Creating an all-weather portfolio

Last year, the Wall Street Journal reported that Ben Inker, Head of Asset Allocation at Boston-based investment firm GMO, managing $100 billion in assets, stated that both U.S. stocks and bonds are heavily overvalued. Mr. Inker continued to say that based on GMO’s calculations, his firm fears that investors in the main U.S. stock indexes, including the S&P 500, will be lucky to earn anything in real, inflation-adjusted dollars over the next seven years. More importantly, Mr. Inker felt that bonds were also overvalued and therefore could not help portfolios as a hedge as much as they could in the past. Inker fears that the standard portfolio allocation of 60% U.S. stocks and 40% bonds is actually likely to leave investors poorer, in real, inflation-adjusted dollars, over the next seven or so years. In light of this and a number of other reasons, investors should consider allocating a part of their portfolio to alternatives, managed futures in particular, to generate returns in what looks to be a difficult upcoming decade.

Within the managed futures space itself, I prefer to allocate money to multiple managers. While modern portfolio theory is based upon many bogus assumptions; it is difficult to argue with one that makes a great deal of sense and for which there is tenable evidence: Uncorrelated assets can, and do, reduce overall portfolio volatility. Or as Rob Arnott wrote: “The power of true diversification should not be underestimated as a means to sustain long-term real spending power at modest risk. The classic 60/40 balanced portfolio is not true diversification. Indeed, one of the best-kept secrets of the investing community is that stock market return so dominates the risk of a 60/40 portfolio that the portfolio exhibits a 98 to 99% correlation with stocks! True diversification involves seeking out uncorrelated or lightly correlated risky markets, not low-risk markets.” [Emphasis added.]

The problem with correlation – and by the same token non-correlation - is that it can disappear in a heartbeat. In other words, the historical non-correlation of two asset classes, or managers, could simply be a matter of coincidence. To address this possibility, I prefer to find managers that are not only non-correlated, but are also using different strategies, different time frames, and trading in different markets. While there are no guarantees in this business, this approach gives one a reasonable chance that the managers’ non-correlation will persist into the future.

Allocating to these managers also gives an investor the best chance at overall profitability. For example, if markets are exhibiting conditions that are difficult for trend followers, discretionary traders in the portfolio may be able to extract profits from the markets that they’re invested in, keeping the overall portfolio moving in the right direction.  For example, ag centered commodity trading advisors (CTAs) that tend to trade on fundamentals and use discretion have performed well over the last several years while the traditional medium- to long-term trend followers struggled as a whole.

Most importantly, a multi-manager and multi-strategy approach has the potential to reduce drawdown and portfolio volatility. Benjamin Graham once said, “The essence of investment management is the management of risks, not the management of returns.” I agree wholeheartedly.

The correlation matrix below shows a group of CTAs that are trading in different markets with different strategies. They are either lightly correlated or non-correlated. The most correlated managers are managers 2 and 4 with a correlation of 0.3 or 30%. The least correlated managers are managers 1 and 5 with a negative correlation of -0.15.

 To illustrate my approach, let’s look at some drawdown and volatility numbers as we add managers to a hypothetical portfolio. These figures assume an equal investment in each manager progressing in a serial manner. The results shown measure a four-year time period.

Notice how diversification lowers drawdowns and pushes the end Sharpe Ratio to a greater value than that of any individual manager.

A multi-manager, multi-strategy approach in the managed futures space has a couple of advantages. With a variety of strategies working for them, investors have the potential to be profitable in most time periods. Also, with several lightly correlated managers, it can be shown that portfolio draw down and volatility decrease, creating a more stable equity curve. A stable and upward sloping equity curve is something every investor should find beneficial for their portfolio. 

About the Author

President & founder of commodity pool operator Sapelo Asset Management; Spalding can be reached at