Case Study: Leveraging Diversification to Reduce Portfolio Risk Without Sacrificing Returns

Nobel Prize laureate Harry Markowitz demonstrated that investors could leverage diversification to reduce portfolio risk without sacrificing returns. The Catalyst Systematic Alpha Fund (ATRFX) offers a compelling case study to demonstrate how this approach can outperform.

By Michael Schoonover | May 16, 2023

In 1952, Nobel Prize laureate Harry Markowitz coined the phrase, “diversification is the only free lunch in investing.” His groundbreaking work demonstrated that, through diversification, investors could decrease portfolio risk without sacrificing returns. In other words, diversification can likely position a portfolio to play offense and defense, potentially mitigating the pain of bear market cycles and positioning for long-term outperformance.

In the decades since Markowitz’s work, investment portfolios continue to get derailed by bear markets despite diversification being one of the core concepts in the training of financial professionals. In this article, we examine the common breakdown that occurs in portfolio construction and how this leads to the ongoing cycle of boom and bust in investor portfolios. We demonstrate how investors can leverage the full benefits of diversification by integrating truly uncorrelated strategies into an overall portfolio.

Throughout the article, we use the Catalyst Systematic Alpha Fund (ATRFX) as a diversification success story. ATRFX implements an all-season strategy with various investment components that are generally uncorrelated to each, all combined in the same fund. Evaluating ATRFX over the past five years, a period defined by several bull and bear market cycles, provides a compelling case study to demonstrate how a true diversification approach has the potential to outperform.

Chart 1: ATRFX As A Case Study for Leveraging Diversification to Play Offense and Defense in One Portfolio

Source: Bloomberg LP and Catalyst Capital Advisors LLC. Monthly return data from 03/29/2018 to 05/16/2023. Example Diversified Portfolio description and details described in Chart 2 and Chart 3. Past performance does not guarantee future results and there is no assurance that the Fund will achieve its investment objective.

Investments in mutual funds involve risks. Performance is historic and does not guarantee future results. Investment return and principal value will fluctuate with changing market conditions so that when redeemed, shares may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. To obtain the most recent month end performance information please call the Fund, toll free at 1-866-447-4228 or visit www.CatalystMF.com. Diversification does not ensure a profit or guarantee against loss.

Past performance is not indicative of future results.

Chart 2: An Example “Diversified” Portfolio That Only Achieved Sub-Optimal Diversification Benefits

The indices shown are for informational purposes only and are not reflective of any investment. As it is not possible to invest in the indices, the data shown does not reflect or compare features of an actual investment, such as its objectives, costs and expenses, liquidity, safety, guarantees or insurance, fluctuation of principal or return, or tax features. Past performance is no guarantee of future results.

The Example “Diversified” Portfolio highlighted in Chart 2 is a relatively common approach that investors take in trying to diversify, such as diversifying U.S. large cap equity exposure by going to different geographies and market capitalizations. Unfortunately, as noted in Chart 1, this portfolio provided little buffer during the trailing year, just marginally outperforming the S&P 500 TR Index during a down market. This outcome is not surprising when analyzing the correlation of the Example “Diversified” Portfolio and its sub-components to the broader markets.

Chart 3: Many Attempts at Diversification Maintain Too High of Levels of Correlation

Source: Bloomberg LP and Catalyst Capital Advisors LLC. Monthly return data from 03/29/2018 to 05/16/2023. Example “Diversified” Portfolio rebalanced monthly at weights reflected in Chart 2 and Chart 3. Past performance does not guarantee future results and there is no assurance that the Fund will achieve its investment objective. Equities, Small-Cap U.S. Equities, Non U.S. Equities, Emerging Market Equities, U.S. Corporate Bonds, U.S. Treasuries, Global Investment Grade Bonds, Global High Yield Bonds, REITS, and Commodities represented by the S&P 500 TR Index, Russell 2000 TR Index, MSCI ACWI ex USA Net TR Index, MSCI Emerging Net TR Index, Bloomberg U.S. Corporate TR Index, Bloomberg U.S. Treasury TR Index, Bloomberg Global-Aggregate TR Index, Bloomberg Global High Yield TR Index, FTSE NAREIT All Equity REITS Index, and Bloomberg Commodity TR Index.

On the other hand, ATRFX only exhibited a correlation of 0.10 to the S&P 500 TR Index as well as a minimal correlation to any of the other traditional and alternative asset classes. The result was positive returns during the trailing year when traditional asset classes suffered and, consequently, long-term outperformance.

Combining Uncorrelated Assets is the Key to Maximizing the Benefits of Diversification

Now is a good time to go back to the work of Harry Markowitz. The formula for returns is relatively straightforward: the expected return is the weighted average returns of the investments in the portfolio. For example, if you combine 10 investments each with an 8% expected return, then the portfolio’s expected return is 8%.

Markowitz demonstrated that portfolio volatility could be reduced by diversifying investments, and that maximum benefits could be achieved when the correlation between investments is zero. In other words, if you combine 10 investments, each with a 15% expected volatility, in a portfolio and they are not completely correlated, then the expected portfolio volatility is reduced to less than 15%. By reducing the expected portfolio volatility, the probability of a negative year decreases and the return per risk taken increases.

Charts 4 and 5 graphically present the mathematical outcomes of Markowitz’s work, looking at the reduction in expected portfolio volatility and decreased probability of a negative annual return. In the examples, each investment has an 8% expected return, and therefore the expected portfolio return in any scenario is 8%. Each investment also has a 15% expected volatility. There are two series: one series showing a portfolio with investments that all have a correlation of zero to each other, meaning that there is no predictive relationship, and a series where the investments all have a correlation of 0.75 to each other, meaning that there is a reasonable predictive relationship between the two (i.e., U.S. large-cap and U.S. small-cap stocks).

Chart 4: Reduction in Portfolio Volatility from Combining Uncorrelated Assets Each with A 15% Expected Volatility.

Chart 5: Reduced Probability of a Negative Year from Combining Uncorrelated Assets Each with A 15% Expected Volatility (Assumes Normal Distribution).

Charts 4 & 5 are hypothetical illustrations only. They should not be considered results of any actual investment or be considered investment advice.

Charts 4 and 5 demonstrate that by going from one to ten investments in a portfolio, the expected portfolio volatility decreases and the probability of a negative annual return decreases. If the investments all have a correlation of 0.75 to each other, the reduction is relatively minimal. Going from one investment to ten investments each with a correlation of 0.75 to each other only reduces the probability of a negative year from approximately 30% to 27%. On the other hand, if all ten investments have no correlation (correlation = 0.00), then the probability of a negative year drops from approximately 30% to 5% as you go from one to ten investments.

This math explains how the Example “Diversified” Portfolio was almost as negative as the S&P 500 TR Index for the trailing year in Chart 1, but why ATRFX was positive. The Example “Diversified” Portfolio is not actually that diversified. Many of the investments have too high of a correlation, and therefore only sub-optimal results were achieved. On the other hand, ATRFX is essentially a portfolio of investments with little correlation to each other and may achieve true diversification.

Conclusion

In our opinion, many investors do not properly diversify their portfolios and therefore recognize suboptimal benefits in trying to leverage the power of diversification. To recognize the full benefits of diversification, investors need to integrate truly uncorrelated strategies into an overall portfolio. The expected result is lower portfolio volatility at the same level of return, which then means the lower probability of a negative year. By mitigating the impact of bad years for the markets, investors can position their portfolio for long-term outperformance.

Investors looking to implement this type of approach need to begin by making sure the portfolio consists of investments that are sufficiently uncorrelated. Investors can also allocate a meaningful portion of a portfolio to a fund like ATRFX which is already combining several uncorrelated strategies into one product.

Glossary
Correlation is a statistic that measures the degree to which two securities move in relation to each other. A perfect positive correlation means that the correlation coefficient is exactly 1. A perfect negative correlation means that the correlation coefficient is exactly -1. A correlation coefficient of 0 implies no linear relationship at all.

About the Author

Michael Schoonover is Chief Operating Officer of Catalyst Capital Advisors LLC, Catalyst International Advisors LLC and Rational Advisors, Inc. He is an experienced financial professional having worked in various portfolio management, operations management, and trust officer roles. He serves in various executive roles for U.S. registered investment advisers and marketing and consulting companies in the investment management industry. He is President of Mutual Fund Series Trust, President of Mutual Fund & Variable Insurance Trust, and President of Strategy Shares. Mr. Schoonover has a Bachelor of Science degree in biochemistry from the University of Michigan and a Master of Business Administration degree with high distinction from the University of Michigan.

Performance (%): Ending March 31, 2023
Annualized if greater than a year

Share Class/Benchmark	YTD	1 Year	3 Years	5 Years	Since 11/1/17	Since Inception*
Class A	9.42	7.22	18.48	11.19	8.84	5.12
Class C	9.11	6.44	17.54	10.32	8.00	4.28
Class I	9.39	7.41	18.69	11.41	9.08	5.31
S&P 500 TR Index	7.50	-7.73	18.60	11.19	10.97	11.20
Class A w/Sales Charge	3.12	1.05	16.16	9.89	7.87	4.40

Class	Adjusted Expense*	Net Expense*	Gross Expense
Class A	2.02%	2.18%	4.75%
Class C	2.77%	2.93%	5.50%
Class I	1.77%	1.93%	4.50%

*The advisor has contractually agreed to waive management fees and/or reimburse expenses of the Fund to the extent necessary to limit total annual fund operating expenses (excluding brokerage costs; acquired fund fees and expenses; borrowing costs such as (a) interest and (b) dividends on securities sold short; taxes and, extraordinary expenses, such as regulatory inquiry and litigation expenses), through October 31, 2023.

The Fund’s maximum sales charge for Class “A” shares is 5.75%. Investments in mutual funds involve risks. Performance is historic and does not guarantee future results. Investment return and principal value will fluctuate with changing market conditions so that when redeemed, shares may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. To obtain the most recent month end performance information please call the Fund, toll free at 1-866-447-4228 or visit www.CatalystMF.com.

Past performance is not a guarantee of future results.

Investors should carefully consider the investment objectives, risks, charges and expenses of the Catalyst Funds. This and other important information about the Fund can be obtained by calling 866-447-4228. The Catalyst Funds are distributed by Northern Lights Distributors, LLC, member FINRA/SIPC. Catalyst Capital Advisors, LLC is not affiliated with Northern Lights Distributors, LLC.

Risk Considerations:
Investing in the Fund carries certain risks. The Fund will invest a percentage of its assets in derivatives, such as futures and options contracts. The use of such derivatives and the resulting high portfolio turnover may expose the Fund to additional risks that it would not be subject to if it invested directly in the securities and commodities underlying those derivatives. The Fund may experience losses that exceed those experienced by funds that do not use futures contracts, options and hedging strategies. Investing in the commodities markets may subject the Fund to greater volatility than investments in traditional securities. There are risks associated with the sale and purchase of call and put options. Emerging market securities tend to be more volatile and less liquid than securities traded in developed countries. The Fund invests in the securities of foreign companies which are generally not subject to the same regulatory requirements and have different accounting, auditing and financial reporting standards from those applicable to U.S. companies. The performance of the Fund may be subject to substantial short term changes.

Lower quality debt securities involve greater risk of default or price changes due to changes in the credit quality of the issuer. Interest rate risk is the risk that bond prices in general fall when interest rates rise. These factors may affect the value of your investment.
Diversification does not ensure a profit or guarantee against loss.

BNP Paribas, the sub-advisor of the fund, does not sponsor, endorse, sell, or promote any investment fund or other vehicle that is offered by third parties and that seeks to provide an investment return based on the returns of the BNP Paribas catalyst systematic alpha index (the “index”). A decision to invest in any such investment fund or other vehicle should not be made in reliance on any of the statements set forth in this document. Prospective investors are advised to make an investment in any such fund or vehicle only after carefully considering the risks associated with investing in such funds, as detailed in an offering memorandum or similar document that is prepared by or on behalf of the issuer of the investment fund or vehicle. You cannot invest directly in an index and unmanaged index returns do not reflect any fees, expenses or sales charges.

Alternative investments may not be suitable for all investors and an investment in alternative funds is suitable only for investors who can bear the risks associated with the illiquidity of the fund’s shares and should be viewed as a long-term investment.

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