Round 3: winning the mental battle against volatility using managed futures

In the previous posts (here and here) I have illustrated a couple approaches to one of the most dangerous parts of personal investing: the mental anguish caused by volatile (equity) markets.  It’s one of the main reasons we as retail investors tend to buy high and sell low: it’s tough to watch the big oscillations that an equity portfolio experiences.

So far I’ve shown a very easy-to-implement solution (the ostrich method) and a somewhat easy approach (a leveraged investment in bonds).  Today I’ll talk about another method, which is adding an uncorrelated strategy to the equity portfolio: managed futures.

I’ve written about managed futures before.  In a nutshell, the strategies employed by these funds tend to be momentum-related, and therefore exhibit near-zero correlation with equities.  That’s about as good as diversification gets.  Let’s take a look at the managed futures index (the Barclay BTOP50) versus the S&P500 since 1997:

Better diversification = better portfolio.  Source: Quandl and BarclayHedge.

Better diversification = better portfolio. Source: Quandl and BarclayHedge.

A few observations:

  • The performance of managed futures does indeed occur at different times than stocks.  There seems to be a toss-up whether managed futures will make money when stocks are gaining value
  • A 60/40 mix of stocks and managed futures looks like better value portfolio diversification than 60/40 stocks and (unlevered) bonds.  This is due to managed futures having 3 beneficial characteristics versus bonds in the period:
    • Better returns (5% p.a. versus 1% p.a.)
    • Correlation to stocks closer to zero (-0.17 versus -0.27)
    • Volatility – and thus ‘diversification bang for the buck’ – higher (8% p.a. versus 5% p.a.)
  • The 60/40 mix of stocks and managed futures seems a lot less ‘equity-like’ than the 60/40 stocks and bonds mix.  That’s the impact of the strategy diversification

So we can see that, when a material part of the portfolio is moved from equities to managed futures, the result is a better risk and return tradeoff.

Extension: let’s consider the same approach as last post, which used futures or similar to create a Triple 5-Year Note.  It turns out that a common practice among managed futures providers is targeted volatility, so we can in effect choose the amount of volatility we would like our investment in managed futures to have.  Some managers keep low volatility (e.g. 5-10% p.a.), whereas others have quite high volatility (e.g. 25-30% p.a.).  Let’s look at the effect of this on the equity/managed futures portfolio:

Higher volatility of diversifier = better diversification.  Source: Quandl and BarclayHedge

Higher volatility of diversifier = better diversification. Source: Quandl and BarclayHedge

We can see:

  • The blue line remains the S&P500
  • The purple line is the 60/40 mix of stocks and managed futures
  • The green and red lines are different mixes of stocks and a theoretical managed futures manager achieving 3x the risk and return of the index (I am aware of managers who have achieved this, but I don’t think their track records are public)
  • In order to make the 60/40 mix of equity and 3x managed futures seem sensible, I’ve switched to a log scale on the chart
  • Two conclusions to note:
    • With the higher volatility, the 60/40 mix has pretty amazing performance, which doesn’t resemble equity very much.  So stocks have essentially become the diversifier, even though they’re a larger proportion of capital.
    • A higher volatility managed futures program means you need less capital invested to get the same diversification benefits.  In this case, switching from 60/40 to, say, 85/15 gives about the same diversification as the old managed futures case with better performance.

In sum: adding a diversifying strategy to the equity portfolio improves risk-adjusted performance quite a bit.  If you’re looking for ‘bang for the buck’, a high-volatility managed futures program should allow for a smaller capital allocation while maintaining diversification benefits.  And that should allow for less portfolio volatility overall, which helps win the mental battle.

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