Optimal Portfolios

I have been doing some experimentation with designing optimal portfolios, something which I last looked at in 2011. I have the monthy rates of return on various asset classes going back to 1996. These include international shares (MSCI World Index, gross) both hedged into Australian Dollars and not. Australian shares (ASX 200 accumulation), Managed Futures (a mix of Man AHL and Winton), direct real estate (a particular US fund as a proxy), hedge funds (HFRI index), the bond market (again I'm using a fund as a proxy), Australian Dollar cash, and gold in Australian dollars. You can use the solver in Excel to find the allocation that monthly rebalanced gives the highest Sharpe Ratio. This optimal portfolio varies over time but generally it doesn't like hedge funds and allocates about 10-20% to gold, and 20-40% to managed futures. Because future performance won't necessarily be the same as past performance (particularly a worry for managed futures) and because managed futures, in particular, are not tax effective – they pay most income out subject to marginal tax rates – I wouldn't allocate according to a particular optimization. A target portfolio gets near the optimal performance while being more diversified and a bit more tax effective:

This graph shows the performance of various assets and a "target portfolio":

Here the target portfolio is 25% international shares (half hedged into Australian dollar and half not), 25% Australian shares, 25% managed futures, and then 5% in each of real estate, bonds, cash, gold, and hedge funds. Then the whole thing is geared up a bit with borrowing. It performs pretty nicely over various historical periods.

Here we have a close up of performance since the financial crisis:

I've managed to match the performance of the Australian index but have lagged behind the MSCI World Index. It matches the performance of the MSCI but has a smoother path. The next graph shows ten year rolling returns:

Here we see that such a portfolio clearly dominates in the long-run over regular stock indices or my own performance, which has not been good over a ten year period recently. The graph also shows how the performance of the Australian stock market has declined. It had very high ten year  returns prior to the crisis, but now has lower returns than international shares over the last ten years.

I have been moving in the direction of the optimal portfolio by diversifying out of Australian shares and buying managed futures, but it has been too slow so far. In the last few months I have been buying $A10k of managed futures each month. I also allocated more to international investments when I reinvested my CFS superannuation fund in their wholesale funds.