Allocating to "Liquid Alternatives"


An investor should not expect to be compensated for taking on diversifiable risk, only for systematic or market risk. A useful analogy is that of a fire-fighter who willingly leaves his protective gear behind to enter a burning house and then expects to be paid more because he took on greater risk. But the risk he took was unnecessary and avoidable.

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The Importance of Correlation

Let us assume you are an investor who owns a “traditional 60/40” stock-bond portfolio. An allocation of 60% to stocks and 40% to bonds has long been viewed as a useful benchmark, albeit naive, by many investors. The recent turmoil in financial markets has led to fairly violent day-to-day fluctuations in the value of your portfolio and is causing you some concern.

You decide to consult your financial advisor about possibly taking some remedial steps. The advisor might agree in principle that your portfolio could benefit from diversification, and she might suggest that one possible way to diversify a traditional portfolio like yours is to allocate a part of it to alternative strategies, which have potentially low correlations to stocks and bonds. She suggests that a solution might be liquid alternatives such as a managed futures mutual fund. Let us explore these ideas at greater length.

Allocating to Liquid Alts: an illustration using managed futures

We use historical data for the period 2007−2016 to show some examples of diversification using managed futures. These are provided purely for illustrative purposes, and are not intended in any way to provide investment advice. Further, past returns and market behavior are not indicative of what may happen in the future. We start our analysis with a traditional stock-bond portfolio, using the following Exchange Traded Funds (ETFs) as investable proxies for stocks and bonds:

US Stocks, US Bonds, and 60/40 Portfolio

Summary Statistics (using monthly returns) as of 1/2007 - 12/2016

The Sharpe ratio was calculated using the Annualize Rate of Return on 3-month T-Bills, which was 0.78%.

Definitions of Terms

No amount of diversification or correlation can ensure profits or prevent losses. An investment in managed futures is speculative and involves a high degree of risk. You can lose money in a managed futures program. There is no guarantee that an investment in managed futures will achieve its objectives, goals, generate positive returns, or avoid losses.

Past performance data quoted here represents past performance. current performance may be lower or higher than the performance quoted above. Past performance does not guarantee future results.