Hedge Funds vs. Managed Futures

In recent posts I have looked at the optimal allocation between stocks and managed futures and between stocks and a composite hedge fund index. The Sharpe Ratio maximizing choice of managed futures was between 55 and 75% of the portfolio depending on the sample of months used. When choosing between stocks and hedge funds though the Sharpe Ratio was maxmized when the whole portfolio was allocated to hedge funds. In fact it was even better to short stocks and go long hedge funds.

But what is the best choice between a generic hedge fund index and a managed futures fund? Using data on the Credit Suisse/Tremont Index and the Man-AHL Diversified Fund for October 1996 to October 2008 the Sharpe Ratio is maximized for an allocation of 30% to the managed futures fund and 70% to the Hedge Fund Index. This portfolio has only slightly higher volatility than the hedge fund index (2.31% vs. 2.14%) and a higher return (1.012% vs. 0.787% per month). By borrowing 72 cents for each dollar invested you could boost returns to the level of the managed futures fund - 1.54% per month with less volatility (3.97% vs. 5.16%) and a slightly lower volatility than stocks.

I've also run portfolio analyses including the MSCI, Man-AHL, Credit Suisse/Tremont, and the TIAA Real Estate Fund and CREF Bond Fund to represent two further asset classes. The maximum Sharpe Ratio was for a portfolio 100% in the real estate fund...

In the real world taking into account tax and other considerations, limitations on leverage (or safer forms of leverage), higher moment correlations, and likely higher future returns from stocks (than in this lost decade period) the best portfolio probably wouldn't be as extreme as these simple analyses indicate. But it would be very different from most people's portfolios and much more similar to the university endowment portfolios. I'll analyse some endowment type portfolios in my next post.