We frequently get the questions from advisors and clients, “How much should I allocate to managed futures and how should I fund the allocations?” Answering this brings to mind a quotation, attributed to a range of people from Yogi Berra to Albert Einstein. It goes, “In theory there is no difference between theory and practice. In practice there is.” That encapsulates the challenge advisors face when thinking about managed futures, even once they’ve made the decision that the strategy deserves a place in a portfolio. There are real behavioral reasons why people may not be comfortable with managed futures, but statistically and empirically, after this year especially, we don’t think there’s a strong argument against including managed futures. However, when going back to the implementation issues, for most advisors, theory and practice are only loosely related. We try here to provide some guidance that may help in these considerations.
- Because managed futures have the potential to bring diversification benefits to a portfolio, based on the statistics, you should hold about as much in managed futures as you can confidently defend when the strategy isn’t performing well. (Almost no one allocates as much as an optimizer would suggest.)
- Despite the potential long-term benefits, managed futures can sometimes be frustrating for extended stretches. Sizing them appropriately is important.
- A managed futures allocation should be big enough to move the needle in your portfolio when it’s working, otherwise the inevitable challenging periods along the way will hardly be worth it.
- But the allocation can’t be so big that you (or your client) will throw in the towel during rough patches.
- The best asset allocation is one that you can stick to for the long term, including through down periods for every component asset class or strategy.
- We believe an allocation to managed futures in the 5% to 10% range is the practical sweet spot for most balanced portfolio investors (although higher allocations are well supported by the statistics).
- We’d fund the allocation from roughly a pro rata mix of stocks/bonds, or for more risk-tolerant investors, somewhat more from bonds given equities’ higher expected long-term returns.
Impact of adding managed futures to a balanced portfolio
If you look at adding managed futures pro rata to a 60/40 portfolio at various allocation levels, starting with 5% managed futures and increasing at 5 percentage point increments up to 25% managed futures (1/1/2020 through 9/30/2022, rebalancing annually), each additional notch higher in the managed futures allocation modestly increases returns since inception, and significantly decreases the portfolio’s standard deviation, thus also materially increasing risk-adjusted return measures (i.e., the Sharpe Ratio and Sortino Ratio).
These measures are impressive, but –to mangle an investment adage– you can’t eat Sharpe Ratio. The investor/client experience is usually driven much more by absolute numbers, positive or negative. Looking at the reduction in drawdowns in various crisis periods may be the most valuable way to understand the real-life implications of a managed futures allocation.
Below we show the reduction in drawdowns of a 60/40 portfolio with the managed futures combinations, using as examples the bear market following the Tech Bubble (2000-02); the Global Financial Crisis bear market (2007-09); and the current inflation/rate-driven bear market. Historical episodes hopefully have some resonance with clients, but there’s nothing quite the same as actually living through a bear market like the current one to reinforce the power of diversifying strategies.
Once again, the numbers are impressive. Even a small 5% allocation to managed futures would have saved you about 2.3 percentage points of performance this year – from a loss of 20.2% to 17.9%. A “bold” 10% allocation would have come close to cutting losses by a quarter!
How much should you allocate to managed futures?
The answer doesn’t come from looking at an optimizer. If the goal is increasing risk-adjusted returns, an optimizer would tell you to allocate more than any client or advisor we’ve met is comfortable with, typically in the range of one-third of the portfolio with some variation higher or lower depending on the measurement period. This is one case where the decision should clearly be based on more than numbers. The practical constraint on sizing allocations to highly diversifying strategies like managed futures tends to be how much of your portfolio you (or your clients) are comfortable holding in an unconventional strategy that’s “not working,” potentially for an extended period. This can be particularly challenging during periods when traditional, simple, easy-to-understand stocks and bonds are doing well at the same time managed futures are struggling.
Why would an optimizer tell you to invest so much in managed futures? Simply put, because the strategy (as measured by the SG CTA Index) has similar long-term returns to a 60/40 portfolio, but with essentially zero long-term correlation to both stocks and bonds: -0.09 correlation to the S&P 500 Index from January 2000 through September 2022, and 0.08 correlation to the Bloomberg Aggregate Bond Index (using monthly returns). Rolling 12-month correlations range between about -0.8 and +0.8 for both, with the potential for dramatic shifts over short timeframes. This makes intuitive sense given the potential for managed futures to be long or short any asset class. The combination of the potential for long-term positive returns with no correlation (and a propensity to perform well during market dislocations) makes the strategy a potentially valuable addition to a portfolio.
How should you fund a managed futures allocation?
Because managed futures have essentially no long-term correlation to anything, it makes sense to fund them pro rata from an existing allocation. The existing allocation has presumably been “optimized” for the investor’s return goals and risk tolerance based on the performance and correlation characteristics of its underlying components. Funding pro rata from these sources should preserve the potential return profile of the portfolio’s core, while adding the diversification benefits and (likely) crisis alpha of managed futures.
A reasonable case could also be made to fund an allocation more than pro rata from bonds, given stocks outperform bonds over long time horizons, and managed futures tend to perform well during extended stock market weakness (i.e., periods of weeks to months, not days to weeks). The “optimal” allocation depends on what is being optimized (risk-adjusted returns, potential maximum total return, etc.). For a client that is more concerned with risk from a specific asset class, or has some other consideration, the funding sources could of course be customized further according to individual circumstances.
Opportunity costs should factor into this calculus, particularly as an allocation becomes larger. To pick an extreme (and unrealistic) example for effect, if a managed futures allocation was funded entirely from equities beginning in 2015, the opportunity cost of that decision would have been huge over the next five years, as managed futures were essentially flat cumulatively, while the S&P 500 was up over 70% and a 60/40 portfolio was up almost 50%. One could of course find counterexamples, but the point is simply that the further one moves away from pro rata funding, the more it becomes an active “bet” against existing asset allocation, and the greater the chance of an extreme outcome that could derail an otherwise successful investment plan.
The long-term numbers tell us that if maximizing risk-adjusted returns is your goal, you should hold about as much in managed futures as you can confidently defend to yourself or a client when the strategy isn’t performing well. As we have experienced many times during the 7+ years we have been investing in managed futures, they can be frustrating for extended stretches before working. This leads to two conclusions. First, the familiar, almost trite (but true) reminder that the best asset allocation is one that you can stick to for the long term. Second is the recommendation that a managed futures allocation should be big enough to move the needle in your portfolio when it’s working, otherwise the inevitable challenging periods along the way will hardly be worth it. But, the allocation can’t be so big that you (or your client) will throw in the towel during rough patches. It can be a tricky needle to thread, but one that we believe is well worth it when considering the long-term benefits to a portfolio. We believe an allocation to managed futures in the 5% to 10% range is the practical sweet spot for most balanced portfolio investors. We’d fund the allocation from roughly a pro rata mix of stocks/bonds, or for more risk-tolerant investors somewhat more from bonds given equities’ higher potential long-term returns.