Modern Portfolio Theory has dominated investing for over fifty years, and all investors should be aware of its basic tenants. One key concept in MPT is that of the efficient frontier, which is the plot of the maximum returns a given portfolio can produce at specific levels of risk.

Q. OK, I think we have a real classic of a buzzword here today, don’t we? This is in the top ten, right?
A. For alternative investing, yes indeed. In Modern Portfolio Theory, a key pillar of alternative investing, you say a portfolio is on the “Efficient Frontier” when it maximizes returns at a given level of risk…. Or provides the minimum possible risk to get a given level of returns.

Q. And we even have an image of what the efficient frontier looks like, sort of an upwardly curving slope. What’s going on here?
A. The axis on the left is increasing returns, and along the bottom its increasing volatility, or risk in MPT parlance. All that blue space is where possible investments lie… some combination of available returns for given risks. The white space is where no investments exist: they would provide yet greater returns for a given risk if they did, but the don’t. And the boundary between them is the efficient frontier.

Q. Is there a reason it’s a curve? Why isn’t that a straight line?
A. Incredibly key point. Imagine just two securities with different return and risk characteristics. They’d show up as two dots here, and connecting them would indeed show a straight line. But when we combine them into a portfolio, we lower the volatility of holding either one separately… the risk is reduced, but the returns remain the same. That causes a bulge in the straight line, and that bulge is equal to the benefits of diversification.

Q. So exactly what does this have to do with alternatives? Wouldn’t straight stock portfolios also show this sort of behavior?
A. Definitely they would and do. But essentially the argument is that more and better kinds of diversification, like by adding hedge funds into a typical portfolio, will get you ever closer to the efficient frontier: more returns for the same level of risks.

Q. And is that really right?
A. Historically, yes… having had some alternative strategies instead of a straight 60/40 portfolio would have increased returns and lowered risks over the past 20 years. Profound diversification is a key reason the Yale endowment is up 100% over the past decade. But there are lots of reasons to think that exactly what’s worked before might not work quite the same way going forward… after all, history doesn’t repeat itself, but it rhymes.