The Risk Contribution of Stocks - Part 3

Traders Magazine Online News, May 3, 2018

John D'Antona Jr.

Ampersand’s new white paper, The Risk Contribution of Stocks, illustrates the riskiness of a 60/40 stock/bond portfolio, showing that 92% of the risk is contributed by stocks. Diversifying the portfolio by adding another asset class such as managed futures yields improvements. Among the scenarios presented in the first paper, a portfolio with 20/50/30 allocations to stocks/bonds/managed futures provided the highest Sharpe Ratio among portfolios whose allocations to the three asset classes were constrained to add up to 100%.  However, in the real world, it’s extremely rare to find portfolios with a 30% allocation to managed futures.  How can investors gain the benefits of diversification without having to sell their stocks or bonds in order to allocate to another asset class like managed futures?

See Parts 1 and 2 here

Here are some key highlights from The Risk Contribution of Stocks, Part 3:

• Ampersand’s hypothetical scenarios showed that a 20/50/30 stock/bond/managed futures portfolio provides the highest reward-to-risk ratio and could be considered the optimal allocation strategy.

• The fact remains that it’s extremely rare to find portfolios with allocations to alternatives as high as 30%. In fact, in most portfolios stocks continue to be the main source of risk, often exceeding 90%.

• The main reasons for under-diversification are the historical lack of available diversifying strategies and, when available, the opportunity cost of utilizing them. With few exceptions, investors who do have access to diversifying strategies tend to allocate only small amounts to alternatives, so stocks remain their largest source of risk. In addition, the traditional way to diversify is to sell stocks or bonds in order allocate to a diversifier such as managed futures.

• The portion allocated to the diversifier (managed futures) forces an investor to choose between stocks and bonds OR managed futures.  In the end, however, this OR decision may result in giving up the returns that the relinquished stocks and bonds might have continued to earn.

• Ampersand proposes a new theory:  there is no need to sell stocks and bonds to diversify into managed futures. How is this possible?  These programs can be accessed by using 10% – 25% margin or collateral, and the stocks/bonds in an investor’s 60/40 portfolio can themselves be posted as collateral.  This is an “overlay” approach, where the alternatives are overlaid on top of the stock/bond portfolio without the need to sell any stocks or bonds.

• Ampersand provides compelling charts that detail the expected returns of various “enhanced” stock/bond/managed futures overlay portfolios as well as the expected risk and Sharpe Ratio.

• The potential benefits of this “enhanced” diversification include: eliminating the opportunity costs of meaningful diversification; better balanced portfolio construction; and higher potential returns for investors with higher risk tolerance.

For the white paper described herein:  https://equinoxfunds.com/sites/default/files/Insights_MF%20Risk%20Contribution%20Part%203.pdf

 

For more information on related topics, visit the following channels:

• Buyside
• Insights/Viewpoints