An Anniversary Thought for Berkshire Hathaway Investors: Diversify Into Managed Futures
Amidst this year’s justified celebration of Berkshire Hathaway’s 50 years of investment returns, we wondered if an investment in Berkshire (BRKA), already hugely successful, could nonetheless be improved by combining holdings of BRKA with those of other assets. An ideal candidate for investment alongside BRKA would be an asset with both positive returns on a stand-alone basis and low correlation to BRKA.
Columbia University professor Benjamin Graham led academia and Wall Street with his pioneering work in the area of value investing. Famously, Warren Buffett was one of his students in the 1940’s. Years later, the Nobel prize-winning work of Harry Markowitz explored the effects of combining non-correlated assets into diversified portfolios with the aim of improving risk-adjusted returns. Markowitz is credited with the often-repeated quip that “diversification is the only free lunch in finance.”
Harvard professor John Linter in 1983 presented the classic paper, “The Potential Role of Managed Commodity Financial Futures Accounts (and/or Funds) in Portfolios of Stocks and Bonds.” In this study he pointed to gains in risk adjusted rates of return that could potentially be obtained by combining equity investment with managed futures.
To examine the portfolio combination of stocks and managed futures, we have focused on Berkshire because of its historical moment and legendary performance. On the managed futures side, our Drury Diversified Trend-Following Program (Drury) would satisfy the requirements of having strong returns on a stand-alone basis as well as almost-zero correlation to Berkshire.
While our investment program cannot cite the same longevity as Berkshire, it has nonetheless been in continuous operation for almost 19 years, a substantial period encompassing many economic cycles and market conditions. For these years, we can examine this investment in relation to BRKA for possible improvement of portfolio returns.
The two performance records, taken individually during this 19 year period, are broadly similar.
The correlation between the two return streams is a low 0.01.
Despite the overall similarity of returns, the paths of producing these returns share almost nothing in common. As modern portfolio theory would predict, the performance of a portfolio holding BRKA is potentially improved by being coupled with a non-correlated asset such as Drury. It is of course equally true that a portfolio holding only Drury is potentially improved by being coupled with a non-correlated asset such as BRKA.
A look at the efficient frontier for this two-asset portfolio suggests that a blend of approximately 50-50 would have produced the highest ratio of ROR versus standard deviation of returns:
Consistent with the theory, the portfolio with 50% each in BRKA and Drury raised the risk-adjusted ROR to a level higher than either asset could achieve individually. For the holder of BRKA, the diversification reduced the portfolio volatility by almost one-third and reduced the depth of the peak-to-trough drawdown by almost half. Finally, the combination of Berkshire holdings with this non-correlated asset cut the length of the drawdown associated with holding Berkshire alone by a whopping 43 months. This means that instead of experiencing a 61-month period (Dec 2007 – Jan 2013) of being underwater, while holding BRKA shares alone, the combined portfolio reduced that period to only 18 months. By the same token, of course, the underwater period of holding Drury alone is reduced from 55 months to the same 18 months.
As we congratulate Berkshire on its 50th anniversary, it can be observed that equity investment, of which Berkshire is an eminent practitioner, can be profitable. It is also possible that the combination of equity investment with other strategies may be return-enhancing as well as volatility-reducing.
*Source: BRKA stock price. Percentage change in stock price month-over-month as of each month-end across the period covered. BRKA stock prices were taken from Yahoo Finance.