Dirty Portfolios – James Bond(s) Version

A few months back we introduced the concept of “Dirty Portfolios”, that add Managed Futures to traditional asset mixes the same way one adds olive juice to a martini to get the infinitely preferable dirty martini. That piece looked at a variety of popular asset allocation approaches and showed that adding Managed Futures improved returns, reduced volatility and drawdowns. It can be found here and has a lot of background info worth reading if you missed it – and apologies in advance for the tortured Dirty Harry quotes.

We received a lot of good feedback! One note we received a few times; “You guys looked at a lot of stock heavy asset allocations, but what about us fixed income investors. Can Managed Futures help diversify here also?”

In keeping with the movie references, here we take a look into fixed income and “license to kill” James Bond(s) quotes. Luckily, he liked a martini already, so we are halfway there. With the Spectre of high inflation causing a SkyFall in fixed income, could portfolios have been neither shaken nor stirred? (Sorry)

A Brief History Of Bond Yields

Sean Connery’s Dr. No hit screens in 1962. The US 10-year yield was right around where it closed 2022, 3.9%. Bond yields and Bond films peak at the same time with For Your Eyes Only in the early 1980s. 14 years later, as Timothy Dalton took over, yields were still high at 8.3%. As Pierce Brosnan pulls on the tuxedo they are 6.0%, as Daniel Craig takes over, 4.6%. In particular, this past 40 years or so have been incredibly good for bond portfolios, as yields reached what looks to be a nadir early in the pandemic at 0.5%. (We’ve ignored Lazenby because…well it was just one movie. Really good one though). Additionally, taking some poetic license, “The Brosnan Years” will be referred to as “The Best Years” for the remainder of this piece.

Source: Bloomberg (US Generic Govt 10 Yr), Mount Lucas

Since the premiere of the latest (last?) movie, No Time to Die in September 2021, the Fed has raised rates 450bps. In 2022 fixed income markets, there was no place to take (A Quantum of) solace. The Bloomberg US Agg Total Return Index returned -13.0%, the largest annual loss in decades. Managed Futures strategies performed well; as a proxy, the MLM Index EV (15V) returned 36.7%. Managed Futures strategies have a habit of doing well when other markets struggle, as it tends to hone in on the factors causing distress. 2022 was no different. The year was characterized by war in Ukraine driving commodity prices higher and high inflation causing interest rates to rapidly rise from pandemic induced lows, which in turn contracted earnings multiples in equity markets. For those parts of the bond markets with credit components, spread expansion added to the duration woes. Emerging market fixed income also suffered.

For the fixed income allocator, the benefit of Managed Futures strategies is that they can be positioned either long or short directly in fixed income markets. Managers typically trade a wide variety of global bond markets at different points on the yield curve and utilize leverage. This means you don’t need to add a very large amount of the strategy to a Fixed Income portfolio to see meaningful benefits, and at the top portfolio level the Managed Futures portfolios work to move around the entire portfolio duration systematically. Managed Futures strategies also get exposure directly in other markets impacted by fixed income prices – commodity exposures participate in inflationary and deflationary themes while currency markets are often expressions of relative interest rates. Indeed, in 2022, the shorts in the Japanese Yen and longs in the oil complex helped generate returns. Over the longer term, Managed Futures strategies are uncorrelated to fixed income markets, adding uncorrelated elements to portfolios improves risk adjusted portfolio returns.

Source: Bloomberg (US Treasury Total Return Index), Mount Lucas (MLM Index EV (15V))

Portfolio Allocation – The Dirty Answer

As we did in the last piece, here we try and answer the main questions on how to use Managed Futures. How much should someone allocate? Fixed income markets are not all the same, ranging from short duration US Treasuries to long duration emerging market or high yield corporate bonds. The “right” amount of a Managed Futures allocation we think would vary depending on the type of fixed income portfolio. Different risk profiles and different asset mixes lead to different answers. We think that even the most risk averse portfolios could benefit from some amount of Managed Futures. Below we show the addition of Managed Futures to some different sectors of the Fixed Income markets, creating a “Dirty” version. As parts of the Fixed Income markets are newer than others, some of the portfolios go back farther than others. Data runs through the end of 2022. For the Managed Futures exposure we use a combination of the original MLM Index (15V) and the MLM Index EV (15V), as we believe it to adequately represent the space in a passive fashion. Portfolios are rebalanced monthly – if you want to Die Another Day…rebalance.

Summary Data

The table below shows the summary total return data over different time periods. Generally, higher total returns, lower drawdowns, similar to lower levels of volatility and much improved in 2022. Optimized solutions look for meaningful Managed Futures allocations – 20-50%.

Source: Bloomberg, Mount Lucas

Now on to the deeper dive.

The Dirty James Bond(s) Portfolios

The US Treasury Market:
We try a portfolio of 15% Managed Futures to 85% US Treasuries, using the Bloomberg US Treasury Total Return Unhedged USD Index.

Source: Bloomberg, Mount Lucas
Source: Bloomberg, Mount Lucas

The most recent period really stands out. Even a 15% allocation to Managed Futures meaningfully reduced the drawdown. The other period that stands out? The years before the pandemic where Managed Futures had a tough time. Drawdowns vs straight US Treasuries were an additional 3% or so. The additional return over the whole period still makes it compelling to us.

The mean variance optimizer chooses to allocate 19% to Managed Futures strategies, 81% to US Treasuries. Given the risk off nature of US Treasuries in many crisis scenarios, we think that’s a reasonable blend.

The Casino Royale of Corporate Bonds:
Data runs from 1976 to end 2022. We use the Bloomberg US Corporate Total Return Value Unhedged Index. For the dirty version, we allocate 75% to Corporates and 25% to Managed Futures.

Source: Bloomberg, Mount Lucas

The Dirty portfolio has a CAGR ~2.5% higher than the reference index, with half the maximum drawdown and a 2022 return of -4.0% vs -15.8%. That is a fantastic result. Corporates suffered from both the duration slide and credit spread expansion, 25% in Managed Futures would have mitigated much of it through the short positions in global bond markets on the duration side, as well as other positions which captured the areas that caused spreads to widen.

Source: Bloomberg, Mount Lucas

An optimizer given the portfolio building blocks and optimizing on risk reward allocates 73% to Corporate Credit and 27% to Managed Futures.

Municipal Bonds:

Source: Bloomberg, Mount Lucas

Here we add just 10% Managed Futures to show you don’t need a lot to make a big difference. CAGR moves up from 6.0% to 7.0%, the 2022 return is improved from -8.5% to -4.4% and the dirty version meaningfully adds to the full period return.

Source: Bloomberg, Mount Lucas

Each of the major drawdowns over the period has been reduced with Managed Futures as a complement.

Running the municipal market through a standard mean variance optimizer gives an optimal allocation of 72% to Munis and 28% to Managed Futures.

From Russia with Love – Emerging Market Debt:
We use the J.P. Morgan EMBI Global Total Return Index. Data runs from 1994 through end of 2022 (which means we miss out on all the Roger Moore years for comparison, sorry Roger). For the “Dirty” version, we add 30% Managed Futures, more than elsewhere because EM Debt is further out on the risk spectrum and has a higher volatility than other sectors.

Source: Bloomberg, Mount Lucas
Source: Bloomberg, Mount Lucas

The EM Portfolio with Managed Futures sees CAGR go from 7.3% to 8.5%, volatility drops from 12.1% to 8.6% for a return/vol ratio change of 0.65 to 0.99, with max drawdown going from -16.8% to -8%. The 2022 return would have been -16.5% vs -2.0%.

Drawdowns are lower. Most recent drawdown period shows significant improvement, a little over 5% vs greater than 20%.

Volatility is generally lower, particularly in the poor periods for Emerging Market Debt.

A mean variance optimized approach allocates about 45% to EM debt with 55% to Managed Futures. Higher than the others as EM Debt volatility is closer to that of the Managed Futures strategy.

So, what’s our 007 cents?

The analysis shows the benefit of adding Managed Futures to many different Fixed Income portfolios. Many Fixed Income investors could benefit from incorporating them and thinking of them as in part systematically altering the overall portfolio duration through Managed Futures’ Fixed Income positioning, with added potential benefits to directly approach inflation through commodity exposures.

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