Trend Following and Optimal Asset Allocation

Managed Futures in Asset Allocation

Managed Futures in Asset Allocation Depends on Stock/bond Correlations

 

I’ve been exploring adding trend following (managed futures) to my asset allocation.

With higher interest rates, the correlation of stocks and bonds becomes less negative. During periods of low correlation (high interest rates), a 60/40 asset allocation becomes 55/35/10 (10% in trend following/managed futures), and during periods of high correlation (low interest rates), 55/25/20.

 

Correlations of Stocks and Bonds

Based on an interesting research paper by Quantica Capital looks at excess returns, volatility, and correlations between stocks and bonds depending on whether we are in a low or high cash rate regime. A T-Bill rate above 3% is considered a high cash rate regime.

 

Correlations of Stocks and Bonds

Above, you can see there are no differences in excess returns or volatility of stocks and bonds during low or high cash rate regimes, but there is a significant difference in correlations. During a low cash rate regime, correlations of stocks and bonds are around -0.3%, and they are positive at 0.2% during periods of high cash rates.

Stepping back, this means during times of high interest rates, when the risk-free rate is above 3%, stocks and bonds are more positively correlated than during times of low interest rates. When should we add managed futures to our asset allocation?

 

When to Add Managed Futures to Your Asset Allocation

Let’s look at the correlation of managed futures with stocks or bonds, depending on whether we are in a low or high cash rate regime.

 

When to Add Managed Futures to Your Asset Allocation

Above, you can see that during low cash rate regimes (in blue), stocks and bonds positively correlate with trend following (TF).

During times of high cash rate regimes (in orange), stocks are positively correlated with trend following, but bonds are negatively correlated. There is quite a bit of dispersion in the error bars around a -0.2 correlation between bonds and trend following.

Thus, trend following (managed futures) is best seen as a bond alternative and is especially useful when the risk-free rate (T-Bills) is above 3%.

 

Trend Following and Optimal Asset Allocation

Assuming you want to start with a traditional 60/40 portfolio, how might you consider adjusting your asset allocation by adding trend following?

 

Trend Following and Optimal Asset Allocation

Above, the x-axis demonstrates theoretical times when stocks and bonds are negatively correlated (–0.5 on the left) and positively correlated (0.5 on the right). When stocks and bonds are negatively correlated, the addition of trend following in your asset allocation is less beneficial. Thus with high interest rates, a  60/40 asset allocation becomes 55/35/10, with 10% in trend following (managed futures).

Conversely, when stocks and bonds are positively correlated, and interest rates are low, bonds are less useful, and a 60/40 portfolio becomes 55/25/20.

 

Managed Futures in Asset Allocation Depends on Stock/bond Correlations

During accumulation, asset allocation discussions are more about the understanding that a large amount of equities in your asset allocation will do better over time as long as you don’t sell low when the market crashes. In de-accumulation when you are drawing down on your portfolio, bonds and cash are needed to prevent sequence of return risk.

I consider myself 3 years away from actual de-accumulation, when I will no longer have any sources of income aside from my investments. Thus, I am adjusting from an accumulation to a de-accumulation portfolio. I am adding some gold and managed futures to achieve a risk parity or permanent portfolio. The idea is that when bonds are more positively correlated to stocks, they provide less diversification. Might gold or trend following replace bonds as your safe assets in some market regimes? Time will tell.

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