Street Calls of the Week
The best macro investors all use this powerful strategy - and it’s not what you think.
When you look at the longest, most successful track records in macro investing, you are left with:
1. Selection or survivorship bias
2. A handful of managers deploying a very powerful strategy
And surprisingly for many, the holy grail for a successful and long track record in macro investing doesn’t revolve around having a Crystal Ball.
Instead, True Diversification is the holy grail of macro investing.
Look at the chart below to understand why.
1. If you have stocks and bonds (2 assets) in your portfolio and they exhibit a positive 0.5 correlation (orange line), by adding another correlated asset like corporate bonds (3 assets now) you will slightly increase your return per unit of risk.
If your old portfolio had a 5% volatility and 4% expected return, you now have 5% volatility and 5% expected return.
Great!
2. But look at what happens if you can add uncorrelated (or negatively correlated) assets – the dark blue line.
If you have stocks and you add uncorrelated (or negatively correlated) bonds as a second asset class, your return per unit of risk increases substantially.
Add 7-10 uncorrelated asset classes to your portfolio, and with a 5% volatility, you can achieve 8% returns.
That’s amazing!
And here is when leverage comes into play.
When assets exhibit a stable zero or negative correlation between each other, investors can use leverage to amplify returns while keeping risk under control thanks to diversification.
Of course, true diversification and the subsequent leverage to amplify its benefits come with a catch.
When correlations flip sign, the assumptions behind these leveraged portfolios are off.
In short: true diversification, a prudent use of leverage to magnify its benefits, and tight risk controls around correlation changes.
These are the key ingredients behind a long-term successful macro track record.
Agree or disagree?
***
This article was originally published on The Macro Compass. Come join this vibrant community of macro investors, asset allocators and hedge funds - check out which subscription tier suits you the most using this link.