Saturday, December 06, 2008

Optimal Allocation to Managed Futures

This post follows up from my recent posts about managed futures including this one on their diversification benefits. The Ibbotson-Pimco study suggested allocating a very large share of a portfolio to managed futures. I ran a simple experiment in a spreadsheet to find the optimal allocation between the MSCI World All Country Gross Index and the Man-AHL Diversified Fund. I use monthly returns from October 2002 to November 2008:

The correlation between these series is -.12 and as you can see the correlation seems to get more negative when more extreme returns are experienced as was discussed in the Altevo Research study. Not all correlations go to one in a financial crisis... The allocation which maximizes the Sharpe Ratio is 34% in stocks and 66% in managed futures. This is designated the composite portfolio:

The returns of this portfolio have a 0.33 correlation to the MSCI but a 0.90 correlation to the Man-AHL fund. Stocks returned 0.60% per month over the period with 4.56% standard deviation (Sharpe = 0.237). The Man fund returned 1.25% per month with a 5.05% standard deviation (Sharpe = 0.663). The composite portfolio returns 1.03% per month with a standard deviation of 3.50%. We can then lever this portfolio to increase returns. Borrowing 30 cents per dollar of equity results in the same volatility as the stock portfolio and a return of 1.27% per month on average (Sharpe = 0.751).

What are the downsides of a portfolio of this type? First, you would be assuming enormous manager risk - even though you could diversify across a small number of managers, all the best managers have developed their techniques from a common origin. Second, the strategies involve short-term trading and may not be as tax efficient as stock mutual funds. But this will depend on the fund structure, your jurisdiction, and whether you are holding the investment in a retirement account or not.

At the moment I only have 1.67% of assets (2.7% of net worth) allocated to managed futures. Moominmama has 2.2% in the Man-AHL Diversified Fund. My long-term target is to allocate 12.5% of assets to managed futures. But even this gives relatively little diversification benefit.

2 comments: said...

I have about $50K worth of MAN OMIP series funds (which I think are similar to the one you used in your analysis - as usual I'm too lazy to do any research), which is about 5%-10% of my asset allocation (depending on whether my home is included as an "investment").

The biggest problem I see with your optimised allocation is that the analysis is based on 6-years data and the period includes a 1-in-100 stock type financial crisis.

If you only used data up to July 2007, wouldn't you get a much lower optimal allocation to the managed hedge fund asset class?

If we don't have another great financial crisis in the next 20-30 years, a 65% asset allocation to managed hedge funds would be far from the efficient frontier.

Beware recency bias ;)

mOOm said...

Well the Man fund performed better prior to 2002 than since :) See today's post which has eleven years of data. The optimal allocation for that full period is higher still to the Man fund. But it is a good idea to check how things would have looked up till July 2007. I'll do that right away. As I don't have a self-managed super fund I can't do such a big allocation anyway... but may be a reason to go down the SMSF path in the future.