Smart Portfolios 1 – The Best Portfolio

Smart Portfolios 1 – The Best Portfolio

Today’s post is our first visit to a new book – Smart Portfolios by Robert Carver. What do we mean by the “best” portfolio?

Robert Carver

Robert Carver

Robert Carver

I recently came across Robert Carver’s website (This Blog is Systematic) from a random tweet and thought that it was very good.

  • Then I found out that Rob had written two books, so I bought them.

Rob used to be portfolio manager for the AHL hedge fund that was part of the Man group.

He was responsible for the creation of AHL’s fundamental global macro strategy, and then managed the fund’s multi-billion dollar fixed income portfolio.

He retired in 2013 and is now an independent investor (and writer).

Robert manages his own portfolio of equities, funds and futures using the methods you can find in his books.

Smart Portfolios

Rob says in the preface that the book is designed to answer three “deceptively simple” questions:

  1.  What should you invest in?
  2. How much of your money should you put into each investment?
  3. Should you subsequently make changes to your investments through further buying or selling?

Everything about investment involves trade-offs:

  • Should you invest in the portfolio with the highest return, the lowest risk, or some mixture of the two?
  • Is buying a couple of investment funds sufficient, or is it worth creating a highly diversified portfolio of hundreds of funds?
  • Do you need to constantly buy and sell to make the highest returns, or should you do nothing?

Life would be very easy if you knew with 100% certainty that bonds will definitely do better than stocks next year. But what should you do if there is only a 55% chance of bonds outperforming ­ and how do you calculate that probability?

Future returns

Forecasting prices is hard because financial markets are complex.

Not only do you have to predict the future, you need to predict the future better than anyone else. Current market prices already reflect the collective estimate of every investor in the world based on all the information that is currently available.

In the first two parts of this book I assume that we can’t predict future returns. I assume that risk-adjusted returns are identical for all assets.

Similarity and risk

All investors know they shouldn’t put all their eggs into one basket.

We also know that some investments tend to be riskier than others.

Rob uses Norwegian bonds and an internet start-up as illustrations.


Fixed costs make it prohibitively expensive to have portfolios with hundreds of shares. So rather than buying individual shares most investors should buy funds:
mutual funds, unit trusts, investment trusts or ETFs.

Rob calls these in aggregate “collective funds”.

Fixed costs are less of a problem as you get wealthier and can invest in larger amounts.

Forecasting returns

Future returns have some predictability. 

  • For example, small firms have consistently outperformed larger firms in the past. 
  • Stocks which have gone up in price over the last 12 months often continue to outperform. 
  • Firms with lower PE ratios or higher dividend yields do better than those in the opposing camps.

Academics call these risk factors – for them, extra profits must be at the cost of extra risk.

Factors can be used to forecast future returns, or passively accessed via smart beta funds.

The Best Portfolio

Is the best car the one with the highest fuel efficiency? The automobile that goes the fastest? The vehicle with the largest number of mechanical horses in its engine? Is it the best looking, or the cheapest? The answer depends on what you personally are looking for in a car.

Portfolios are no different; a set of investments that suit one person will be completely inappropriate for another. I define the best portfolio as:

The highest expected real after costs total geometric absolute return, for a
given level of risk and time horizon, in a particular investment currency.

So we need to take into account inflation, costs and risk, and we should be agnostic between capital gains and dividends.

We need to decide on the currency in which we will spend money in the future.

  • At the same time we should ignore returns relative to other investors (or, strictly, a benchmark).

Rob doesn’t mention taxes, but I would argue that we need to look for the best after-tax return.

The two main tax breaks in the UK (SIPPs and ISAs) allow access to almost all asset classes, but the other two key tax breaks (principal private residence relief and VCT / EIS) are restricted to property and early stage private equity respectively.

  • So you might face a trade-off between post-tax returns and pre-tax ideal asset weightings.

For example, many people living in London will be over allocated to property because of the high real-estate prices there.

Another area where tax can affect your choices is dividends.

  • In some circumstances investors can choose to receive money as dividend income or as capital gains.

The balance between capital gains and dividend allowances changes regularly, but the CGT allowance for next year is £12k, whilst the dividend allowance is now down to £2K.

And a third area where tax might be relevant is spread-betting.

  • I know Rob is not a big fan because under many circumstances spread bets are expensive compared to some alternatives.

But winnings are tax-free, so there’s another trade-off to think about.

Geometric mean return

The geometric mean better reflects what you will actually earn over time [than does the arithmetic mean].

Geometric means are the same as compound growth rates.

Compound interest is a wonderful thing, but it magnifies losses as well as gains.

The geometric mean is always lower than the arithmetic mean, unless all annual returns are identical. A good approximation is that the geometric mean is equal to the arithmetic mean, minus half the variance (the standard deviation squared).

The lumpier the returns, the more the arithmetic mean will flatter them.

Geometric vs arithmetic returns

Geometric vs arithmetic returns

The average real return of S&P 500 equities in the US from 1928­- 2016 was 8.2% and for 10 year bonds it was 2.2%. However, the geometric means were 6.2% (equities) and 1.8% (bonds) respectively.

Using the geometric return makes pure equity portfolios less attractive than more diversified alternatives.


Since 1900 [UK] equities have returned around 5% annually after inflation. In 90% of calendar years annual returns were between -16% and +40%.

This is just a model: there is no guarantee that it will be correct. Firstly it might be the wrong model. It could be too simplistic, ignoring as it does the very worst and very best returns, and not specifying the rest in much detail.

Secondly, the model parameters are subject to variation [depending on which years are sampled].

Finally, the future might be very different from the past.


Risk is the possibility of losing money. But there are numerous ways of measuring it, and there is no consensus on what is a tolerable level of risk.

I use my own preferred measure of risk (expected geometric standard deviation of returns), and show later how that translates into likely outcomes over different time periods.

However, I can’t just set a specific level of risk tolerance. So later I explain how to adapt your portfolio to different levels of risk tolerance.

Real returns

Because we care about real returns there is no truly `risk free’ investment. Leave your money in cash or in a bank account and it will almost certainly be depleted by inflation.

Inflation-linked bonds issued by stable governments come closest to being risk free for long-term investors, but buying these will usually lock in a guaranteed negative return.

Tracking error

Differences between your return and a benchmark are known as tracking errors.

It’s nice when tracking errors are positive on average, since you are outperforming, but tracking errors that are large in magnitude mean you are deviating too much from your benchmark.

It’s important to specify exactly what size of tracking error you are comfortable with, and how you’re going to measure it.

A simple measure of tracking error is the standard deviation of relative returns between your portfolio and the benchmark.


You need to measure your expected portfolio growth in the currency in which you will do your future spending. Spreading your portfolio over multiple countries will mean you are exposed to changes in foreign exchange rates.

It’s possible to eliminate this risk by currency hedging, or using funds that do this hedging for you.

I’m extremely sceptical about the need for currency hedging. Hedging doesn’t improve pre-cost returns. Currency returns are fairly random so hedging won’t systematically gain or lose anything.

Hedging also reduces the diversification benefit by making assets more correlated with each other. Then there are the costs.


That’s it for today.

  • It’s been an enjoyable and clear introduction and I’m looking forward to reading the rest of the book.

Until next time.

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Mike Rawson

Mike is the owner of 7 Circles, and a private investor living in London. He has been managing his own money for 35 years, with some success.

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