Bigger Portfolios?

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A better portfolio is one that benefits from meaningful diversification, which cannot be achieved with stocks and bonds alone.  Diversification lowers the risk of a portfolio, but in the process may leave some incremental returns on the table.  What options are there for investors who want better portfolios, but are comfortable taking more risk and would like to target higher returns?  

One solution is to make the better portfolio bigger: to scale up a well-diversified portfolio and thereby increase its returns while delivering the same better risk-return balance. In practice, this means getting more than a dollar of exposure for each dollar invested, but in a way that carefully manages risk.

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Revisiting better.

In our last piece, Better Portfolios, we showed that adding diversifying strategies like trend following to a stock portfolio improved its risk-return balance. The trade-off? Slightly lower absolute returns—but with significantly less risk and better downside protection.

2005-2024: Adding trend following to stocks:

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Now, what if we could scale up that improved portfolio while keeping its balance intact? By dialing up the risk (volatility) to match an all-stock portfolio, we can aim for higher returns without disrupting diversification, making fuller use of an investor's capital. To illustrate, we compare the same all-stock portfolio to a “1.5x” scaled version of the Stocks + Trend mix from above:

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What’s happening here?

• Volatility is now comparable to the 100% Stocks portfolio.
• Returns now outpace stocks by ~2% a year (about 20%).
• Max Drawdown is slightly reduced from -50.9% to -43.2%.

Drawdowns of these magnitudes are extremely painful, but for investors who are comfortable with an all-stocks risk level, the improvements are meaningful.

The same principle applies to any portfolio. When you scale up, you preserve its balance of risk and return, only on a bigger scale. Notice how the Sharpe Ratio (an indicator of risk-adjusted returns) stays the same, showing that we’re increasing overall exposure rather than merely piling on more risk. In short, capital efficiency lets you pursue higher returns for the same level of risk—or the same return with less risk.

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Is this magic?

Not really. Capital efficiency is achievable using financial instruments like futures contracts: agreements to buy or sell an asset at a future date for a specified price. They allow investors to gain exposure to stocks, bonds, and other asset classes without tying up all their capital. Large funds and institutions use these techniques to:

• Enhance returns without blindly piling on risk.
• Achieve diversification across multiple asset classes.
• Reduce costs through institutional pricing and risk management expertise.

While using futures carries financing costs (near the risk-free rate, like short-term Treasury bills), the net return is essentially the underlying performance of the exposures minus costs. As long as the expected return of the assets exceed the borrowing cost, scaling up will be additive to returns.

They’re not new either.

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Using futures for asset class exposures has long been broadly available to managers of mutual funds and ETFs (in addition to Limited Partnerships), delivering capital efficiency while allowing the investor (or advisor) to avoid the complexity and risks of managing them directly.  Futures contracts have been trading at the Chicago Board of Trade for over 150 years and asset managers have been offering futures-based strategies to deliver scaled portfolios of stocks and bonds in mutual funds since the early 90’s.

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Isn’t “scaling up” just “leverage”?

Yes, but not all leverage is created equal. Leverage simply means boosting your buying power beyond your cash on hand. Scaling a well-diversified portfolio is very different from using debt to take a concentrated bet on one asset or asset class—which merely magnifies risk. Moreover, leveraging highly volatile assets can trigger margin calls and other irrecoverable losses.  For example, scaling our 100% stock portfolio by 1.5 times significantly increases both risk and drawdowns.

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Applying leverage to a well-diversified, lower-risk portfolio can responsibly increase risk to an investor's appetite while aiming for higher returns. Let’s again consider our “1.5x” scaled better portfolio. It effectively holds:

This combination remains diversified, keeps the same proportional balance of assets, factors in the cost of scaling up, and results in a bigger, better portfolio that still aims to control risk and still makes meaningful improvements.  For the same risk budget, the returns are improved.

Putting it all together.

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Bigger portfolios aren’t magic—they simply use smart, cost-effective tools (like funds designed for capital-efficiency) to scale a well-diversified portfolio to a desired return target with an acceptable level of risk. By choosing better building blocks (e.g., stocks, bonds, trend following, gold and others) and amplifying them appropriately, investors maximize the opportunity to achieve their financial goals without abandoning the risk discipline they’ve worked to establish.

However, for some investors, better and bigger still might not cover every base. Their portfolio also needs an additional dimension, it must be broader too—expanding into private markets and other diversifiers.

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Sources:

Stocks : VTSMX (Vanguard Total Stock Market Index Fund) 2005-2024,
Trend following: SG Trend Index (SocGen Trend Index) 2005-2024
‍Portfolios are rebalanced annually.
Returns, volatility and drawdowns based on end of month values.  

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