The free lunch of portfolio diversificationMacquarie Professional Series

This article has been written by Winton.

The Winton Global Alpha Fund is proudly brought to you by the Macquarie Professional Series. 

“The only free lunch in finance” is a phrase coined in the 1950s and used often today that refers to portfolio diversification. Skill is required to capitalize on its powerful effects, however.

Winton’s strategies seek to benefit from diversification by using multiple signals to invest systematically across almost 100 markets around the world.

The importance of diversification in investment management is intuitive enough – placing all hope in a single investment is foolhardy given the decidedly uncertain nature of financial markets. Yet diversification is particularly important for Winton’s systematic approach to investing for two main reasons.

First, Winton’s investment signals often only have a slight edge, given the difficulty of beating financial markets. This means that when a signal is applied to a single market, the results can be highly variable. This variability reduces, however, as we increase the number of times we employ our edge – whether by adding new signals, increasing the number of markets we trade, or taking a longer investment horizon.

Second, the positions our strategies take are, for the most part, directional and unhedged. Thankfully, different signals and markets tend to be profitable at different times. And this differentiation enables us to reduce the risk of a given position by diversifying our portfolios across multiple signals and many markets.

The less the correlation between those signals and markets, the greater the diversification benefits on offer. If positions do not move together, their fluctuations are bound at times to offset one another. This will reduce overall portfolio volatility while providing the same level of return.

There is, however, a tendency for market behavior to change suddenly and to create correlations where none previously existed. Winton manage this risk by taking additional measures, such as by conducting proprietary stress tests on our portfolios and limiting our use of leverage.

Are Winton’s strategies a good portfolio diversifier?

As well as playing a central role within Winton’s strategies, diversification is often a driver of an investor’s decision to allocate to Winton. This is because Winton’s systematic approach to investment management tends to result in long-term returns that diverge from those of equities and bonds, making it a valuable addition to a typical equity-bond portfolio.

When considering adding Winton’s strategies to a portfolio, it is also important to understand the limits of diversification. Diversifying a portfolio is not the same as hedging it. And while it is true that the long-term correlation between the Winton Global Alpha Fund and equity and bond markets is effectively zero, its directional nature means that it will often move in tandem with traditional investments for months at a time, if not years. This makes Winton’s strategies inappropriate for investors seeking explicit portfolio protection against market crashes.

Diversification is a “free lunch” that investment managers and investors alike can feast upon. Winton’s systematic approach gives us the ability to apply a wide range of investment signals and be fully invested across almost 100 global markets, around the clock. It is an approach that gives our investors’ portfolios every chance of putting on a few pounds.