This is an excellent piece from JP Morgan Asset Management and GIC. It presents a different framework for institutional investors looking to diversify away from traditional portfolios, making the case that portfolio starting points play a large role in where you should end up. The paper starts by classifying hedge funds by their risk/return profiles, with Managed Futures strategies going into the Loss Mitigation sub-group. They then examine the optimal allocations to the sub-groups and show that standalone hedge fund allocations should be different than hedge fund allocations that are being integrated into 60/40 portfolios. They conclude a few important things:

Correlations

First, they note that hedge funds classified as Managed Futures, Commodities and Macro have lower equity correlations while Equity, Event Driven and Credit are more correlated to stocks.

This is one of the beauties we see in Managed Futures and Macro and why they work so well in broader portfolios. The economy is cyclical, so fixed income and stock markets inherit that cyclicality. Commodities are rarely in equilibrium, cycling between oversupply and undersupply. Traditional portfolios are dominated by long exposures, which rely only on the right-hand side of a return distribution. Managed Futures and Macro are one of the few places where you can get access to the short side of a return distribution, the down part of a cycle. The other factor that drives the lower correlations – commodities and currencies are just more different from each other than equities are from each other. Sugar is nothing like cattle and nothing like silver or natural gas – completely different supply/demand pictures. While individual companies have their own fundamentals, sales cycles and market wide multiples drive a large part of valuation. The economic cycle is a common factor.

When building multi-asset optimized portfolios, being able to maintain the low or negative correlation throughout regimes and having a positive expected rate of return is the holy grail. The investing world witnessed this in 2022 as the long since forgotten phenomenon called inflation ran through stock and bond portfolios like a bad lunch. Managed Futures? Kept the negative correlation and provided positive returns; it is generally a regime agnostic strategy. More details in this piece. The times it struggles are during periods of particularly low macro volatility, typically quite good for traditional assets that prefer the stability of cash flows and abhor the instability of crash flows, which Managed Futures craves.

The chart from the piece that highlights the performance in equity drawdowns is also important – while Managed Futures is generally uncorrelated most of the time, in stress periods it has been negatively correlated and produced positive returns.

The chart below illustrates the remarkable consistency Managed Futures has shown during equity drawdowns relative to other alternative investments. This is a fairly high hit rate for Managed Futures and Macro strategies, certainly compared to Event Driven, Credit and Equity strategies.

Asset Allocation

The second conclusion that jumps out is that optimal allocations to underlying hedge fund strategies are very dependent on whether there is a broader portfolio concern in the background. Standalone hedge fund portfolios will likely want more exposure to stocks and credit than hedge fund portfolios that are being built to complement or diversify broader portfolios that already contain equity and credit. We completely agree. Equity and credit portfolios are generally thought to be negatively skewed. In our view, the right thing to do when adding hedge fund exposure to an existing portfolio is to look for strategies that can be negatively correlated, aim at the highest positive skew possible, and then rebalance fairly aggressively.

For many investors, Managed Futures are a portfolio element, slotting into broader portfolios. As we built our Managed Futures strategies over the years we have stayed investor focused, always keeping the broader portfolio goals in mind.

Over the past couple of decades many public pensions have reduced public equity exposure in favor of private equity, private credit, real estate and fixed income. The volatility laundering debate notwithstanding, if one believes they have less equity beta, then having a Managed Futures strategy that takes equity exposure may be a fine decision. If one has a portfolio that is already heavy public equity, then skipping additional long equity exposure inside the Managed Futures strategy may be more appropriate. It is the same with volatility targeting positions. In a standalone hedge fund allocation that is optimizing solely for that portfolio, volatility targeting positions may be a fine thing to do. We are not against it in all circumstances – our view is that where you stand depends on where you sit. If you sit with a large equity portfolio that doesn’t volatility target itself, you likely want a Managed Futures strategy that doesn’t volatility target either. In that world, one should optimize for the broader portfolio and make decisions that most help the whole. We have written more on that skew maximizing approach here.

This last JPM/GIC chart is excellent.