As We See It: Small Markets

Right to the Source ….

The current trend in the managed futures world is … expand the portfolio, trade every little market in every suspect exchange around the world to get the maximum diversification. That’s fine I guess if your goal is to create a standalone investment with the best possible Sharpe ratio. But if your goal is to diversify a broader portfolio, adding many second-tier markets may be counter-productive. Let me explain.

Right now, moves in the stock market are being determined by moves in the 10yr Sterling bond, the gilt, and as the LDI debacle unfolds and spreads into other markets. Gilts down, stocks down. All concentrated managed futures portfolios would trade the gilt, and would be short. However, if your fixed income portfolio trades a zillion different bond and interest rate contracts, the impact of that gilt short, and its diversifying character, would be diminished. It’s highly unlikely that something that happens in Sweden or Thailand would have the same impact as something that happens in the UK, a major money center. It’s the major things that cause major problems in equity and credit markets. A more concentrated managed futures portfolio is likely to have more exposure to those major drivers.

This problem gets compounded by the desire of quants to “risk adjust”. In the current environment, risk adjust means cut the gilt short because volatility has gone up. That may risk adjust for the manager, but not the holder of the broader portfolio. He now has less participation on the source of market volatility. We’ve written more about how that looks in a portfolio here and here.

Remember, what’s good for the manager’s Sharpe ratio may not be good for your portfolio Sharpe ratio.