Most investors know and understand the traditional 60:40 portfolio of stocks and bonds. There are many other model portfolios, with clever names and metaphors, out there blending different weights and different assets. Almost all benefitted from the low rate, low inflation market environment. So far, 2022 has been difficult across the board for these models as stocks, US Treasuries, and credit have all fallen, and even short-dated bonds have not helped.
To keep things interesting, we illustrate the role of Managed Futures in the portfolio below while having a bit of portfolio naming fun. We start with several of the more popular asset allocation models and garnish them with some Managed Futures. The same way adding an olive to a martini makes a dirty martini, can we enhance a classic by adding a Managed Futures “twist” and creating a “dirty” version? Apologies in advance as we then torture the ‘dirty’ reference with Clint Eastwood quotes.
The primary role of Managed Futures strategies is to diversify the portfolio, and allocators should always strive to evaluate those strategies under that context. When accessed through a pure trend following approach, Managed Futures offers an uncorrelated, positively skewed portfolio element with a positive expected rate of return that can complement the broader portfolios of equities, credit, and real estate.
The risk premium earned by investors participating in Managed Futures inherently has a different driver than equity markets. Think simply about how Goldman Sachs is structured. The investment bank side raises money for everything from companies to municipalities through equity and credit underwriting. The other side manages trading desks to facilitate the risk transfer of exogenous operational price risks that impact the running of a business. Both are risk premiums that companies face; markets exist to transfer them to investors. These two risk premiums are complementary, but they need to be accessed differently. One funds economic activity by investing in equity and credit securities from the long side, directing capital to those who seek to expand and transfers their capital risk. The other takes on exogenous input and output cost risks in commodity prices, currency movements, and changes in interest rates, facilitating hedging that allows businesses more price certainty in operations while focusing on their core expertise. Crucially, this risk premium needs to be accessed from both sides of the market: trend following long and short. The combination of the two risk premiums is very attractive, as one side thrives on stability and rising growth, while the other thrives in times of economic uncertainty and macro volatility that typically hurts equity and credit investors.
Put simply, where the investor premium in equity and credit markets looks for cash flows, the investor premium in the futures markets looks for “crash” flows.
Portfolio Allocation – The Inflation Problem
Traditional portfolio construction generally assumes holding long positions in different asset classes and relying upon low asset correlations to build better portfolios. Over the last few decades, an environment of declining bond yields and low inflation meant that, generally speaking, bond prices would rise any time stock markets fell meaningfully. As markets began to price that, in the event of any serious economic slowdown or episode of poor market functioning, the Federal Reserve would come to the rescue and cut rates. Somewhere during the pandemic this reached a nadir on two fronts. First, bond yields in developed markets reached such low levels that price appreciation on bonds became difficult to envisage. Take a typical 10yr bond with a duration of 8 for example. Starting at 400bps yields and dropping to 200bps would make 16% (simplified for ease). With yields bouncing around 50bps, it is hard for long dated yields to move meaningfully lower. Second, the stock bond correlation of the past 40 years generally relies upon inflation being reasonably low and steady. When inflation is notably higher, the economic link between stocks and bonds starts to break down as the Fed is less willing to reduce rates. Welcome to 2022 – both stocks and bonds have fallen. Those that use leverage to increase the risk profile of stock and bond portfolios have been particularly hurt. Sometimes bonds can diversify stocks, sometimes bond price falls can be the driver of what is hurting stocks.
For the portfolio allocator, the benefit of adding Managed Futures is that it can be either long or short different assets, giving it the ability to adapt positioning across different market regimes, including getting short bonds early this year. How long does the current regime last? No one knows, but as a portfolio element (2022 through the time of writing at the end of Q3), Managed Futures has diversified stock and credit portfolios pretty well, similar to the experience of previous crises in 2000 and 2008 (albeit those were deflationary, not inflationary).
Portfolio Allocation – The Dirty Answer
Yet, decades of complacency have left portfolios underexposed to investments that have historically done well in times of price uncertainty and volatility, and ill-equipped to handle the current market environment. For the allocator looking for exposure to these factors, several questions come to mind when considering Managed Futures. How should they be used? What allocation should they get? Great questions. The tough part- the answer is, as always, client driven. Where you stand, depends on where you sit. Different risk profiles, different asset mixes, different goals lead to different answers on what is right. Returns? Drawdowns? Volatility reduction? All fine ways to frame the approach.
To answer some of these questions, and to prioritize how typical investors allocate capital, we show the addition of Managed Futures to some typical portfolio allocations, creating a “Dirty” portfolio. As many of the portfolios have different asset mixes for which data isn’t always readily available, some go back further than others. Data runs through the end of Q3 2022. For the Managed Futures exposure we use the MLM Index EV (15V). We believe it to adequately represent the beta in the space while having some features that make it particularly useful as a diversifying portfolio element. In short, the MLM Index EV (15V) doesn’t contain equity markets, it does not adjust position sizes for volatility, and it passively represents the beta to pure trend following.
The analysis below uses common interpretations of each portfolio approach and represents them with total return building blocks, shown on a monthly rebalance schedule. Do not underestimate the importance of rebalancing in an asset allocation with uncorrelated, volatile components- closest thing you get to a free lunch in finance.
Much as we like the details and minutiae – some folk want to cut to the chase. What happens when you add Managed Futures to popular portfolios and make a dirty version? The table below shows the top-level stats over the time horizon, as well as 2022 and the Managed Futures allocation an optimizer wants. Portfolio allocations are sourced from http://www.lazyportfolioetf.com/ and re-created with representative asset class indices.
Now on to the deeper dive.
The Dirty Portfolios
The Harry Browne Permanent Portfolio:
25% stocks, 50% bonds split by maturity, and 25% Gold. Data runs from early 1992 through end of Q3 2022. For the dirty version, still equally splitting things, but adding Managed Futures.
“It’s a question of methods. Everybody wants results, but nobody wants to do what they have to do to get them done.”Clint Eastwood as Dirty Harry in Sudden Impact (1983)
The Permanent Portfolio with Managed Futures sees CAGR go from 6.6% to 7.5%, volatility drop from 6.3% to 5.7% for a return/vol ratio change of 1.04 to 1.30, with max drawdown going from -16.8% to -8%. 2022 through Q3 would be -16.8% vs -5.8%.
Drawdowns generally lower over the period, but not always. Most recent drawdown significant improvement.
Volatility is generally lower, particularly in poor periods for stock and bond markets.
A mean variance optimized approach allocates 19% to US stock, 51% to short term US Treasuries, 6% to long term US Treasuries, 4% to gold, and 20% to Managed Futures. Looks pretty reasonable.
The Margaritaville Portfolio:
Proposed by Scott Burns in 2004 who suggests his traditional margarita consists of three equal parts, and his “lazy” asset mix follows suit with a 33% allocation to TIPS, International Stock, and US Stock. Internal debates aside on the proper Margarita recipe, this formula works well enough. It also fits with our theme nicely, but an olive in a Margarita sounds awful. And yet many people still (incorrectly) put ketchup on hot dogs…
“You know what makes me really sick to my stomach? Is watching you stuff your face with those hot dogs. Nobody, I mean nobody puts ketchup on a hot dog.”Clint Eastwood as Dirty Harry in Sudden Impact (1983) – again.
Let’s see what adding an olive to a Margaritaville Portfolio tastes like?
Maybe adding an olive to a margarita isn’t such a bad idea! CAGR goes up ~1% annualized, from 6.0% to 7.3% and volatility drops from 10.9% to 7.8%. That’s an improvement on both sides of the ledger when it comes to the ratio, going from 0.60 to 0.95. Drawdowns go from -39.5% to -22.8%. 2022 so far would have a drawdown of -6.7% with the Dirty Margaritaville rather than -21.3%.
Each of the major drawdowns over the period has been reduced with Managed Futures as a complement.
Volatility consistently runs lower, particularly in crisis periods.
Running the Margaritaville portfolio through a standard mean variance optimizer gives an optimal allocation of 22% to US stock, 0% to international stocks (as they are strongly correlated to US stock with lower returns over the whole period), 47% to TIPS and 31% to Managed Futures.
The Swensen Lazy Portfolio:
This comes from the Yale University CIO David Swensen and includes a Real Estate Investment Trust (REIT) allocation at 20% to the usual stock and bond mix. Data runs from early 1999 to the end of Q3 2022.
Yet another “lazy” portfolio, but to loosely quote our thematic protagonist yet again from The Dead Pool (1988), “Portfolios are like Opinions. Everybody has one.” While we hope to have successfully cleaned up that iconic reference, let’s make the Swensen approach “dirty.”
This portfolio benefits from how well REITs have done the past 20 years. CAGR runs at 6.4% vs 7.1% with Managed Futures added at 20%. Where Managed Futures shine here is in volatility and drawdown reduction – volatility drops from 11.33% to 8.6%, drawdowns reduced from 42.7% to 28.7%. The rough ride of 2022 so far, a loss of -22.5% is reduced to -10.9%.
2022 stands out for lower drawdowns, as we suspect that REIT exposure this year has hurt more than stocks and bonds. Managed Futures gains reduce the overall portfolio loss.
Volatility consistently runs lower, particularly in crisis periods, running typically a few percentage points lower.
The mean variance optimizer chooses to allocate 23% to Managed Futures strategies, 13% to US stock, 20% to TIPS, 40% to bonds with largely de minimis allocations to non-US developed and emerging stocks (again likely as they have underperformed US stock with a high correlation). Although likely very end point specific, REITs also don’t get much weight from the optimizer.
The Armstrong Ideal Portfolio:
From Frank Armstrong’s book The Informed Investor, it keeps bonds at 30%, allocates 31% to non-US stock, splits a further 31% among US stocks with a small value tilt and adds an 8% REIT allocation. Data runs from June 1996 to end Q3 2022. What would make it more Ideal in our eyes?
“Go ahead. Make my day!”Sudden Impact (1983)
This portfolio has a CAGR of 6% annualized over the period, reducing allocations pro rata, and adding 20% Managed Futures increases the CAGR to 7.1%. Volatility drops to 8.3% from 11% (the benefit of adding uncorrelated return streams). This is also borne out in the drawdown stat, moving from -40.8% to -27.0%. 2022 through the end of Q3 shows a loss of -18.7% for the Armstrong Ideal Portfolio being reduced to -7.4% with the dirty version.
In each of the drawdown experiences over the portfolio histories, we see the “dirty” portfolios showing smaller losses and generally faster returns to high water marks. One of the underappreciated benefits of regular rebalancing uncorrelated strategies is that gains made in one area get recycled into asset classes that have lost value.
Volatility is consistently reduced with the addition of Managed Futures strategies, particularly in the extreme values like the 2008/09 crisis and over the past few years of pandemic and then inflationary rate rises.
An optimizer given the portfolio building blocks and optimizing on risk reward allocates 69% to short term US Treasuries, again avoids non-US stock, and then allocates ~12% to US equity, 2% to REITs and 16% to Managed Futures.
The Larry Swedroe Minimize Fat Tails Portfolio:
This one flips the traditional 60:40 portfolio on its head and allocates more to bonds at 70%, splitting that equally between TIPS and regular US Treasuries. The equity allocation at 30% is equally split 15% each in US small cap value and 15% emerging markets. We show data from early 1999 through the end of Q3 2022.
Adding 20% Managed Futures gives us the “Dirty Larry”, a bit on the nose at this point in the metaphor perhaps, but it’s worked well so far…
“I hate the system, but until someone comes along with changes that make sense, I’ll stick with It!”Magnum Force (1973)
Let’s find out if we should, indeed, stick with it?
This is an interesting one: the most bond heavy portfolio we have looked at so far. Given the fat tails referenced in the name, and the stock bond balance, it seems like this is predicated on bonds not being generators of fat tails. 2022 is an interesting test case. Overall CAGR is 5.5% for the standard portfolio version. Adding Managed Futures at 20% to make it a “dirty” portfolio increases that CAGR to 6.2% and drops the volatility from 6.3% to 5.1% for a ratio change of 0.87 to 1.22. The maximum drawdown in the original is -19.5%, the dirty version clocks in at -10.8%.
Over the past 20 years or so (and arguably the past 40 years of monetary policy regime) that we examine, bonds have been uncorrelated to stocks and, generally speaking, have gone up when stocks have gone down. Broadly, those are the same characteristics as Managed Futures. In 2022 though, we have a different regime – starting yields were very low and inflation has meant yields going up at the same time as stocks are going down. Managed Futures can be long or short markets. Short fixed income, long USD, and long commodity exposures in Managed Futures have been much more preferable in the inflationary 2022 than long fixed income exposure, which has been difficult. The most recent drawdown period illustrates this well.
Volatility profiles are generally similar, the dirty portfolio appears to have less spikes.
The optimizer looks to allocate 15% to Managed Futures in this bond heavy portfolio with 20% to TIPs, 54% to short dated US Treasuries, with 9% to US Equity and approximately 2% to Emerging Markets.
The 60:40 Portfolio:
There may be no portfolio more “classic” than this. Do we dare to make a “dirty” version?
“You’ve gotta’ ask yourself a question. ‘Do I feel lucky?’ Well, do ya…Punk?”Dirty Harry (1971)
We have data going back to early 1976 through the end of Q3 2022 and use the S&P 500 and Bloomberg US Aggregate Bond Index.
Almost 50 years of data. A CAGR of 9.5% for 60:40, with 9.7% annualized volatility and -32.5% drawdown. The “dirty” portfolio, with its addition of 20% Managed Futures, sees CAGR go to 11.3%, volatility drop to 8.3%, and maximum drawdown drop from -32.5% to -20.6%. That’s a pretty good outcome. Lucky? Hardly.
2022 through end of Q3 for the 60:40 is not quite as bad as it gets, but it is certainly notable at -20.1%. The “dirty” version: a much more manageable -8.8%. Like in 2008/09 period and the tech bubble unwind, Managed Futures strategies again have proven to be a great diversification element.
An optimizer looks to allocate 21% to Managed Futures strategies, 19% to stocks and 60% to US bonds.
We will keep this short. For those looking to add Managed Futures strategies to other assets and model portfolios, there are many reasonable options depending on your different goals and risk tolerances. It always comes down to this: build a good portfolio of strong diversified elements that each do their job, and then rebalance. We think the starting point is to take the portfolio constructs you like – Margaritaville, 60:40, Permanent Portfolio etc. – and make a “dirty” version with Managed Futures at 10-20% or so, depending on your tastes.
Why do they call me the Dirty Portfolio? “I get every dirty job that comes along.” – Dirty Harry (1971)