A fundamental consideration in portfolio construction is to assess how a portfolio’s constituent assets interact with each other and contribute to the portfolio as a whole. Ideally, the mix of assets will allow the portfolio to weather a variety of market conditions in meeting its investment objectives.
A basket of assets that share similar investment strategies will likely require similar market conditions to perform. While this may be rewarding when those conditions are favourable, the overall portfolio may be susceptible to losses when those conditions are unfavourable, as they almost inevitably will be at some point.
The argument then follows that it is optimal to have different investment strategies that can perform under different conditions. This is the value proposition of portfolio diversification – the sum (investment portfolio as a whole) being greater than its parts (individual allocations within the portfolio). The metrics for success here are simple. (1) Improvement in the returns of the portfolio or (2) mitigation of risk in the overall portfolio, typically measured by volatility or the severity of drawdowns. Ideally, both (1) and (2) can be achieved without compromising the other.
With diversification in mind, let us investigate how a managed futures strategy, such as Man’s AHL Alpha Program, may affect a traditional investment portfolio.
As each client’s portfolios differ in make-up and objectives, for illustrative purposes, we can use a typical “balanced” portfolio model, comprising of 65 per cent growth assets and 35 per cent defensive assets.
The example analysis below looks at a traditional investment portfolio as follows.
Traditional portfolio
Now, adding a 10 per cent allocation to the AHL Alpha Program to the portfolio above, funded from its growth component, the new portfolio appears as follows.
Enhanced portfolio
So what effects does this substitution have on the original investment portfolio? The charts below show the changes in the key metrics: annualised return, annualised volatility and worst drawdown. The grey bars represent the results of the original traditional portfolio, and the orange bars represent the results of the new portfolio, comprising the traditional portfolio with the 10 per cent allocation to the AHL Alpha Program.
Example: Traditional portfolio vs enhanced portfolio
October 1995 to September 2015
Financial adviser use only. Past performance is not a reliable indicator of future performance.
Bonds: Bloomberg AusBond Composite 0+ Yr Index. Cash: Bloomberg AusBond Bank Bill Index. Australian equities: S&P/ASX 300 (Accum.) Index. Property: S&P/ASX 300 AREIT (Accum.) Index. World equities: MSCI World Net Total Return Index. The chart is provided as an illustration only of two hypothetical portfolios and is not designed to predict the future performance of the AHL Alpha Program. To illustrate Man’s longest running AHL Alpha Program, the past performance of AHL Alpha plc from October 1995 to September 2012, AHL Strategies PCC Limited: Class Y AHL Alpha USD Shares from September 2012 to August 2014 and AHL Alpha (Cayman) Limited from August 2014 to September 2015 are used in this chart. This chart is not a chart showing the performance of Man AHL Alpha (AUD). It is not designed to predict or forecast the future performance of the AHL Alpha Program or Man AHL Alpha (AUD). Performance figures for the indices are calculated exclusive of all fees and, for the AHL Alpha Program, are calculated net of all fees. Performance figures are calculated as at 30 September 2015. 1. Volatility measures the degree of fluctuation around the average performance of the AHL Alpha Program and the indices comprising the traditional portfolio shown above from October 1995 to September 2015. The higher the volatility, the higher the degree of fluctuation in returns. 2. The chart also shows maximum drawdown which is the single largest percentage drop in price from any month end peak to the lowest price reached at the end of a subsequent month, while the investment is in a drawdown (that is, below a previously attained month end high). In the above example, the maximum drawdown for both portfolios occurred from November 2007 to February 2009.
Source: Man Investments Australia (based on portfolios published by three leading research providers).
In comparing these two hypothetical portfolios, the results show that the 10 per cent allocation to the AHL Alpha Program delivers an improvement to the annualised return from 7.9 per cent p.a. to 8.4 per cent p.a., an improvement to the annualised volatility from 8.0 per cent p.a. to 6.8 per cent p.a. and an improvement to the worst drawdown from -34.7 per cent to -28.2 per cent3.
In summary, an allocation to the AHL Alpha Program provided effective diversification to the traditional investment portfolio by improving its returns while reducing its risk metrics.
