From the November 01, 2010 issue of Futures Magazine • Subscribe!

The art of asset allocation

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).

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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.

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