A Better Blend: Stock, Bond and Managed Futures

Assume its 1984, and you have 3 investment choices in front of you:

  • Stocks:    Buy the S&P 500 Index and pay 50 bps in fees per annum.
  • Bonds:     Perpetually buy 10 year bonds and pay 30 bps in fees a year.
  • Managed Futures:    Build a trend following portfolio around 4 futures contracts: S&P 500 futures, 30 Year Bond futures, Crude Oil Futures and US$ futures, since  each represents a different asset class. At each month-end, for each of the 4 contracts, you go long a contract when its 1 year trailing return is positive, and short when it is negative.  Equalize the risk of all 4 contracts, and penalize your returns by a) assuming you pay 1% a year in commissions, rolls and fees, and b) ignore your return on the cash that is not being held as margin, which up until recently considerably boosted your returns.

The simple portfolio of investing 50% of your money in stocks and 50% in bonds turns out to be quite attractive over the last 30+ years.  Your returns are only 0.8% lower than if you had held equities alone, because long maturity yields fell dramatically over this period, so your equally blended portfolio achieves almost the same return with a fraction of the risk, whether you define risk as annual standard deviation (volatility) or maximum % loss.

The only real drawbacks to this portfolio are a) going forward your bond returns (at current low yields) are extremely unlikely to be this high, and b) at some point along the investment path, you still can expect to lose 25% of your money.

 S&P
500
10 Year
Bond
50/50
Port
Avg Annual % Return8.9%7.3%8.1%
Annual Volatility14.8%7.8%8.3%
Return to Vol Ratio0.600.930.98
Maximum % Drawdown-54%-11%-25%

This is the 50/50 portfolio compared to equities alone.

 

 

 

 

 

 

 

 

 

This is the max percentage drawdown or loss you would experience in each portfolio.

Consider adding the third strategy, which only requires trading once a month.  First compare the performance stats of all three strategies over the last 33 years in isolation.  A simple managed futures strategy has volatility and returns that fall between stocks and bonds, and a return to risk (or information ratio) between the two asset classes (with drawdowns slightly worse than bonds alone).

 S&P
500
10 Year
Bonds
Mngd
Futs
Avg Ann % Return8.9%7.3%8.0%
Annual Volaility14.8%7.8%11.2%
Return to Risk Ratio0.600.930.71
Max % Drawdown-54%-11%-18%

Putting the 50/50 portfolio side by side with a portfolio that puts 1/3rd in each strategy, an investor ends up with pretty much the same return, but the risk, as measured by volatility improves, while your max percentage loss is cut in half from -25% to -12%.

 50/501/3rd
Each
Avg Ann % Return8.1%8.0%
Annual Volatility8.3%7.3%
Return to Risk Ratio0.981.10
Max % Drawdown-25%-12%

Below is a chart of the two portfolios cumulative returns through time.  You start and end up in virtually the same place, but the ride is a lot smoother.

 

 

 

 

 

And the two max % drawdowns in the portfolios.

There are other ways of slightly improving the portfolio blend—you could add more than 4 futures to your managed futures strategy for further diversification.  Similarly, a risk parity version of the 1/3 portfolio that equalizes volatility among all 3 strategies improves your risk-adjusted returns and brings your max % loss down to -10.4% from -12.4%.

But all this is making a simple message more complicated—the value added from a managed futures allocation, whether you DIY or outsource it is huge.  The only free lunch in investing is diversification, and managed futures are a huge diversifier.   The simplistic managed futures strategy simulated here has a 0.10 correlation to US stocks and 0.28 correlation to 10 Year Treasury returns.  Managed futures can and will have periods where returns are unflattering when viewed in isolation.  But that’s missing the point.   Investors should seek out multiple return streams with positive expected return over a reasonable time horizon that diversify their portfolios and blend them together.  Managed futures fit this diversification role perfectly.

 

Is There a Canadian Housing Bubble?

Anecdotal evidence from newspapers (a recent NY Times article on Toronto affordability) and online blogs like Zero Hedge would have you believe, if you like to keep a handy list of financial bubbles around the house like I do, that Canadians have lost their minds, and are in the midst of a housing bubble.  But the fact is that the numbers just don’t bear this out.

To get a financial bubble, especially one in housing, you need to have a lot of loans collateralized by rising home values.  Growth in residential loans remains historically anemic at around 6% at a national level.  Looked at over longer periods of time, mortgage loan growth looks to be in slow decline. Sorry.  No bubble here.

(Data from Cansim & Teranet)

Rising prices should also be incentivizing real estate developers to build new homes or to fix existing houses for an easy flip.  But, Canada’s housing permits and housing starts growth have gone nowhere for 6 years.  Sorry.  No bubble.

As you can see in the last chart, there is really only frothy price behavior evident in two Canadian cities: Toronto and Vancouver.  If you live in Montreal, Quebec City or Halifax, your home value has only kept track with broader Canadian inflation.  While if you live in an oil-producing city like Edmonton, Calgary or Winnipeg, you have made about 10% on your home over the last two years.  Hardly the 60% and 80% appreciation that has happened in Vancouver and Toronto respectfully.  Sorry.  No Canadian housing bubble.  Put another way, housing appreciation in NY and LA is not indicative of the US as a whole.  Same holds here.  Canada is not merely Toronto and Vancouver.

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