Constructing a diversified portfolio in which correlation between constituent asset classes and investment strategies is meaningfully low can be challenging.
Combining equities and bonds is a staple approach in asset allocation and these asset classes form the core of most portfolios. For much of the time, the combination can be an effective portfolio strategy.
But how well do such conventional, long-only approaches work during the longer term, across market cycles encompassing stockmarket sell-offs? This can be put to the test using historical performance data, which shows how portfolio diversification can be dramatically improved through an allocation to managed futures.
There are different types of managed futures, but systematic, trend-following strategies are the most widely used. These, and other types of managed futures, are also known as commodity trading advisers (CTAs) as they originally invested mainly in commodity markets. This is not the case today, but the name remains in use.
Trend-following CTAs use futures contracts, options and currency instruments to be long or short of an asset class or market based on price movements, with the aim of identifying and latching on to upward and downward trends.
Sophisticated computer programs and quantitative screening allow trend-following strategies to do this in numerous markets at once.
When a trade is initiated, exited and how much risk exposure is taken depends entirely on empirical price data and a CTA’s own system for analysing and interpreting this information. Human emotion and guesswork are entirely removed from the investment, decision-making process.
We have chosen equities and bonds against which to assess the correlation characteristics of managed futures because these asset classes typically form most investors’ core holdings.
It is important to weight each portfolio component equally to properly highlight their effect on performance. Portfolio 1 represents an equally weighted equity and bond portfolio. Portfolio 2 comprises the same equity and bond components, plus an allocation to managed futures. Again, all the components are equally weighted (see graphics).
The data shows that in times of crisis, such as when the dotcom bubble burst in 2000, portfolio 1 falls by more than 16 per cent at its lowest point in September 2002 and did not regain its starting value for another 13 months. In total, portfolio 1 takes more than three years to get back on level terms with portfolio 2.
Meanwhile, portfolio 2 barely drops at all. In November 2002, after a period of trading just off its starting value, portfolio 2 begins to climb steadily into sustained positive territory, a full year ahead of portfolio 1.
During another period of market turmoil, between May 2008 and February 2009, portfolio 1 falls more than 20 per cent, giving up most of the gains made during the six-year period since the previous low point in 2002. In contrast, portfolio 2 is less volatile and has a much better profile in terms of the depth and duration of drawdown periods.
Looking at the 2008 market collapse, we again see the superior performance of portfolio 2. Although it falls from its peak in May 2008, the decline is far less severe and the recovery time is shorter than portfolio 1.