AXS Insights

3 Indicators of a Well-Behaved Portfolio

Is investing simply about maximizing returns? Not necessarily. We believe a more pragmatic objective is to maximize risk-adjusted returns, which normalize performance relative to a measure of risk to account for the degree of risk that must be accepted in order to achieve a return. That makes comparing returns between investments easier. Looking at performance through this lens helps keep unproductive investor behavior in check, especially when markets go sideways.

We all seek to strike the right balance between rewards and risks befitting of our investment goals. That’s why many investors diversify. The classic combination of 60% equities and 40% fixed income has long been the standard for diversification for individual investors, whereas some institutional investors have long incorporated an important third component into that combination: namely, alternative investments. How can we tell if the institutional investor approach of allocating beyond just equities and fixed income has the potential to enhance portfolio benefits?

AXS Investments examined three useful indicators that measure how well an investment portfolio behaves through long-term market cycles.

  1. Portfolio Volatility - Measured by standard deviation, a higher percentage indicates a wider dispersion of asset values and a lower number means that swings in value are more tempered.
  2. Maximum Drawdown - Insight can also be gleaned by looking at portfolio returns during drawdown periods. Recovering from a deep loss requires outsized returns to get back to par — for example, an investment that loses half its value has to double to claw back to where it started. So, an important goal is to limit the depth of negative returns in times of market turmoil.
  3. Return per Risk - This equals return divided by volatility. Instead of considering only absolute performance, this figure “prices” your return per risk. Put another way, what unit of risk are you willing to assume for each unit of return you want? Investors should want to avoid “expensive” returns where returns don’t outweigh the risk they have to take.

The more risk-averse and emotional an investor is, the more they may want a portfolio with lower volatility, shallower drawdowns and a higher return per risk. The portfolio behaves more “efficiently” and increases the probability of meeting investment goals. Riskier portfolios may have a better probability of achieving higher returns, but can also expose investors to more severe losses.

Effects of Diversifying with Managed Futures

Let’s attempt to construct an efficient portfolio. To diversify the traditional 60/40, consider an asset class with very little dependency on traditional assets. For our analysis, we selected managed futures because of their historically low correlation (a statistical measure of how two securities move in relation to each other) with equities and fixed income, at -0.11 and 0.26, respectively.*

We created a “Diversified Portfolio” with 40% equities, 40% fixed income and 20% managed futures.* Next, we compared the performance of these two portfolios from January 2000 through June 2020 (20.5 years) to see how they stacked up against the three indicators mentioned.

Portfolio Efficiency Blog Table graphic

* Sources: Morningstar and AXS Investments (i) Equities: S&P 500 Index; (ii) Fixed Income: Bloomberg Barclays US Aggregate Bond Index, (iii) Managed Futures: BTOP50 Index, BarclayHedge, an index that replicates the overall composition of the managed futures industry. Includes data from 1/1/2000 through 6/30/2020.

 Past performance is not a guarantee of future results. Investors cannot invest directly in an index. Index returns do not reflect any fees, expenses or sales charges. Returns are based on price only and do not include dividends. This analysis is for illustrative purposes only, does not represent the AXS Investments Funds and is not indicative of any actual investments. These returns were the result of certain market factors and events that may not be repeated in the future.

Portfolio Volatility

By adding the non-correlated return streams of managed futures, overall volatility dropped by a considerable 2.82%. The diversified portfolio experienced a less bumpy ride over time. While many investors believe they can stomach volatility, that is not always easy when their account values are rising and falling wildly. More stability may offer comfort and discourage ill-advised buying and selling behavior.

Maximum Drawdown

When the traditional portfolio fell by a third in our time period, the diversified portfolio lost 20%. The 12.61% differential is meaningful. The 60/40 investor had to earn 48.24% from the nadir to return to whole, whereas the diversified investor only needed 24.89% to recover. One awful market correction can set back progress for years. As we explored in our Performance of Managed Futures During 21st Century Recessions paper, managed futures outperformed equity markets handily in the last two major downturns.

Return per Risk

Ultimately, we believe performance eclipses all other measures of success. When risk is factored in, the diversified portfolio earned a 22% higher return per risk. To be clear, that does not imply that, in absolute terms, the diversified allocation outperformed its traditional counterpart. The former earned an annualized return of 5.41% and the latter earned 5.85%.

HINDSIGHT IS 20/20

While the absolute return of the 60/40 might have been slightly higher than the 40/40/20 blend, it comes at heightened risk and assumes staying the course through thick and thin. Moreover, investor goals and time horizons come due as planned and the market may not always be accommodating. Managing drawdowns and portfolio volatility offer a smoother portfolio glidepath.

Along the 20+ year run in our research, the volatility and maximum drawdown of the portfolio with a managed futures allocation were reduced. Its portfolio efficiency was amplified, which underscores the benefit of diversifying with a truly non-correlated investment strategy.

This information is educational in nature and does not constitute investment advice. These views are subject to change at any time based on market and other conditions and no forecasts can be guaranteed. These views may not be relied upon as investment advice or as an indication of any investment or trading intent. This content should not be construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security by AXS Investments or any third-party. You are solely responsible for determining whether any investment, investment strategy, security or related transaction is appropriate for you based on your personal investment objectives, financial circumstances and risk tolerance. AXS Investments does not provide tax or legal advice and the information herein should not be considered as such. AXS Investments disclaims any liability arising out of your use of the information contained herein. You should consult your legal or tax professional regarding your specific situation. All investing is subject to risk, including the possible loss of the money you invest. Alternative investments may not be suitable for all investors.

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