We’ve all heard the old adage that diversification is the only free lunch in investing, but Paul Bouchey, CFA, debunked that notion at the CFA Institute Wealth Management 2012 conference in Miami. To be clear, Bouchey did not challenge the notion that we can reduce risk without sacrificing return through diversification. He did, however, call out another free lunch — volatility harvesting.
As the recent financial crisis illustrates all too well, volatility causes investors heartburn and tempts them to abandon otherwise prudent long-term investment plans. Bouchey pointed out, however, that volatility actually creates alpha-generating rebalancing opportunities for any core portfolio. One of the criticisms of capitalization-weighted indexing, especially in global indices, is that indexes can become very concentrated as specific securities or sectors outperform other sectors. Concentration reduces diversification and thereby increases volatility, which hurts capital accumulation.
We often forget that growth in wealth approximately equals the arithmetic average return over an investment horizon less half the volatility of the return. This is a fundamental, indisputable mathematical principle. As a result, volatility creates a drag on compound growth rates, and hence wealth accumulation, holding returns constant. In other words, the journey matters. A tough journey creates worse investment outcomes, even if the average return stays the same.
Here is a thought experiment: suppose we flip a coin and you double your money on heads, but lose half your money on tails. The expected return is 25% [i.e., 0.5 × 1.00 + 0.5 × (-0.50)]. Despite this very attractive expected return, this bet will not accumulate wealth over time because the volatility inherent in the coin flip impedes capital growth.
In an almost Zen-like approach to investing, we can turn the notion of volatility drag to our advantage through rebalancing. Suppose you only bet half your capital on each flip of the coin, which is analogous to a 50–50 allocation to the stock market and the risk-free asset. After each flip, you rebalance to restore a 50–50 allocation. In that case, you can expect to grow your wealth by more than 6%. A portion of the difference from the no-growth case represents the rebalancing premium.
In a portfolio context, it implies that a contrarian rebalancing strategy selling outperforming assets and buying underperforming assets avoids portfolio concentration, manages volatility, and increases a portfolio’s growth rate when it would otherwise be impeded by excess volatility. In other words, there is a growth premium for rebalancing that Bouchey refers to as “volatility harvesting.”
Portfolio managers can harvest more volatility through rebalancing as the volatility of individual assets increases. However, if the assets are highly correlated, individual positions will not outgrow other positions, and rebalancing opportunities will be scarce. So, Bouchey notes that emerging market portfolios are replete with opportunities to harvest volatility.
Interestingly, this source of alpha cannot be arbitraged away. The mathematical principle remains even if all investors follow this principle.
This principle lends support for different investment strategies, like naïve 1/n diversification, minimum variance, equally weighted, fundamental weighted, or “diversity” weighted portfolios. A diversity weighted portfolio underweights the positions with the largest market capitalizations and overweights positions with the smallest market capitalizations, but not so much that it makes the portfolio equally weighted. One can imagine an infinite number of algorithms to accomplish this, but Bouchey suggested one that looks slightly more equally weighted than capitalization weighted. So, the diversity adjustment need not be dramatic. It works particularly well for creating country diversity in global portfolios. By definition, however, it introduces some tracking errors.
Matthew Kenigsberg, CFA, who attended Bouchey’s presentation, pointed out that Stephen Hawking would caution us against taking the idea of the rebalancing premium to extremes, in order to avoid being sucked into a financial black hole. Suppose you were to continuously rebalance (e.g., every millisecond) an equally weighted portfolio in which one of the securities goes to zero. What would happen? You would continuously reinvest in the security that goes to zero until it consumed the entire portfolio into a sucking, swirling financial eddy of despair.
In the end, Bouchey encouraged the audience to recognize two things. First, capitalization weighted indexing may maximize diversification, but it does not maximize diversity because positions can become very concentrated. Second, volatility is not the same as risk; it creates exploitable opportunity than cannot be arbitraged away through systematic rebalancing that preserves diversity.