Risk vs. Return; the Holy Grail redefined

In searching for the Holy Grail, investors look for yield on the one hand while trying to control risk with the other.

At best, they want a yield which is massive and risk which is minimal. That is why the balance between risk and risk premia, typically measured by the Sharpe Ratio:

Sharpe Ratio = (Investment Return - Risk Free Return) / Standard Deviation of Returns)

is so coveted by Financial Advisors

The old adage ‘No pain, no Gain’, still rings true. The Pain is, in this case, the denominator. If your investment behaves like a roller coaster it means the standard deviation of returns is high, and hence the Sharpe Ratio will be low. But if the return of that roller coaster is massive, maybe you will be more tolerant of the volatility, given the risk premia achieved. Not all souls (or hearts) are equal, some will tolerate a high denominator, while others simply cannot. For the latter a good financial advisor will look for your heart and soul’s well-being and provide investment advice that is appropriate to your risk tolerance.

Improving the numerator/denominator ratio is of such importance that Nobel Prizes have been awarded to those who have succeeded in its pursuit. Most notable is the work on the Efficient Frontier, which aims to reduce the denominator of a portfolio using optimal correlations, for a given performance.

However, the problem is that over time the performance of portfolios that adhere to this theory differ very little from those produced by a monkey throwing darts, and countless explanations and excuses have been written advocating and defending the policy.

To make matters worse risk itself has morphed and the advances in technology are producing a tectonic shift in the industry. The digital alchemist has appeared to try and make the unpredictable predictable with new trends in asset management that tend to simplify, automate and democratise alpha; looking for efficiencies and performance through the use of advanced technology.

Automation of investment decisions is not new, but cheap high-performance storage and massive processing power are enabling a golden era for robots to manage investments in ways impossible to replicate just a decade ago for most players. Massive neural networks and gigantic amounts of information are involved in detecting hidden patterns, trading cycles, humanely impossible to see correlations and arbitrage opportunities across all asset classes.

At the same time, the packaging of investments in vehicles that retail as ETFs are composed in real-time from hundreds, if not even thousands, of instruments. These are giving birth to a new era of passive investment, where the old 2/20 fee structure is under severe pressure. These massive baskets are traded like single securities, creating new unintended concentration of risks when volatility spikes.

In our next instalment, we will delve into how this new information era is creating opportunities for new entrants whilst simultaneously thinning the herds of those who are unable or unwilling to adapt.

Federico M Dominguez (Oct 2019)