Building an Antifragile Investment Portfolio

Greg Johnsen, CFAEastgate Advisors, llc

Life Is Full of Randomness and Uncertainty

Some examples:• Evolutionary changes in biological organisms.• Genetics.• Lottery winners.• “Expert” forecasts.• Global market returns.

Can we actually benefit from uncertainty, randomness, disorder or volatility in our investing?

YES!

By Building Antifragile* Investment Portfolios

*Taleb, Nassim Nicholas. “Antifragile. Things That Gain From Disorder”. Random House, 2012

Fragility

• Something fragile breaks when stressed or something unexpected happens.

• But, something that is antifragile benefits from stress, randomness, disorder or uncertainty.

A fragile investor is one who owes $100,000 and loses a job, an antifragile investor is one who has $100,000 in savings.

Fragile Versus Antifragile

Antifragility• Antifragility limits the adverse impact on us when bad

things happen.• Antifragility does not mean avoiding bad things.• Antifragility allows us to survive and prosper with the

uncertainty and randomness of life.• Antifragility does not require advanced degrees.• Antifragility does not require predicting the future.• Antifragility does require accepting controlled stresses.• Antifragility is not the same as certainty.

Antifragile Investing

• Investors who require a return which exceeds the return of a risk free asset must assume risk (stress).

• An antifragile investment portfolio benefits from volatility, randomness and uncertainty and has greater upside potential than downside risk.

• Antifragile portfolios possess optionality.

What is Optionality?

• Optionality allows investors to take advantage of opportunities or avoid assuming more stress than desired.

• Optionality is a valuable trait of an antifragile portfolio.

Some Investing Truths• Market returns are mostly random and uncertain.• Investors do not have control over global markets.• Skilled, active managers exist but fewer of them exist than the

investment industry would have us believe exist.• Even skilled active managers have cyclical periods of

underperformance.• Most active manager excess returns are statistically random

outcomes: It takes from 11 to 44 years of return history to determine, with 95% certainty, whether an active manager has skill or is just lucky.

• Investors do not have control over active manager returns.

% of Active US Equity Managers Outperforming Style Benchmarks

Source: Morningstar Direct. © 2014 Morningstar. All Rights Reserved.

More Truths….

• Investment fees and expenses are one of the things an investor can control.

• Investment fees and expenses matter. • Investors tend to feel losses more acutely than

gains, so managing down-side risk is important.• Investors also control the risks they choose to

assume.

Conclusions

• Investors should focus on controlling what they can actually control.

• Investors should build antifragile investment portfolios that benefit from randomness and uncertainty.

• Investors should measure success over years and not quarter-by-quarter.

Some Basic Theory

William Sharpe’s market portfolio concept (1964)• Best expected return for the market risk assumed.• He called this the “efficient” market portfolio.

Eugene Fama’s Efficient Market Theory (1970)• Market prices reflect all known information relating to the price

of an asset.• Only new information has an impact on prices.• Each asset should have the same price in all global markets if

markets are efficient.• Implies that active management should not add value.

Sharpe’s Global Market Portfolio

 

- Market Risk +

-- Ex

pect

ed R

etur

n +

+ Global Market Portfolio of all investible risk assets Levered GMP:

GMP + borrowing

De-levered GMP:GMP + Risk Free Asset

Risk Free Asset

What Does The Actual Global Market Portfolio Look Like?

– $150 trillion in global markets*• 67% was debt/bonds ($100 trillion)

– US bond market was about 24% of total global debt• 33% was equities ($50 trillion)

– US stock market is about 50% of total global equities

– 67%/33% allocation implies an expected return of about 4% annually to the global markets portfolio.

*2012 Bank for International Settlements (BIS) quarterly global review of bank holdings report.

Investment Risk Considerations

• Some investment risk has expected returns.• Some risks have no expected returns.• Investors need to understand their risk

tolerances.• Investors should avoid uncompensated risks.• Volatility by itself is not compensable.

Examples of Compensated Risk

• Market risks– Risk relative to the global market portfolio– Size (small stocks have outperformed large)– Low price-to-book stocks (unloved stocks)– Term (longer maturity bonds have outperformed)– Credit quality (lower quality has outperformed)

• Leverage• Liquidity

Examples of Uncompensated Risk

• Idiosyncratic risk- lack of adequate diversification.• Fees- A form of wealth transfer. Higher fees do not

necessarily result in better returns, just wealthier investment managers.

• Active Risk- Few active managers have demonstrated statistically significant, persistent skill. Fama’s efficient markets theory implies that positive excess returns should not exist if markets are efficient.

• Principal-Agent risk- what is good for the agent is not always good for the principal (investor).

Building Antifragile Portfolios

• Consider Sharpe’s global market portfolio.– Diversified across markets and asset classes.

• Combine the global market portfolio with the risk free asset to de-lever the market portfolio or to manage down-side risk.

• Or, lever up by borrowing or using small cap stocks, emerging markets, high yield bonds, private markets in higher % than they are found in the global market portfolio (a form of leverage).

Some Considerations

• A de-levered global market portfolio has lower risk and a lower expected return than the GMP.

• A levered global market portfolio has higher risk and a higher expected return than the GMP.

• Investor down-side risk tolerances and return requirements are important.

Building Antifragile Portfolios

• Start with a mutual fund or ETF with global, multi-asset class market exposures.

• Combine it with a US treasury bill to control down-side risk or to manage liquidity.

• Add specialist managers/funds to add incremental value or lever up the GMP if needed (examples include emerging markets debt, small cap stocks, commodities, REITs).

The Antifragile Portfolio

• Global markets portfolio (95% ticker AOR)– Global equities (60%)

• US equities (large, mid and small)• Non-US equities (large and mid)• Emerging markets equities (large and mid)

– Bonds (40%)• USD denominated bonds (US and non-US issuers)• US treasuries (all maturities > 1 year)• US credits (investment grade, non-investment grade)

• US Treasury Bill (5% UST)• Cost: = .24% annually (plus advisor’s fees)

Antifragile Portfolio Benefits• You have a globally diversified GMP proxy which benefits from

the unpredictability and randomness of global asset returns.• You have built an investment portfolio that can experience

small but not catastrophic losses.• You control the level of down-side risk you assume by

combining the GMP with a risk free asset.• You can control investment expenses. • You have preserved the majority of your up-side return

potential and possess optionality.• Your portfolio is theoretically supported.• You have reduced your stress and simplified your life.

Thank you for your time.

Feel Free to Contact Us

Greg Johnsen, CFAEastgate Advisors, llc

gjohnsen@eastgateadv.com