The Alembic
January 11, 2019·2 comments·In Brief
Investment portfolios are being optimized in pieces, and that optimization is destroying the whole. Asset managers reward sub-portfolio managers for creating balanced, low-risk components. But what gets measured individually often breaks apart when combined. The aggregate portfolio ends up sacrificing conviction and character in pursuit of a smoothness that was going to happen anyway.
• Individual portfolios are being rewarded for the wrong thing. Firms measure sub-portfolio Sharpe ratios and Information Ratios, incentivizing managers to sand down every edge. This sounds prudent until you realize the aggregate portfolio achieves risk reduction without the sacrifice.
• What works in isolation doesn't work when combined. A balanced sub-portfolio with low volatility looks good on its own performance report. But when rolled into the larger portfolio, it's already done the risk-balancing work the aggregate portfolio needed to do anyway.
• The problem is systematic and almost invisible. This happens across investment firms of every size and type, baked into how allocation responsibilities are assigned and how agents are measured. It's not a mistake anyone is making on purpose. It's the natural result of the incentive structure.
• Conviction is being sacrificed for redundant risk reduction. Sub-portfolio managers smooth out structural biases and factor tilts that would have strengthened the aggregate portfolio. They're creating "good cider" that spoils in the brandy-making process.
• The cost of this approach compounds in ways nobody measures. If every component is optimized for standalone performance, what happens to the overall portfolio's ability to express a real strategic view or to perform in unexpected environments?
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This commentary is being provided to you as general information only and should not be taken as investment advice. The opinions expressed in these materials represent the personal views of the author(s). It is not investment research or a research recommendation, as it does not constitute substantive research or analysis. Any action that you take as a result of information contained in this document is ultimately your responsibility. Epsilon Theory will not accept liability for any loss or damage, including without limitation to any loss of profit, which may arise directly or indirectly from use of or reliance on such information. Consult your investment advisor before making any investment decisions. It must be noted, that no one can accurately predict the future of the market with certainty or guarantee future investment performance. Past performance is not a guarantee of future results.
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Comments
Rusty when I saw the word Alembic - I clicked expecting “The Elder Scrolls IV: Oblivion” images…
Thanks your cider /brandy analogy is very accurate. So true that allocators end up “over-fitting” the mandates of the individual components without thinking of the overall correlations as it is harder to visualise.
I always skipped alchemy, as the temptation to use it to cheat was just too strong for me - thanks for the response!
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