The "free lunch effect" - Don't be afraid of volatility

Salient Capital has written a very good white paper on the effects of diversification. Using simple concepts from modern portfolio theory, the authors describe what they call the "free lunch effect" and make a key distinction on how risk reduction occurs in a portfolio. There is nothing truly new here but the presentation nicely shows the two different channels of diversification and the important impact of their free lunch effect.

This effect is the gain from diversification through holding uncorrelated assets. When you add an asset to your portfolio, you actually effect volatility through two channels. One, there is a de-risking channel because volatilities are not the same. You can just reduce portfolio risk by adding assets which are less risky. That is easy. But, there is a significant cost because returns will also fall and at best be the weighted average of the returns between assets. De-risking diversification by itself, when the correlation between assets is one, does not improve information ratios. It is the second channel through differences in correlation that provides investors with a real benefit. As the correlation declines, the benefit of diversification increases. This is true diversification because you can lower risk for the portfolio by more than just the weighted average of asset volatility included in the portfolio. You receive a gain in the information ratio of the portfolio.

The table above shows the impact of adding bonds to an equity portfolio through the simple mix of a balance 60/40 blend. Since bonds have a lower volatility, you will get lower risk, but there is the added benefit from the fact that the two assets are not perfectly correlation. However, you can take a deeper view and see that most of the risk reduction comes from de-risking and not diversification. The lower return comes from just holding a less risky asset which had historical lower performance.

If it is low correlation that provides the most portfolio benefit and not de-risking, it makes sense to hold a risky asset with corresponding higher return that will provide more bang for the buck from its low correlation. It does not make sense to hold a low correlated low risk asset. The figure below shows the added free lunch effect from holding a risky asset which is uncorrelated. This solution is all driven by the simple formula for finding the volatility of two assets. All of the action is in the correlation between the two assets.

So if you want the free lunch effect, what assets should you buy? The results may surprise some. The key benefit comes from managed futures and commodities even though both are riskier assets as measured by volatility. The diversification benefit from alternative investments does not come from long/short equities but from the strategies that are fundamentally different. Investors should not be afraid of volatility if the there is more benefit from lower correlation.