Expected Returns: An Investor's Guide to Harvesting Market Rewards

28

Enhancing returns through managing risks, horizon, skill, and costs

• This chapter reviews four paths for improving portfolio performance and drills into each of them.

• Risks. The simple way to boost long-run returns is to raise the weight of riskier assets in the portfolio. The more complex but better rewarding approach requires leverage. Within each asset class, buying the riskiest assets almost invariably gives worse long-run returns than levering up lower volatility assets. Even across asset classes, investors can reduce portfolio volatility by smart diversification and then convert improved risk-adjusted returns into higher raw returns by applying moderate leverage.

• Horizon. Investors with a long time horizon can exploit it by over-allocating to illiquid asset classes and reaping related illiquidity premia. Other possibilities include contrarian market timing and opportunistic reinsurance underwriting.

• Skill. Active investors may try to add value through skillful security selection and market timing, either in house or externally. Even when markets are not fully efficient, they are competitive enough to make the task challenging. Building an active management culture and resources internally is not easy, nor is it easy to identify consistent outperformers among external managers.

• Costs. Reducing fees and other implementation costs is often the easiest way to enhance net returns. It is harder to decide on the allocation between (cheap, abundant) beta products and (costly, ...