major economic factors and market indexes.
Another use of derivatives arises when an investor wants to reduce the risks in a portfolio without selling positions. Reducing risk without scaling back existing positions is difficult in a long-only portfolio. But the introduction of derivatives allows the investor to reduce or eliminate risks such as broad market declines. These hedging positions can be permanent, or they can be put in place only when the investor believes market risks are high. This is a form of portfolio insurance.
Derivatives also allow an investor to add leverage to a portfolio. While leverage can increase risk, it also allows the investor to increase the potential return and to decrease risk by creating a portfolio with true diversification. Remember that a portfolio of risky assets actually is less risky than any of the individual assets if the investments have negative correlations with each other.
Leverage greatly increases the opportunities open to an investor. For example, the bulk of the portfolio can be invested in risk-free or low-risk assets that also will have low returns. The remainder of the portfolio can be invested in a variety of risky assets. Purchasing these assets with derivatives means only a small amount of cash is needed, and the potential gains are magnified far beyond the returns possible with a nonleveraged, long-only purchase. This type of positioning often is known as a barbell strategy.
The key difference between a portfolio with derivatives and one without derivatives is in the concept of relative returns versus absolute returns.
Relative returns are the returns of an investment manager or investment vehicle compared to a market index or benchmark. For example, most mutual funds that invest in U.S. stocks are compared to the Standard & Poor's 500 Index. If the fund earns a higher return than the index, the manager is considered to be good or skillful. This means that in a declining market, an investor can make a good investment decision that loses a lot of money. If the index declines 25 percent and the mutual fund loses only 20 percent of its value, the fund is considered a big winner. The investor has earned great returns relative to the index but has earned poor returns on an absolute basis.
An absolute return investment is one that is not measured against a broad index and whose return pattern tends to be independent of the index. Absolute return investments also tend to earn positive returns over time that do not depend on a particular direction of inflation, interest rates, economic growth, or the major market indexes. A grouping of relative return investments can be an absolute return portfolio if the investments are uncorrelated with each other. For example, a simple two-asset portfolio could consist of a stock index fund and a derivative investment that sells short the index. These assets should have a negative correlation and jointly would be an absolute return portfolio.
Absolute returns are critical to long-term investment success because, as we have seen, the major market indexes can endure long periods of negative or low returns. The individual investor is not served well by the traditional relative-return portfolio during such periods. During bull markets, a diversified portfolio that seeks absolute returns will earn lower returns than a traditional long-only portfolio. But the absolute return portfolio should have less risk and volatility than the long-only portfolio, should earn similar returns to the long-only portfolio over the long-term, and will earn higher returns during the extended periods when the long-only portfolio is earning less than its long-term average.
Was this article helpful?