From the December/January 2013 issue of Futures Magazine • Subscribe!

Dynamic duo: Managed futures and hedge funds

To study the effect of allocating to hedge funds and managed futures, we form a baseline “traditional” portfolio, 50% stocks 50% bonds and add hedge funds or managed futures in 5% increments (see “Building a portfolio,” below). As in Kat’s paper, when adding in hedge funds or managed futures, the original 50/50 portfolio will reduce its stock and bond holdings proportionally. For example a 10% allocation to hedge funds or managed futures means there is a 45% allocation to both stocks and bonds. (Note: All portfolios are rebalanced monthly.) 

Similar to Kat, we studied the differences in how hedge funds and managed futures combine with stocks and bonds. Kat found that adding hedge funds to the 50/50 portfolio lowered the standard deviation, as he hoped. Unfortunately, hedge funds also increased the negative tilt of the distribution. In addition to the portfolios becoming more negatively skewed, the return distribution’s kurtosis increased, indicating fatter tails. However, Kat found that when he increased the managed futures allocation, the standard deviation dropped faster than with hedge funds, the kurtosis was lowered and, most impressively, the skewness actually shifted in a positive direction. Kat noted, “Although hedge funds offer a somewhat higher-than-expected return, from an overall risk perspective, managed futures appear to be better diversifiers than hedge funds.”

Our results show that Kat’s observations have held up. When we increased the hedge fund allocation, the portfolio return went up and the standard deviation went down. However, the previously discussed “negative side effect” of adding hedge funds was present, as the skewness of the portfolio fell and the kurtosis went up. 

But when we added managed futures to the traditional portfolio, we observed more impressive diversification characteristics. In fact, managed futures appear to have improved the performance profile more in this period than with Kat’s study. Adding managed futures exposure increased mean return and simultaneously increased the skewness of −0.76 of the traditional portfolio to a positive 0.05 at the 45% allocation level. The standard deviation dropped more and faster than it did with hedge funds, and kurtosis also improved, dropping from 2.23 to –0.21 at the 40% allocation level.

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