The art of asset allocation

by Daniel P. Collins

Diversification is a goal of nearly every portfolio manager and trading program. Even long-only mutual funds benchmarked to some broad market index claim to be diversified among large cap, mid cap and small cap equities, and to certain segments of the investing world that qualifies. 

We, however, realize that a long-only equity portfolio, while a solid part of any portfolio, is tied to equity markets and is not diversified. Accordingly, the typical mix of bonds and equities does not create optimal diversification. In 2008, many investors learned that every alternative is not equal. Many investors with a liberal allocation to hedge fund alternatives realized even those "alternatives" were tied to equity markets. Equity short notwithstanding, equity based hedge funds tend to be tied to the equity sector. These are legitimate strategies and many of them have performed quite well recently, but if you goal is to be non-correlated to equities, you have to go somewhere else. 

Managed futures, as a stand alone product, appears to be much more diversified as they can be long or short in such diversified sectors as currencies, interest rates, grains, stock indexes, energies, metals and softs. Yet even those particular programs that concentrate on one sector look to diversify within that sector. For example, currency strategies have an entire world of different currencies they can trade (see "Forex: One sector, multiple strategies," September 2010). "The currencies markets have extremely good liquidity, it is deeper than the equity markets," says Sol Waksman, president of BarclayHedge. 

You also can gain diversification by trading the same sector in different ways. FX Concepts managed nearly $1 billion in trend following forex strategies before expanding with carry trade and eventually option writing strategies. 

So, diversified commodity trading advisors (CTAs) offer a more diversified stand alone investment than any long-only mutual fund, yet they know that they are just one portion of a wider portfolio. And more and more investors are realizing that as managed futures have seen solid growth in the last few years, other alternatives have lost ground (see "Head of the class," below).

Lee Partridge, portfolio strategist for the San Diego County Employees Retirement Association, said in a Futures interview, "Diversification really doesn’t come from the number of positions you have in the portfolio or the number of managers that you have. It really goes back to how many different return streams you have that are clustered together and how many of them are fundamentally different than one another (See "A diversified approach to diversification," August 2010).

Partridge doesn’t follow the typical categories managers and databases place themselves in, rather, he breaks down markets into return streams and what drives positive and negative performance in each. He says the three key drivers are the rate of growth in the global economy, the rate of inflation and the level of risk aversion versus risk appetite. 

Therefore, Partridge will look to invest in equity-based hedge funds and those allocations will be placed in his equity bucket. He allocates 10% to divergent strategies and 10% to market neutral relative value. 

Legendary CTA Mark Rosenberg ,chairman of Ssaris Advisors LLC, has long built alternative portfolios based on a mixture of convergent and divergent strategies. While not every alternative strategy falls neatly into one of those buckets, divergent strategies look for large dislocations in the markets they trade, with trend following CTAs being a classic example; whereas convergent strategies tend to be based on reversion to the mean principles. 

Ssaris Senior Vice President Prav Sambamurti says, "Convergent strategies perform well in a normal market environment with stable to declining volatility when fundamental information is processed and interpreted rationally, whereas divergent strategies benefit from periods of imperfect information."

Sambamurti also points out that many convergent strategies lack the liquidity offered in managed futures. Waksman agrees and says that is one of the reasons for the emergence of managed futures. "Prior to 2008, investments were made on assumptions based on return on investments. Now people are taking into account the risk based on return of investment. If you are taking risk, a liquidity risk, how much should you be compensated for that, how do you quantify that," Waksman asks. 

What that means is that when allocators take into account the greater liquidity risk into certain investments, they would reduce their exposure to those investments as they eat up more risk. If you just look at standard deviation or value at risk, that liquidity risk is not exposed. So, they are allocating a percentage of risk capital based on an inaccurate picture of risk.

Ssaris considers liquidity risk and adjusts allocation to less liquid strategies based on that in addition to the traditional risk measures. 

"You have to take a discount to the rate of return," Waksman says. "For every risk you take, you should be getting compensated."

One of the alternative categories that suffered the most redemptions since 2008 is fund of funds. This strategy performed poorly and many would cite its concentration in convergent strategies that underperformed in 2008 (see "A precipitous drop," below). If they had followed Rosenberg’s model, they would have had allocated more to strategies that excelled in 2008. 

Longtime CTA Salem Abraham looks at it even simpler. He makes the point that most asset classes, besides managed futures, are long the economy and are based on averages. He says investment advisors devise programs that work in average markets, but managed futures performs best when you need it most. 

You don’t wear seat belts to work on a normal day, Abraham says, "you wear seat belts to work in a wreck."

This is so simple, yet it is often overlooked. And it supports Partridge’s view of looking at the return streams of an investment and not the variety within it. 

Even as diverse an approach as managed futures can suffer from periods where underlying conditions create correlations. CTA Bob Pardo pointed this out during the positive performance in 2008. He noted that in an anomaly, nearly all physical commodities were following equities; first up and then down. Managed futures benefited from its ability to go short just as easily as going long. And we know that when the dollar is under stress, managed futures programs can become more correlated as most commodities will benefit from a weak dollar and programs likely also will be long currencies versus the dollar. 

Many CTAs at the time reduced their exposure across all markets sectors due to the increasing correlation.

Following Abraham’s point, you can determine how diversified your portfolio is by asking yourself or your manager(s) a few simple questions. What would happen to this investment if the market crashes? What if interest rates spike 500 basis points? What if the dollar collapses? 

Difficult economic conditions tend to create correlations in asset classes where none previously existed. The key to portfolio allocation is to have investments that will perform well in whatever economic conditions we may face.