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Modeling the Perfect 10% Expected Return Portfolio


"They say it can't be done, but it don't always work..."
-Yogi Berra

In baseball, no major league player has hit .400 since Ted Williams hit .406 in 1941 for that team 250 miles northeast of New York.   The last time a player reached 4,000 career hits was in April of 1984 when Pete Rose did it while playing for Cincinnati.  Lastly, no player had collected a batting triple crown in 45 years until Miguel Cabrera did it in 2012 with Detroit.  These are all amazing feats of skill that are remembered because of their rare achievement over the course of an entire season or, in Rose's case, a career.

The thing is, though, that players don't need to hit .400 or collect 4,000 hits to be considered great.  The greatest (legitimate) hitters of my lifetime hit .284 and .267 over their careers; of course Ken Griffey Jr. and Mike Schmidt also had career OPS's of .907 and .908 respectively.

In the world of asset management, we tend to remember the great years that managers like John Paulson or George Soros have posted in the past with almost the same admiration that we have for sporting heroes.  However, the benchmark for a good asset manager is consistency.  For asset managers, of endowments and foundations especially, the equivalent of the .300 average is the much heralded 10% annual return... with low volatility to boot.


A NICKLE AIN'T WORTH A DIME ANYMORE

The 10% return has been hard to come by lately; thanks in no small part to global, accommodative monetary policies.  That's not to say it can't be done, however... it just takes a little creativity, solid risk management, and a willing and knowledgeable investment board.

I'm building off of a couple of previous posts where I've discussed portfolio construction that can be found with these links...

http://tancockstradingblog.blogspot.com/2016/03/hedging-tail-risk-why-var-is-not-risk.html
http://tancockstradingblog.blogspot.com/2015/09/creating-vix-signal-to-manage-asset.html

I wanted to see if I could build an optimal portfolio using index instruments that would produce an expected annual return of 10%.  I took the last 150 months of historical data from the following indices for my optimization process (Note: I used the ETFs as a proxy for index data):


For the record, 'CSHFI' stands for Credit Suisse Hedge Fund Index.

Using these instruments, I was able to produce four distinct portfolios that all have an expected annual return of 10%.


PORTFOLIO 1 - 100% INVESTED

The first solution was to create a portfolio without the benefit of leverage that would meet the return target and a portfolio optimization model produced a portfolio with the following allocations and characteristics:
 

Monte Carlo Simulation:

The red line signifies the 95% confidence interval.


PORTFOLIO 2 - 150% INVESTED

The only way to reduce portfolio risk and still meet our return requirements is to add leverage to the portfolio.  This example assumes 50% of additional leverage and the optimization model produced the following allocations and characteristics:

Two things to note: 1) the expected return of 6.7% is on the 150% portfolio and equates to a 10% return on investment and 2) due to the portfolio leverage, a loss of -66% would result in the liquidation of the portfolio... assuming rising margin requirements and withdrawals didn't already kill the book.

Monte Carlo Simulation:


PORTFOLIO 3 - 200% INVESTED

Now let's see what happens when we lever the portfolio up 1 full time to create a 200% fully invested portfolio.

Monte Carlo Simulation:


PORTFOLIO 4 - THE EFFICIENT PORTFOLIO

Lastly, we come to the portfolio that produced the optimal return/risk profile.  Unfortunately, it came with a total leverage of 285%.

Monte Carlo Simulation:


IT CUTS BOTH WAYS

You have to remember when using leverage that it's a double edged sword... systemic events like we saw in 2008 can have disastrous ramifications on highly levered portfolios that lack proper risk management.  A lot of alternative investment products got carried away with leverage pre-2008 and did not live to tell about it.

However, when used appropriately, like in our 150% invested portfolio... leverage can provide a huge benefit to investors who need to produce consistent results to fund annual liabilities.

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