Optionality - Small risks, Large returns
Diversification is a free lunch: it can increase returns without increasing risk, or deliver the same returns at lower risk. Other “free lunches” are harder to find. We believe optionality is one.
Optionality is, most crudely, a position where the upside payoffs are far larger than the downside risk.
This is a useful feature for our investment toolkit as it provides an opportunity to boost portfolio returns at both an absolute and risk adjusted level .
The return profiles can look a bit like insurance. The hedge funds that bought credit default swaps on Greek government debt back in 2010 made returns up to 650 times their investment  - that is $1000 into $650,000 while taking only a small risk (eat your heart out, bitcoin). This is a rare outcome and a rather extreme example of the power of optionality.
At Monmouth Capital we are, for the most part, adaptive and agnostic to the future trajectory of markets but, depending on our return ambition, we want two possible portfolio structures:
Deliver returns however the future environment evolves OR
Do well in one outcome and not be hurt in the others.
Buying cheap optionality is an effective aid to this.
The bigger picture
The portfolio construction process at Monmouth Capital is defined by the intelligent application of the tenets of portfolio theory, empirical evidence from the past decades of research, a healthy respect for psychology and our 20 years of experience. These include:
Asset class dominance: this is the main driver of long term returns  and swamps choice of fund manager. An example: if US markets are down 20% and European markets are up 20%, the very best US fund manager will probably perform more poorly than even the worst European fund manager
Factor tilts: defined and proven risk factors such as value and momentum should produce extra returns over time. Harvesting this extra return is not always straightforward but they exist if the investor knows how to use them intelligently.
Diversification: if we knew which asset class would perform best in the next year we would put all our money into that. But we don’t (despite the best efforts of many). Diversifying our exposure enhances returns per unit of risk leaving a portfolio more robust, lean and effective.
Rebalancing: countercyclical selling of what has become more expensive (lower expected future returns) and buying of what is cheaper (higher future expected returns) can hurt short term returns as it goes against momentum. However, over the longer term it will add to returns due to the tendency of asset classes to revert to the mean in long cycles.
Time: compounding of returns is the path to riches but like a rolling snowball takes a while to get going. There are no shortcuts which is why it is not prone to arbitrage.
What can we do beyond these core drivers to enhance returns? There are a few obvious ways:
Taking on extra market risk
A good rule of thumb when thinking of investing is that returns are the compensation for taking on risk. Taking on more risk should, over time, deliver higher returns. But, of course, this is on average. In the shorter term there will be greater dispersion in returns as we move up the risk spectrum. Your 10% average return can be anything from 0% to 20%. In the very long run we should earn the higher return but for extended periods we may earn very different returns (otherwise it wouldn’t be risky).
Currently we are in an extremely low volatility environment. This compresses risk premia (the compensation for taking risk) and forces investors up the risk curve in the hunt for their required returns. The longer this continues the more investors become used to a higher risk level. This can be jarring if (when) volatility increases. They suddenly find their portfolio is highly inappropriate relative to their actual risk tolerance.
We can accentuate idiosyncratic (single stock) risk
This introduces the possibility of risk of ruin (total loss of capital) and downside shocks. Hedge funds that carry only a few positions can do extraordinarily well for many years but their profile can become ugly very quickly: witness the Valeant Pharmaceuticals debacle which caused major losses and, perhaps worse, serious reputational damage to hedge fund royalty including Pershing Square, Paulson and Sequoia .
We can time the market tactically
An example is the ‘risk on/risk off' strategies that were all the rage a few years ago (before volatility died). This requires the ability to predict the near future at both first and second order (what happens and how markets react to what happens). The danger here is both in errors of commission (what we do) and omission (what we don’t do). There are highly experienced and knowledgeable market participants who sold out of the market in 2010 and have been waiting for the resumption of the bear market, sitting in cash during one of the longest bull markets in history.
The mindset of optionality
Optionality requires both technical expertise and the ability to abstract and hold variant perceptions.
What is important in this framework? It is preferable for the optionality not to be costly. We don’t want to disturb the profile of our primary return driver (the asset allocation) with large carry costs. (If it is not cheap then it needs to offer higher certainty. This can be tricky as it takes us back to the caveat of predicting how the near future evolves.)
Cheap optionality will usually only be available for outcomes that at this moment seem unlikely. This is where the ability to hold variant perceptions is valuable. The human mind struggles with outcomes that are either a) different from the present trajectory or b) different from our current committed positions.
We are in an economic environment that is for the most part benign. Looking out on this environment it is difficult to envisage another type of world - a world with high inflation or strongly rising interest rates, for example. Assets that benefit from rising rates are cheap. The consensus is that natural interest rates are now lower than in the past and that inflation has been permanently tamed. Indeed, many investors today have never experienced a rising rate environment as adults!
Our desire for performance is always balanced with the desire for robustness. We don’t accept the goodwill of the market to deliver the returns we require. Instead, we approach the future in terms of probable outcomes and payoffs. The mindset of optionality allows us to consider what seem like less probable outcomes and identify positions that can benefit without a significant drag on returns.
For most times in most environments the optionality mindset offers little; positions may be deemed worthless or even a bad investment. Holdings may appear to offer nothing. Clients might justifiably ask, “Why do you have 3% in this? It has been flat, while everything else has done well.”
But when (and there is always a when) the world is turned upside down and markets sag and sink, the option will kick in. And the sucking pain of hard times becomes instead that of mere discomfort. That doesn’t sound like much of a pay-off but, as much research has demonstrated, avoiding extreme emotional pain can be critical to sticking with your financial plan.
 Risk-adjusted return refers to return per unit of risk. It is the bedrock of portfolio theory and the default measure of investment skill. Returns should be considered both in an absolute sense and with consideration of risk. One or other is incomplete.
 Ibbotson and Kaplan (2000) provide a good overview of the research and literature. At heart the primary driver of returns is whether we are exposed to risk assets or not.