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How much should you allocate to managed futures?

November 3, 2008

 

With the record of various asset classes so far this year abysmal for everything but managed futures (check the YTD numbers in our last newsletter here), many people have been calling Attain saying they get it.

These investors get that managed futures can be a great diversifier. They are saying they want exposure to managed futures, they want the diversification, they want to be able to go long AND SHORT commodities (something criminally lacking from the bevy of commodity funds and ETFs which popped up over the past two years), and so on…….. But, a few have said – Attain hasn’t covered one big question……

And that question is; “How much should I allocate to managed futures?” If you’re ready to diversify, what percent of a total portfolio should and or could be allocated to managed futures?

This is a great question, and one that is frankly asked too rarely. We all hear about diversification, and many put a managed futures program, hedge fund, or commodity ETF to work in their portfolio. But the devil, as always, is in the details. Are you allocating enough to your portfolio’s “diversifier”? Are you allocating too much?

As you can see, the seemingly simple question of how much to allocate becomes rather complex rather quickly. Allocate too much, and you could be increasing the overall risk for the portfolio. Allocate too little, and the diversification may not have enough punch to actually offset a crisis period like we’re in right now.

A study done by the Chicago Mercantile Exchange many moons ago, attempted to tackle this problem for the average investor by publishing a study on the effect differing allocations to the Managed Futures asset class have on a so called traditional portfolio (stocks & bonds) .

The graph below from the Chicago Board of Trade shows that a traditional portfolio (55% stocks, 45% bonds, and 0% managed futures) presents an investor with the greatest risk and lowest returns. This is what anyone reading this newsletter would expect (especially recently), and is the whole reason for seeking out alternative investments which can both increase the return and reduce the risk.

As you can see in the table below, as incremental amounts of managed futures are added to the portfolio, the return increases as the risk decreases (just what we’re looking for) up to the point where a portfolio comprised of 45% stocks, 35% bonds, and 20% managed futures offers an investor the greatest returns and least amount of risk.

After that level, things start to go the other way, with increases in return coming at the expense of increases in risk as well. The ideal portfolio is an efficient one, where you can get the maximum amount of return for the lowest amount of risk; and indeed this type of graph is called an “efficient frontier” chart.

 

So that’s it? The answer is 20% towards managed futures? Not so fast. It unfortunately is not as easy as simply looking at the past return data and generating an efficient frontier.

For starters, the data is dynamic. The CME’s study above was from back before the internet bubble burst, and represents much higher average stock market performance.  Running the same study today, after managed futures have been steadily outperforming stocks, sees the efficient frontier having moved significantly. When using data up through the end of October, the data now shows the ideal portfolio as 40% stocks, 20% bonds, and 40% managed futures. (a doubling of the allocation).

So is this the answer – 40% of a portfolio in managed futures. That could be part of the puzzle, but take a closer look at the numbers in the updated efficient frontier chart above. We’re talking about compound annual returns of just 5% at the ideal portfolio mix level, at the efficient frontier. So while this may be the mathematically correct level (based on past data, and assuming your other investments are just stocks and bonds), it may not be the so called efficient frontier for your portfolio. Many investors are willing to take on more risk than that for some extra return, and if we actually look at the Barclay’s managed futures index performance versus the S&P 500 performance from 1994 to the present, we can see that the returns are about equal, but that the managed futures index has much less volatility in returns. (nearly half the volatility at 8% vs 15%). Past performance is not necessarily indicative of future results.

Compound ROR	'94-Oct 07	'94 - Oct 08	Difference
Bonds	3.84%	3.86%	0.02%
Cash	4.07%	3.94%	-0.13%
Commodities	4.77%	1.86%	-2.91%
Managed Futures	5.83%	6.06%	0.23%
Hedge Funds	11.11%	9.51%	-1.60%
Real Estate	13.98%	8.93%	-5.05%
US Stocks	10.98%	6.89%	-4.09%
World Stocks	8.90%	3.63%	-5.27%
Risk (Volatility)	'94-Oct 07	'94 - Oct 08	Difference
Bonds	5.24%	5.43%	0.19%
Cash	0.46%	0.47%	0.01%
Commodities	9.30%	13.19%	3.89%
Managed Futures	7.96%	7.90%	-0.06%
Hedge Funds	7.53%	7.71%	0.19%
Real Estate	14.06%	16.97%	2.91%
US Stocks	13.98%	14.96%	0.98%
World Stocks	13.50%	15.32%	1.82%

 

Risk/Reward Shift

There is something else interesting going on in this table showing the risk and reward characteristics of various asset classes. The table above shows the risk and reward profile of various asset classes for the 13 years ending from January 1994 to October 2007 (right before the credit crunch took root) as compared to the 14 years ending October 2008.

You would not expect a single year to have much affect on numbers compiled over 150+ months of data, but we can see that some dramatic shifts in risk and reward have occurred in the past year. The average returns for everything except managed futures and bonds have come down dramatically (world stocks being cut in half, from 8.9% to 3.6%), while the risk (as measured by volatility) has increased dramatically for these same asset classes. This can be seen better graphically in the chart in our chart of the week section below. The Risk/Reward Shift chart shows the current level of return per unit of risk (as measured by volatility), with the same assets risk/reward levels as of October 2007 also listed.

The chart clearly shows a significant shift lower (less return) and to the right (more risk) for hedge funds, real estate, commodities, US and World Stocks. For anyone putting together a diversified portfolio including these pieces, this is clearly disturbing, as the goal on the efficient frontier chart is just the opposite - to go up and to the left (more return, less risk).

Things will definitely oscillate back the other way, perhaps resulting in some higher returns for asset classes such as US stocks (and hedge funds, in my opinion),  but it will be very difficult for each of these asset classes to “work off” the increased risk which is now part of their profile.  That increase in risk is the troubling part for portfolio builders who are looking at reducing portfolio volatility, as it isn’t likely to change back after a bounce back to the upside (it may even increase depending on the size of the bounce). That leaves them with only one option, mathematically speaking, to lower portfolio volatility, and that is adding higher amounts of those assets which have lower volatility.

For this reason, many investors are allocating higher amounts than usual to managed futures. With their historical risk roughly equal to hedge funds, and only behind cash and bonds in terms of low volatility; the risky world of futures trading is becoming a safe haven of sorts for investors seeking safety from the record high volatility (risk).  

So what is the proper answer? What percentage of a total portfolio should be allocated to managed futures? Unfortunately there is no singular answer which will work for everyone. We have some clients who have upwards of 75% of their portfolios in managed futures in this environment. And while that has historically been a very high number which would result in higher portfolio risk for sure, with only the hope of higher portfolio returns, it is actually right in line with what the efficient portfolio calculates as the ideal weighting from Nov 2007 through October 2008. Over that short period, the efficient portfolio was 85% towards managed futures and 15% cash.

But unless you will be readjusting your portfolio very frequently, we don’t recommend using a time period as short as 1 year for calculating your efficient frontier. In fact, if we had looked at the 13 year period ending October 2007, the efficient frontier would have told us that 80% of assets should be in hedge funds, and 20% in real estate. That obviously wouldn’t have worked out well over the past year, as real estate has crumbled and hedge funds have had their worst period perhaps ever.  

The best advice we can probably give is to balance out your portfolio as evenly as possible between the major asset classes – Bonds, Cash, Commodities (long only), Managed Futures, Hedge Funds, Real Estate, US Stocks, and World Stocks – to form a base portfolio. From there, try and retain enough flexibility to increase allocations in areas which are outperforming (such as managed futures right now) and decrease areas which are struggling (such as World Stocks).  

So an aggressive investor may be looking at an allocation of 50% or more to managed futures during this prime environment, while a more conservative investor may only be looking at taking the 5% or 10% which she has moved away from stocks and reallocating that to managed futures to bring its total exposure up to around 20%.

In the end, it’s a personal choice based on what else you have in your portfolio, and where you think we’re headed in terms of market conditions.

- Jeff Eizenberg