Buy a basket of ugly funds for portfolio stability

Each week, a professional investor tells MoneyWeek where he'd put his money now. This week:Carl Mauritzon, partner at the Symphony Fund.

When I first entered the financial industry, it seemed perfectly logical to conclude that the more volatile an investment was, the more inherently risky it was. But I have come to realise that volatility is often a poor measure of true risk. It's often least effective at critical junctures. Volatile instruments can form the basis of a robust portfolio you ignore them at your peril.

Digital currency Bitcoin is a good recent example of an investment that could well be highly risky, but is invariably dismissed for the wrong reason. Just because something is volatile doesn't mean it's simply a "punt" or a gamble. Volatile instruments, when correctly harnessed, can be some of the most valuable investments in a portfolio and combining uncorrelated, volatile instruments could well lead to the best risk-adjusted returns.

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This is, I believe, contrary to how most investors allocate their money. After all, it is appealing to combine a group of funds with lots of smooth lines rising at roughly 30 degrees from left to right. Many think this is the path to the smoothest overall return. Yet, counter-intuitively, combining lots of 'uglier' but uncorrelated funds can provide far more stability with the caveat that each individual element has a positive expected return.

One of the more popular measures of risk is standard deviation (SD). If you assume that the distribution of returns is normal (ie, that it follows the same "bell curve" pattern as many other things in life), then a five SD move is supposed to occur once every 100 years. However, in reality there have been several such moves in equities (S&P 500) within the last 15 years. So it is worth questioning whether such risk measures can in fact accurately quantify true risk.

Using such a measure, you could define something as low risk if the SD is low, yet in real life a multiple of that expected volatility can occur, and when it does, it is likely to be sudden and highly unexpected. Our belief is that there have to be elements in a portfolio that can exploit these types of situations.

Allocating the bulk of a portfolio's capital to a low-volatility fund is, in our view, far riskier than giving a smaller sum to a more volatile manager. Investors need to question where the lack of volatility comes from. It could be due to buying illiquid assets that are marked to a model, and not to the current market. Asset-backed investments, such as property and private equity, often fall into that category. Or the manager may use a strategy that is likely to have lots of small gains, followed by a large loss, which it then doesn't have enough "punch" to recover from. Or it may even be a Ponzi scheme!

Keeping the bulk of a portfolio in cash-like instruments, and giving comparatively smaller amounts to a volatile manager, has a number of benefits. You reduce your exposure to one company or fund, you reduce overall fees, and your potential downside is clear it is simply the money you allocate. Furthermore, if the correlation between these volatile funds is low, your portfolio is not subject to all the funds suffering together when the market falls.

This is the basis of a truly diversified portfolio. Examples of uncorrelated volatile instruments include Bluecrest's Bluetrend investment trust (LSE: BBTS) and the SPDR Gold Trust (NYSE: GLD), which had a correlation with the S&P 500 between September 2008 and March 2009 that was negative.