At the Framework Investing we are very concerned with the foundations of a good investment idea and portfolio structure.  That concern manifests itself in our focus on both sound valuation and behavioral investing.   Research has clearly shown that the probability of successful results from a process that rests on those two pillars is far higher than without it.

However, often times those two pillars are not enough to generate the returns that we desire, either on the individual investment level or at the portfolio level.  It is for this reason that the Framework Investing was written.  To go beyond applying sound thinking and valuation understanding to account for both a variety of market environments and return targets – to tilt the balance of risk and reward in the investor’s favor.  To do that, we need to use derivatives and, in our case, implicit leverage.  This is a critical set of concepts that, as improving investors, we must attempt to understand and build the skills necessary to employ for the benefit of our own investments and those who depend on them.  This kind of work is what makes us better!

In this week’s external influences contribution, IOI offers an article published in Institutional Investor from 2010.  The article is written by Cliff Asness, David Kaliber and Michael Mendelson, all of Applied Quantitative Research (AQR).  If you are a frequent SIGNAL reader, you will recognize Mr. Asness name as we are serious students of his work.  This piece, entitled Using Derivatives and Leverage to Improve Portfolio Performance penned in 2010, with the wounds from the 2007-8 Financial Crisis fresh in people’s minds.  So, it is written to help people confront the real sources of the Crisis (more often behavioral than anything else) and explicitly outline how Derivatives and Leverage are both constructive and necessary parts of an institutional quality portfolio strategy.

As Intelligent Investors, this is a must read article for us.  It is moderately technical, but the technical concepts addressed in the paper are ones that IOI addresses directly in it’s 103 and Master Class coursework.  They are important if you are at all concerned with the return results of a given investment portfolio.  Asness et. al address the risk / return problem head on by tackling how risk can be perceived inaccurately at the asset type level vs. the overarching “is what I am trying to achieve reasonable?” level.  The paper focuses some time on one of our favorite topics, “risk parity”.  The IOI team has spent much time discussing the “risk-parity” concept pioneered by Bridgewater and utilized today by a variety of investors.  This kind of portfolio-construction thinking is a logical extension of the basic investment structuring strategies outlined in the Buffett’s Alpha paper, as well as in The Framework Investing and explained thoroughly in IOI’s coursework.

It is a piece that is worth your time to read to see how Derivatives and Leverage can be used to both improve returns and reduce capital at risk – even at the institutional level.  These techniques can be reapplied using options and we look forward to providing some examples of how that might work in the coming months.  To be continued…