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Managed Futures – Aristotle and Synergy
Rob da Silva – Head of Research
“The whole is greater than the sum of its parts” is an important and influential concept that applies to many aspects of life and certainly to the theory and practice of investing. It was first coined over 2370 years ago by the Greek philosopher Aristotle in his tome “Metaphysics”. In modern English its reduced to one word – synergy. The Oxford Dictionary defines synergy as “The interaction or cooperation of two or more organizations, substances, or other agents to produce a combined effect greater than the sum of their separate effects”. That’s a mouthful – so just refer back to the first ten words of this paragraph.
What has that got to do with the headline? In finance Diversification = Synergy and managed futures/alternatives can play an ongoing role in that synergy.
Diversification can be paraphrased from Aristotle as “the portfolio risk is less than the sum of its parts”. That is essentially Finance 101 and is universally accepted. This note takes a quick look at impact of managed futures on the risk of the whole, not the part.
Many investors look at products in the Alternative space in isolation – returns, volatility, drawdowns, Sharpe ratio, and a myriad of other metrics. That is interesting and instructive, but only to a limited degree. It is viewing it as a part, not as the whole. The more important perspective of the product is what it does to the whole portfolio when properly blended into it. Often it can provide useful diversification benefits that lower volatility or improve returns or both.
A product that on its own might not look tremendously appealing may in fact make valuable contributions when blended with the right ingredients. You can look at a clove of garlic and understand its metrics as a food but conclude ‘I’m not taking a bite out of that!’. When blended into a bolognaise sauce, however, the outcome for the whole is likely be much improved by the addition of that small part. Note carefully that it’s the combination of the right ingredients that will achieve the better outcomes. You would not blend garlic into a chocolate cake (or at least most people wouldn’t).
Let’s look at the impact of adding managed futures to a multi-asset portfolio. The following analysis uses standard Markowitz processes to calculate efficient frontiers. The universe of “ingredients” used in the blending is a set of 9 broad-based market indexes and the Credit Suisse Managed Futures Liquid Index. The data set spans Jan-2000 to Apr-2020 (20.25 years) and captures a variety of market cycles and risk events (including the tech wreck and the GFC). The maximum weight to any one asset is limited to 25%.
The key metrics that indicate an Alt product would blend well are an acceptable Sharpe Ratio (high return, low vol, or both) and a low average correlation to all the other assets in the mix. There are other metrics that can play a role but these are key.
The table below details the optimal portfolio where up to 25% can invested in the Credit Suisse Managed Futures Liquid Index compared to the optimal portfolio where this asset is excluded.
The results are interesting – there is a slightly lower absolute return but a much higher risk-adjusted return (Sharpe ratio) due to a 27% drop in volatility.
Those outcomes are visibly observable in the graph below which compares the growth of $10,000 for both optimal portfolios. The end point for the portfolio with Alts is slightly below its sans-Alts peer but it displays a much “smoother ride” along the way.
The consequence of the “smoother ride” is that the drawdown experience is much better – as evidenced by the table and graph below:
Finally, the improved risk-adjusted return doesn’t happen only for the optimal portfolio. The chart below shows the two efficient frontiers: “No Alts” and “with Alts”.
- Slightly lower return (5.86% v 6.07%)
- Much lower volatility (4.25% v 5.84%)
- Much higher Sharpe ratio (1.32 v 1.00)
For every risk/return point along the efficient frontier for the “no Alts” option, there is a corresponding point on the efficient frontier “with Alts” that provides the same return but with less risk (as measured by standard deviation).
Adding Alts to a portfolio is not about market timing or trying to figure out the “best time to buy Alts”. It is more about blending the “right” Alternatives product/s with the appropriate portfolio in a consistent way that achieves better risk-adjusted returns in the long-run.
Next month we look at how long-only large-cap Aussie equity managers have fared in the COVID-19 market rout.
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