Managed Futures Investments: Lowering Portfolio Volatility through Strategic Trading
In the world of investing, diversification is a key teaching from Modern Portfolio Theory (MPT) that helps investors spread their risk across various asset classes. A recent study highlights the benefits of including non-correlated asset classes, such as managed futures, in a diversified investment portfolio.
By managing allocations appropriately, extended diversification can potentially be achieved without taking on a significant increase in risk. This approach allows investors to hold onto their stocks and bonds while allocating to managed futures, without the opportunity cost of selling stocks and bonds.
The traditional portfolio, whose allocations add up to 100%, is compared to another portfolio whose allocations add up to 150%. Surprisingly, the 20/50/30 stock/bond/managed futures portfolio, with stocks contributing 36%, bonds 30%, and managed futures 34% to the risk of the portfolio, has the highest Sharpe Ratio of 0.95, making it the optimal risky portfolio for all investors.
The inclusion of managed futures, an alternative asset with potentially low correlation to equities and bonds, generally reduces total portfolio risk by lowering overall volatility and smoothing returns across different market environments. This happens because non-correlated assets do not move in tandem with traditional stocks and bonds.
When managed futures are added to a portfolio, the total risk (volatility) of the portfolio tends to decrease because the portfolio’s components do not all decline simultaneously. The systematic risk, which is the risk tied to broad market movements, can be mitigated due to exposure to different economic drivers and market factors. The idiosyncratic or asset-specific risks remain, but because these are diversified across more independent sources, their impact on the portfolio’s overall risk is reduced.
This diversification effect leads to a better risk-return trade-off, often represented as an outward shift of the efficient frontier — achieving higher expected returns for the same level of risk or the same return with lower risk. In practice, adding managed futures and similar alternatives expands the investment opportunity set beyond traditional stocks and bonds, enabling investors to construct portfolios with higher Sharpe ratios and improved resilience to market downturns.
It is important to note that non-correlation is not a guaranteed constant; correlations can shift over time and under different market conditions, so these benefits depend on the asset selection and timing. Also, while volatility and downside risk can be lowered, these assets do not eliminate risk entirely.
In summary, the inclusion of non-correlated asset classes like managed futures helps to lower total portfolio risk and improve risk diversification by reducing correlation-driven volatility, enhancing the portfolio’s resilience without necessarily guaranteeing positive returns at all times.
Table 5 shows the assumed volatilities and correlations for stocks, bonds, and managed futures. The article also discusses the effects of relaxing the constraint on the tangency portfolio, such as portfolios with 50% allocated to managed futures, but in a 60/40/50 portfolio rather than a traditional 30/20/50 portfolio.
Assumptions about the volatilities and correlations of stocks, bonds, and managed futures, as well as expected returns and the risk-free rate of interest, are based on values realized during the period 1987-2016. A 50/50 stock/bond portfolio has a risk of 8.4%, a 50/50 stock/managed futures portfolio a risk of 9.0%, and a 50/50 bond/managed futures portfolio a risk of 5.8%.
The article also discusses the impact of adding a non-correlated asset class (managed futures) to a portfolio on total portfolio risk and its components. The risk of the 50/50 stocks/managed futures portfolio is 28% lower than their average risk, while the risk of the 50/50 stock/bond portfolio is 16% lower than the average risk of stocks and bonds.
A portfolio in which the risk contributions of various components are equalized is sometimes called a "risk parity" portfolio. Table 6 shows the risk of hypothetical portfolios with a range of allocations to stocks and bonds, with the balance allocated to managed futures. MPT imposes a constraint on the tangency portfolio that the allocations sum up to 100%, even when borrowing or lending is involved.
A risk-averse investor can invest 50% of her total wealth in T-Bills earning 1% and 50% in the tangency portfolio, reducing risk to about 2.7% with an expected return of about 3%. A more risk-tolerant investor can, in theory, borrow say 75% at the risk-free rate and leverage the risky portfolio to 175%, taking on greater risk of about 9.5% while seeking to earn a higher return of close to 9%.
References: [1] [Article 1] [2] [Article 2] [3] [Article 3]
- Leveraging technology and data-and-cloud-computing can aid in analyzing and managing allocations in a diversified investment portfolio, including those with managed futures, thereby potentially improving the risk-return trade-off and expanding the investment opportunity set.
- By integrating finance, technology, and data-and-cloud-computing solutions, investors can tap into the benefits of including managed futures in their portfolios, such as lowering total portfolio risk, reducing correlation-driven volatility, and enhancing the portfolio's resilience, while keeping track of assumptions about the volatilities and correlations of stocks, bonds, and managed futures.
