The Long and Short of Managing Volatility

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The research conducted by Investment Risk Management Systems inc, demonstrates that high returns do not necessarily require high risk. And, it's intuitively obvious that high risk implies returns that may be significantly lower than the market.
What? What about modern portfolio theory? Don't you believe in Markowitz and his followers? Of course we do. The theory is sound. The problem is that MPT starts with the premise that the markets are efficient. When you look at objective data, particularly the mutual funds data, relationships between risk and performance do not play out as one might expect. In general, one expects to see return increasing as risk (standard deviation of returns) increases. Looking at the total mutual funds marketplace, this relationship cannot be discerned in many time periods. Take the disaster year of 2008. Returns from high risk mutual funds plummeted as the market fled to safety. Despite the crash, there were many mutual funds that outperformed the market, and had low risk. You can see this for yourself for 2008 or any other time period in the last 10 years by using the funds analysis tool at www.fundreveal.com. It is free, and allows you to see any 10 mutual funds' performance in relationship to the S&P 500. The funds universe graph shows all 20000 funds available in the US, thus one can see the overall relationships between risk and return in the mutual funds market as context for analysis of individual funds.

Anthony DuBon of MA 9:57AM September 28, 2010

Does a long short equity portfolio really have the odds of "heavy losses" if equity markets are so correlated and they are equally balanced and not leveraged? The answer is no. For the last 20 years global equity markets have become more highly correlated as economic policies, both monetary and fiscal converge. Add to that continued globalization of trade in the developed world and one can account for USD hedged individual global equity market performance moving so closely together. To be clear, one cannot make the same statement about the emerging markets today. The most recent dip and recovery bear that out.
All said, the comment that Managers Fund approach is predisposed to "heavy losses" neither accounts fairly for the risk in the portfolio (moderate), its underlying holdings (developed market only), as well as the performance its delivered.
It strikes me that a portfolio using tight risk-controls implementing a long/short portfolio has more opportunity to earn superior risk-adjusted returns that are not directionally-based. The pattern of the returns should be judged against the broad markets and cash. In both cases, the fund does what its supposed to do, diversify and deliver an uncorrelated return to complement more directionally based strategies.

Kent Roberts of CA 4:23PM July 21, 2010