Asset Allocation Review

The Portfolio Balancing Act:

The unprecedented bull market of the late 1990s fueled an optimism that led many investors to expect big things from their investment/retirement portfolios. But in the early years of the new millennium reality set in as investors realized that the days of easy returns in the stock market were gone. The market’s decline, although painful, has served as a wake-up call for most investors. It has provided them with the opportunity to take a closer look at their portfolio and has forced them to further diversify their holdings across multiple asset classes. It was inevitable that portfolios too heavily weighted in a single asset class (i.e. NASDAQ related stocks) would eventually suffer large drawdowns once the markets within that single asset class reversed course. Diversification really is the key to investment success over time. The right asset allocation weighting can help investors ride out the stock market’s ups and downs in a far superior fashion when compared to a portfolio only comprised of stocks.

A well-balanced portfolio begins with the correct ingredients. The key is mixing various asset classes together to create a stable and truly diversified portfolio. So where do we begin?

The Overview:

• Review the various indices that are available to build strong
  well-balanced portfolios. [More]
  
• Present an overview of the Lintner Efficient Frontier study to
  provide guidance on proper asset class allocation. [More]
  
• Construct a portfolio that specifically fits an investors financial
  objective and risk tolerance. [More]

Portfolio Case Studies:

Question: How do you make a portfolio more efficient? This is an age-old question continually debated by financial advisors and investors. Too many investors focus primarily on maximizing their returns at the expense of portfolio volatility. This often leads them to overweight their portfolios in a single asset class.

In this section we will review five different portfolios each catering to investors with very different objectives and risk tolerance levels. The case study portfolios will be adjusted by adding an appropriate allocation of Managed Futures products into the mixture. An historic analysis between the investors current portfolio allocation will then be compared with a new targeted portfolio with a balanced multiple asset class allocation. The analysis for each case study was performed from January 1985 - May 2003 during arguably the strongest secular bull market the stock market has ever seen, making this analysis all the more impressive.

Lets take a look at a number of portfolios each with different asset classes weightings.

• 100% Stock Investment Portfolio
• 75% Stock/ 25% Bond Investment Portfolio
• 100% Stock Investment Portfolio with International Equities
• 60% Stock/ 40% Bond Investment Portfolio
• 25% Stock/ 75% Bond Investment Portfolio

COMMODITY TRADING INVOLVES SUBSTANTIAL RISKS DUE IN PART TO THE HIGHLY SPECULATIVE NATURE OF SUCH TRADING. AS A RESULT, AN INVESTMENT IN A COMMODITY TRADING ACCOUNT IS ONLY SUITABLE FOR YOU IF YOU HAVE ADEQUATE MEANS TO PROVIDE FOR YOUR CURRENT NEEDS AND PERSONAL CONTINGENCIES AND YOU CAN BEAR THE ECONOMIC RISK OF LOSING YOUR ENTIRE INVESTMENT.

PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

Asset Class/Index Overview:

All asset are not created equal. This list of indices offers investors a variety of stock, bond and managed futures products to serve as building blocks for our portfolio allocation mixtures. Click on the market index for a detail description.

COMMODITY TRADING INVOLVES SUBSTANTIAL RISKS DUE IN PART TO THE HIGHLY SPECULATIVE NATURE OF SUCH TRADING. AS A RESULT, AN INVESTMENT IN A COMMODITY TRADING ACCOUNT IS ONLY SUITABLE FOR YOU IF YOU HAVE ADEQUATE MEANS TO PROVIDE FOR YOUR CURRENT NEEDS AND PERSONAL CONTINGENCIES AND YOU CAN BEAR THE ECONOMIC RISK OF LOSING YOUR ENTIRE INVESTMENT.

PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

Efficient Frontier Review:

In his study Dr. John Lintner of Harvard University demonstrated that introducing Managed Futures products to a traditional stock and bond portfolio could potentially enhance portfolio efficiency. Dr. Thomas Schneeweis of the University of Massachusetts Amherst, updated Lintner's work in 1995, confirming the validity of this alternative asset strategy. These two historic studies concluded that portfolios that include a third asset class (Managed Futures) increased return levels while simultaneously reducing portfolio volatility.

Table one clearly outlines the benefits of Managed Futures. For this case study we will define reward by the portfolios Compounded Annual Return. The larger the annual return the greater reward. In the real world, however reward generally comes at a cost; known as risk. In this case we will define risk by the portfolios Annualized Standard Deviation of Monthly Rate-of-return (ROR). The larger the Annualized Standard Deviation the greater the risk. With these risk/reward definitions in place let's construct some portfolios each with capital allocated to three different asset classes. The asset classes are defined as follows:

• The Stock portfolio is defined by an equal 50/50 weighting between the S&P 500 Index and the NASDAQ Market Index.
• The Bond portion is defined by the Lehman Brothers Aggregate Bond Index.
• The Managed Futures portion is defined by the MAR Trading Advisor Qualified Universe Index.

Case Study:

Portfolio A is constructed entirely of stock. Its annual return is 9.85% but the portfolios volatility is high with an annualize standard deviation of 19.34%. The annual return of Portfolio B is 9.65%, lower than that of Portfolio A, but its risk measure is substantially less volatile coming in at 11.96%. Portfolios' C - F begin to introduce a Managed Futures (MF) component into mixture. These portfolios maintain the stock portion at 60% but slowly decrease the bond portion while increasing the Managed Futures portion. Notice that the asset allocation of Portfolio C produced the least amount of risk compared with the reward measure. Portfolios D and E showed improved returns but at a cost to increased risk. None the less each of the portfolios that included Managed Futures exhibited greater rewards and less risk than Portfolio A. Table one shows the positive impact Managed Futures can have on a diversified investment portfolio. For this case study the optimal allocation of Managed Futures ranges between 10 to 30% depending upon the financial objective and risk tolerance of the investor. At these levels, the portfolios efficiency is maximized as noted by the Sharpe Ratio a measure of return stability. The greater the Sharpe Ratio the smoother the equity curve.

Table 1: Portfolio Performance (January 1985 - April 2003)

Chart 1 illustrates the dramatic improvement a diversified portfolio can have on risk reward measures as they pertain to the portfolios above. The red bars represent risk, the larger the bar the more month-to-month volatility associated with the portfolio. The green bars represent reward, the larger the bar the more return associated with the portfolio. Portfolios C - E define the optimal allocation mixture based on a straight forward reward to risk profile. This is especially clear when each portfolio profile is compared with Portfolio A, which has 100% of its capital allocated to the stock market. It should be noted that the stock market was in the midst of one of the greatest secular bull markets ever during most of the test period, making this illustration all the more impressive.

Chart 1:

COMMODITY TRADING INVOLVES SUBSTANTIAL RISKS DUE IN PART TO THE HIGHLY SPECULATIVE NATURE OF SUCH TRADING. AS A RESULT, AN INVESTMENT IN A COMMODITY TRADING ACCOUNT IS ONLY SUITABLE FOR YOU IF YOU HAVE ADEQUATE MEANS TO PROVIDE FOR YOUR CURRENT NEEDS AND PERSONAL CONTINGENCIES AND YOU CAN BEAR THE ECONOMIC RISK OF LOSING YOUR ENTIRE INVESTMENT.

PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

Index Definitions: