Posted by Rabin Tambyraja, professional investor and co-founder of AxiaFunder on 11/21/2019

The only free lunch in finance?

Harry Markowitz the Nobel prize winning economist and godfather of modern portfolio theory famously remarked that diversificationis “the only free lunch in finance” and as a result it is a term that gets tossed around fairly indiscriminately in the investment community – often by financial advisors and private wealth managers or in product marketing pitches. The usual intention being to reassure investors their exposure is not concentrated on a single risky bet but instead spread across a number of supposedly independent wagers. In other words - not putting all your eggs in one basket! 

The idea being that this should significantly increase the likelihood of a positive return given there should (at least in theory) be only a remote chance that all these smaller bets yield negative outcomes simultaneously. 

However, the danger is when investors are sold what they are told is a diversified, low risk, investment but the individual sub-investments are either correlated to each other or to one or more common factors. We witnessed this to spectacular effect during the global financial crisis of 2008, when portfolios of bonds were packaged together to “reduce risk” through diversification without acknowledgement that in many cases, no matter which way they were sliced, diced and packaged up, they were in fact all still exposed to similar risks – namely rising interest rates and slowing property price growth. 

It is also true of many of the more traditional markets open to smaller investors – for example property, where prices will broadly tend to rise and fall with moves in the broader economy, not to mention the government’s fiscal and monetary policy. 

Similarly a major geopolitical shock can cause entire stock markets to react such that it makes little difference whether you chose to buy shares in a tech start up or the most stable utility - particularly with increases in globalisation and interconnectivity between markets and sectors and where computers are able to exploit even the smallest arbitrage in prices within fractions of a second. 

Hence as a rule investors would always be well advised to always “look under the bonnet” when they are offered products that claim to diversify their risk exposure.

One type of investment that should live up to its claim of offering real diversification however, is a portfolio of legal cases – obviously as one part of a well structured investment strategy spread across a number of asset types. 

While the outcome of any single case is clearly binary - either a Win - in other words the claimant is successful (either through a negotiated settlement or at trial), or a Loss, by dividing your total investable sum amongst a number of claims an investor can significantly increase the likelihood of a positive return on their overall investment. 

Lets illustrate this by taking the example of an investor with £10,000 to deploy in third party litigation funding. 

Say in the first instance he or she invests the entire sum in a single case that has the potential to return £3 for every £1 invested, then the possible scenarios for their return would look like those illustrated below. Note this assumes (as with all cases listed on the AxiaFunder platform) that non-avoidable After-The-Event insurance is in place to protect the claimant and their investors against liability for a defendant’s costs. 

Despite a litigation funder’s expertise in reviewing and selecting only the cases with the highest chances of success (many funders in the market quote win rates of >80%!) that should yield the investor a sum of £30,000 (=3 x £10,000) on their original stake, there is always the possibility that for whatever reason the claim is unsuccessful and the investor is left empty handed. To be conservative, let's assume this probability is 30%. 

Now instead, say the same investor decides to split their capital and allocate £5,000 each to two entirely different legal claims. Assuming AxiaFunder’s legal and financial experts have done their homework and estimated that each of these cases stands at least a 70% chance of success, based on simple binomial probabilities, the range of potential outcomes would now look like this. 

While the investor still benefits from an outcome where both cases win and they comes away with £15,000  (3 x £5,000) + £15,000 (3 x £5,000) = £30,000, more importantly they have reduced the probability of coming away empty handed to just 9% vs. the original 30% when they invested entirely in one case. Instead there is now a probability of 91% of making a return of at least 50% on their initial £10,000 stake!

Thus by spreading their original £10,000 investment across an increasing number of separate, uncorrelated legal claims, investors can in theory increase the likelihood of making attractive returns (and consequently reduce the risk of losing everything) to insignificant levels as shown in the graphic below. 

Note graphic solely for illustrative purposes 

In fact, following these assumptions, investing in a portfolio of 10 legal cases should in theory be sufficient to generate positive returns over 90% of the time. 

Furthermore, these returns are unlikely to be correlated with the other holdings of typical small investors - equities, bonds or property. In fact, one could argue that a downturn in the economy, for example in the (now hopefully remote) scenario of a hard Brexit, the volume of legal disputes might potentially even rise. It could be argued therefore that litigation funding in fact offers investors true diversification.

The AxiaFunder platform is set up this way to enable investors to review details of each case available for litigation investment and make their own choices on how many and which ones to invest in, depending on their own individual return requirements and tolerance for risk. 

Hence with AxiaFunder, ordinary investors in the UK can not only participate in the attractive returns available from funding legal cases for the first time, but by spreading their investment across a number of legal claims, can potentially maximise their gains while at the same time reducing the probability of negative returns. With AxiaFunder’s unique case funding model, investors are always in the driving seat. 

Below is a link to a short (2 min) video on the AxiaFunder website that also demonstrates how the platform enable investors to diversify their risk when gaining exposure to this exciting new asset class.

By Rabin Tambyraja, professional investor and co-founder of AxiaFunder