Sunday, December 07, 2008

Varying the Allocation to Managed Futures

The chart (the y-axis is logarithmic) shows the effect of varying the allocation to managed futures from 10% to 90% (with the remainder of the portfolio in the MSCI World Index) for the period of the last eleven years. To avoid any drawdown during the 1998 crisis (which looks so insignificant now) you needed an allocation of 40% to managed futures. To avoid drawdown in the 2000-02 bear market about 50%, while in the current crisis a 70% allocation has been necessary (which is close to the maximum Sharpe ratio portfolio). As I noted in yesterday's post, there are good reasons not to allocate so much to managed futures. Still these kind of results might make you rethink allocating so much to stocks or at least index funds.

Enoughwealth commented on yesterday's post asking what would the optimal allocation be from the point of view of July 2007 - i.e. before the current financial crisis started. Using data from October 1996 to July 2007 the Sharpe ratio is maximized for a portfolio that is 45% in stocks and 55% in managed futures. Borrowing 32 cents per dollar of equity results in the same volatility as stocks and a 1.5% average monthly return (Sharpe = 1.03) vs. 0.79% for stocks (Sharpe = 0.44). BTW the unleveraged portfolio with the maximum Sharpe ratio is the optimal portfolio in the Markowitz portfolio allocation model. One can then mix that portfolio with a cash allocation or leverage it up depending on your risk preferences.


The optimal Sharpe-Markowitz allocation only takes into account the means, variances and covariances of the two return series. It doesn't take into account higher moment correlations, which are important for understanding the attraction of managed futures.

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