Dennis Rodman Visits The FOX Business Network at FOX Studios on December 9 2014 in New York City. Picture: GETTY IMAGES/LAURA CAVANAUGH
Dennis Rodman Visits The FOX Business Network at FOX Studios on December 9 2014 in New York City. Picture: GETTY IMAGES/LAURA CAVANAUGH

Dennis Rodman is one of the greatest basketball players of all time, but you would never know by looking at his numbers. He averaged only 7.3 points per game in his professional career, and is the lowest-scoring inductee in the National Basketball Association’s Hall of Fame. He’s better-known for his tattoos, piercings, hairstyles and excursions to North Korea. But Dennis Rodman can teach us a lot about portfolio construction.

Though he was a great player, a team full of Dennis Rodmans would have been terrible because he didn’t score enough. But when you add a Dennis Rodman, who was a great rebounder and defender, to four other players who can score, he makes them a lot better. He was a member of five championship teams, including the 72-win Chicago Bulls team of 1995-96 that is widely considered to be the best ever.

The Dennis Rodman allegory comes from Chris Cole, principal at Artemis Capital, a hedge fund based in Austin, Texas. Cole wrote a paper in 2016 about portfolio construction that remains relevant to this day. You see, most money managers look at returns to the exclusion of all else. If they want a higher-returning portfolio, they simply add an asset that has higher returns, bringing up the average, without much consideration for risk. I wrote about this idea a few years ago in the context of Warren Buffett’s criticism of hedge funds. One of the fund of funds Buffett bet wouldn’t outperform the S&P 500 Index actually had higher risk-adjusted returns than the benchmark. More succinctly, it had a higher Sharpe ratio. But even the venerable Sharpe ratio has shortcomings.

The Sharpe ratio measures returns normalised for the level of risk. The higher the ratio, the more attractive the risk-adjusted return. But it fails to capture other risk characteristics, notably negative convexity, which is the tendency for an asset price to go down faster than it goes up. Long-Term Capital Management had a very high Sharpe ratio right until it imploded, as did sub-prime collaterised debt obligations before they went bust. By adding positively convex assets to a portfolio, even when they have mediocre returns, one can dramatically improve the risk characteristics without sacrificing much in the way of performance. This would smooth out the ups and downs of a portfolio, which is important from a behavioural finance standpoint.

The conventional wisdom around this idea is that you should mix your peas and carrots. For example, adding bonds to a portfolio of stocks because bonds are thought to have negative correlation with stocks, which smooths out the volatility. But history has shown there can be long periods when bonds are positively correlated with stocks, diminishing the usefulness of bonds as a hedge. This is where exposure to long volatility — strategies that involve the purchase of options — comes into play.

Long volatility or tail-risk funds have a reputation of being money-losers and a drag on returns. But just as you wouldn’t have a team full of Dennis Rodmans, you wouldn’t have a portfolio that was strictly long volatility. Long volatility, or tail risk exposure, when added to a portfolio of stocks — and bonds — can greatly improve the risk characteristics while smoothing out returns.

The tail-risk fund Universa Investments LP, run by Mark Spitznagel, has some literature (and YouTube videos) explaining the futility of adding bonds to a portfolio of stocks for diversification. Bonds almost always return less than stocks, so you’re intentionally bringing down returns to achieve diversification. By adding small exposure to long volatility, it actually enables you to reduce your allocation to bonds, and increase your allocation to stocks, which helps you to achieve higher returns than you would have with a standard portfolio of 60% stocks and 40% bonds.

Sure, holding long volatility exposure in isolation is no fun. Options decay over time and long volatility funds are characterised by long periods of small losses with brief periods of exceptional gains. Most investors don’t like that payoff, but long volatility exposure is meant to be held alongside a diversified portfolio of other assets. You might have heard that the California Public Employees’ Retirement System famously slashed  its tail-risk allocation right before the pandemic crash of 2020, missing out on a $1bn payday.

Everyone wants to load up their team with Larry Birds and Magic Johnsons. But high scoring players do even better when there is someone who can rebound and pass them the ball. It’s not enough to simply look at the returns of an asset or even the risk-adjusted returns; you have to look at an asset’s individual contribution to portfolio risk and how it interacts with other assets in the portfolio. Risk management in finance is still in the Middle Ages, and not much more sophisticated than “I like the stock.” Investors seem to learn and relearn this lesson every few years.

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