Efficiency instead of complexity

OLZ-Research Note 01/2019

The path to a higher return leads via the systematic inclusion of risk. Or: Why it is worthwhile for investors to recall Harry Markowitz’s principle for efficient portfolio construction.

Return waste despite negative interest? Many in-vestors – both private and institutional – do in fact leave their free lunch on the plate because they focus only on returns and neglect the underlying risk of their investments. The one-dimensional pursuit of returns leads to portfolios which are not adequately diversified. That’s money: Better diversification increases portfolio efficiency so that a higher return can be achieved with the same risk, or the same high return with less risk – free of charge! How best to approach this trade-off between risk and return was first scientifically ana-lysed for consistency by Harry Markowitz in 1952.1The principle of diversification is as old as the hills. What Markowitz is unanimously credited with is formalising it as a way to improve performance and the associated concept of portfolio efficiency.2Up to this point, the risk of investments had been neither systematically quantified nor included in the investment decision process. It was principally based on the goal of maximising returns, which is still often the case today. OLZ, on the other hand, systematically integrates risk into the design of investment solutions.

 This research note is intended to remind investors of Markowitz’s principle: The realisation that systematic diversification through the inclusion of risks and correlations in the investment process can improve performance over the long term. This applies both to the definition of the investment strategy and to its implementation – asset allocation. The building blocks of the investment process are asset classes. The first part deals with the characteristics of asset classes and their significance in determining the investment strategy. In the second part, we show how important it is to make a clear distinction between the invest-ment strategy and its implementation – effective asset allocation. In the last section, we show that active risk management exploits the freedom of the investment strategy and thus improves performance without sacrifying liquidity or increasing costs and complexity. 

Asset classes: Their contribution to diversification  

Asset classes are the building blocks of the investment strategy. An asset class comprises securities with homogeneous, comparable return and risk characteristics. It is important that these differ significantly from the characteristics of other asset classes. This heterogeneity is a prerequisite for the inclusion of an asset class in a portfolio in order to improve diversification and thus, portfolio efficiency. The asset manager’s selection ability and specific skills in implementation do not play a role when defining an asset class.

An important criterion of an asset class is that it is available to all investors and not just to specialists or specific investor groups. It must be investable at a reasonable cost and able to absorb a large investment volume without liquidity bottlenecks.

Typically, groups of securities are organised in indices, with each security weighted according to its relative market cap. In this way, the asset class meets another requirement: Transparency and stability in its structure.

Strictly speaking a combination of different asset classes (hedge funds) should not be considered a separate asset class. Even high-yield bonds which combine the characteristics of bonds and equities should not be regarded as a separate asset class (in the puristic sense).

The potential for increasing efficiency depends on the degree of risk-return diversification between asset classes. The lower the correlation between investments, the greater the diversification effect.

Even though there is broad agreement among investors on the definition of an asset class: In reality, their classification and list vary. As a result, the investment strategies of peer groups differ both in composition and complexity. 

Asset allocation: Implementing the investment strategy  

Effective implementation – asset allocation – in-volves either a passive replication of the benchmark, respectively the investment strategy, or an active approach. Only in the latter case do the active management and selection capabilities of the port-folio manager come into play. Nowadays, it is good form among investors to place diversification and portfolio efficiency in the foreground. The reality then looks somewhat different.

In specialist publications it is repeatedly stated that the investment strategy (benchmark) determines 90 % of portfolio performance. Consequently, ef-fective implementation, i. e. the second level of the investment process, would be hardly important.3This statement needs clarification because there is a risk that it will otherwise be misinterpreted. The above statement applies if a priori passive or benchmark-like implementation of the investment strategy is assumed. It also includes the opinion that active management or portfolio optimisation is of no use.

However, as Markowitz has already noted, the mar-ket cap index (benchmark building block) is not an efficient portfolio. Optimising asset allocation to improve portfolio efficiency, or adjusting it over time to respond to changing market risks (as we will show later), automatically increases the effect on performance. The more effective portfolio struc-ture deviates from the benchmark, the more perfor-mance is influenced by active investment decisions.  

If investment strategy were as dominant as is being disseminated, the difference in return be-tween two portfolios would have to be explained solely by the different investment strategy. Various studies aim to determine the contribution of active management (excess return). This is done by peer group comparison of different pension funds or investment funds. For each portfolio, the bench-mark return is compared with the actual returns achieved (cross-sectional regression). This allows the average return of the peer group to be neu-tralised. This is relevant for institutional investors such as pension funds or insurance companies, who must be invested regardless of the market situation (i. e. for whom a complete exit from the market is not an option). Thus the tidal effect of the market neutralises itself, which lifts all boats anyway regardless of the benchmark and active asset allocation.

These comparisons show that the investment strategy (benchmark) explains less than 50 % of the difference in returns between different funds 4, which means that implementation is at least as important as the investment strategy.5  

In other words: Those who take a passive approach to implementing the investment strategy and turn the benchmark into a portfolio are only following Markowitz halfway and leave half of their free lunch untouched. This should not be an option for institutional investors such as pension funds, who are caught in a field of tension between minimum return requirements and low interest rates.  

Within-horizon risk: The dilemma of pension funds

In principle, the longer the investment horizon, the higher the risk capacity. This is true for investors who are primarily interested in the value of the portfolio at the end of the investment period and who can sit out fluctuations. Institutional investors, on the other hand, are subject to regulatory re-quirements with regard to coverage ratio and risk of loss. They are bound not only by the end-of-horizon risk but also by the within-horizon risk. Although pension funds have a very long investment horizon, they cannot simply sit out short-term fluctuations in value, they must take measures.

Due to their current obligations and requirements, their risk capacity does not correspond to the actual investment horizon, which in turn results in a lower expected return. In addition, pension funds must grant their policyholders a minimum return. As a result, the focus on returns is often at the expense of long-term risk management.  

The pressure to achieve a minimum return in-creases interest in alternative investments which promise a higher return. The offering is wide and is constantly being expanded by the financial industry. This includes risk capital investments (private equity, venture capital), infrastructure investments, high-risk interest rate investments (private debt, distressed debt, high-yield debt) or hedge fund strategies.

Alternative Investments: Do not try this at home!

“Do not try this at home”, warn fire-eaters and knife-throwers. The same applies to complex in-vestment vehicles. An expansion of the investment strategy to include alternative investments can make sense and contribute to better diversification and higher returns.6 But it requires a high level of experience and financial knowledge on the part of the investor as well as advanced governance of the investment policy. Alternative investments increase complexity considerably while absorbing many resources in portfolio management process.7In addition, they are generally significantly more expensive than equities and bonds 8 and certain specific risks must be taken into account, particu-larly with regard to limited liquidity.9 The volatility reported in many alternative investments is based not on mark to market (MTM) prices but on ap-praisal values whose fluctuation is lower.10 The risk figures (standard deviation and correlation) are therefore not comparable with liquid invest-ments. The financial crisis of 2008 was also a consequence of the fact that the risks pertaining to complex investment products were wrongly assessed. The supposed diversification effect of these investments proved to be merely cosmetic and became the opposite during the crisis. The decline in liquidity typical of financial crises meant that the correlation between supposedly diversify-ing investments tended towards 1 (full correlation).

Aim for Markowitz 1.0: 70 years old and not in the least outdated 

How can the return on investment be improved without increasing risk and costs or violating the regulatory framework? The simplest and cheap-est advice still is to follow Markowitz. Instead of expanding the investment strategy with complex, expensive and difficult to understand alternative investments, OLZ recommends an old-fashioned in-vestment strategy based on the basic components: cash, bonds and equities. However, this should not be implemented passively, but optimised on the basis of risk. The aim of optimisation is to create a risk-return efficient portfolio. To this end, the risk characteristics of each investment must be con-sistently taken into account. Markowitz has always emphasised that market cap weighting is not an efficient form of portfolio construction. According to Markowitz, the focus on risk and diversifica-tion is the only free lunch for investors.11 Almost 70 years after the publication of his research work, this lunch has become even more lavish due to the exponential increase in passive investing.12

Abbildung 1: Anlageklassen (Auswahl) mit den Dimensionen Kosten, Illiquidität und Komplexität

Risk: Persistent rather than static

But risk is not a static figure. It is subject to fluctu-ations. In contrast to returns, however, it tends to persist over time, leading to long phases of high (or low). This property allows the risk to be modelled and estimated, which is not the case for returns.

When defining the investment strategy, the risk parameters are included as long-term average values. The resulting optimised investment strategy is geared to the risk profile of a long-term investor. For pension funds and insurance companies in particular, this does not adequately reflect reality. For them, the static weighting may involve too much or too little risk in certain market phases.

However, in view of the current state of emergency on returns, pension funds must be able to make optimum use of their risk budget.

A more sophisticated further development – but still consistent with Markowitz – can take this into account by adjusting the weighting of the liquid asset classes (cash, bonds and equities) according to the market risk. 
Risiko ist nicht statisch, aber persistent

Doch Risiko ist keine statische Grösse. Es unter­liegt Schwankungen. Im Gegensatz zur Rendite ist es im Zeitverlauf jedoch tendenziell persistent, was zu langen Phasen mit hohem (bzw. niedrigem) Risiko führt. Aufgrund dieser Eigenschaft lässt sich das Risiko modellieren und schätzen, was bei der Rendite nicht der Fall ist.

Bei der Definition der Anlagestrategie fliessen die Risikoparameter als langfristige Durchschnittswer­te ein. Die daraus resultierende, optimierte Anlage­strategie ist auf das Risikoprofil eines langfristigen Investors ausgerichtet. Gerade für Pensionskassen und Versicherungen spiegelt dies die Realität nur ungenügend wieder. Für sie kann die statische Gewichtung in bestimmten Marktphasen zu viel oder zu wenig Risiko innehaben.

Aufgrund des aktuellen Renditenotstandes müs­sen die Pensionskassen ihr Risikobudget jedoch optimal ausnutzen können. Eine etwas raffiniertere, aber immer noch mit der Markowitz­-Lehre konsistente Weiterentwicklung kann dies berücksichtigen, indem die Gewichtung der liquiden Anlageklassen (Geldmarkt, Anleihen und Aktien) dem Marktrisiko entsprechend an­gepasst wird.

Bottom line

The current financial market situation presents institutional investors with major challenges. How-ever, the required return should not be achieved by building up risks and complexity. On the other hand, it makes sense to exploit the return poten-tial of the basic portfolio (equities and bonds) by building an efficient portfolio through effective diversification. The degree of freedom within the investment strategy should also be exploited. Furthermore, the fact that risk is not a stationary parameter but, due to its fluctuation, can break through the risk budget of the investment strategy should also be taken into account. The solutions require a systematic inclusion of the risks and a rethink, or at least a critical questioning, of the passive investment approach.


[1] Markowitz, 1952, Portfolio Selection, Journal of Finance. Im Jahr 1959 folgte eine ausführliche und systematische Darstellung über die Bildung von effizienten, diversifi­zierten Portfolios in «Portfolio Selection: Efficient Diversification of Investments», John Wiley & Sons.

[2] Markowitz, 2006, De Finetti Scoops Markowitz, Journal of Investments Management. Markowitz anerkannte, dass ein europäischer Mathematiker, Bruno De Finetti, bereits 1940 das Problem der Berechnung von risiko­rendite­effizienten Portfolios unter Annahme unkorrelier­ter (nicht jedoch korrelierter) Risiken gelöst hatte.

[3] Brinson, Hood, Beebower, 1986, «Determinant of Portfolio Performance», Financial Analyst Journal. Eine Analyse über 91 US-­Pensionsfonds zeigt, dass im Durchschnitt etwa 90 % der Schwankungen der Portfoliorendite durch die jeweilige Benchmark erklärt werden. Im Laufe der Zeit verwiesen Kommentatoren die 90 % auf die Rendite und nicht auf die Variabilität der Rendite, und «erklären» wurde durch «bestimmen» ersetzt.

[4] Ibbotson, Kaplan, 2000, «Does Asset Allocation Policy Explain 40 % 90 % or 100 % of Performance», Financial Analyst Journal.

[5] Xiong, Ibbotson, Idzorek, und Chen, 2010, «The Equal Importance of Asset Allocation and Active Management», Financial Analyst Journal.

[6] Die Schweizerische Bankiervereinigung ortet in der 2017 erschienenen Publikation «Der 3. Beitragszahler der beruflichen Vorsorge, Impulse zur Optimierung» ungenutztes Rendite­-Potenzial aufgrund mangelnden Einbezuges von alternativen Anlagen.

[7] Knut Kjaer (ehemaliger Geschäftsführer des Norwegischen Staatsfonds), 2010, Asset and Risk Management in a Post­-Crisis Market, CFA Institute Third Annual European Investment Conference, Copenhagen.

[8] Bundesamt für Sozialversicherung BSV, 2011, Vermögensverwaltungskosten in der 2. Säule.

[9] Cochrane, 2005, The Risk and Return of Venture Capital, Journal of Financial Economics.

[10] Franzoni, Nowak,  und Phalippou, 2012, Private Equity Performance and Liquidity Risk, Journal of Finance.

[11] Markowitz, 2005, Market Efficiency: a Theoretical Distinction and So What?, Financial Analyst Journal.

[12] BlackRock, 2017, Index Investing Supports Vibrant Capital Markets.