The Efficient Frontier

For those needing a refresher on what exactly the Efficient Frontier is… see below in Part 1. For those in the know who just want to see what the curve looks like now… skip to Part 2.

1. What is It?

The Efficient Frontier sounds like something out of Star Trek, but it is actually an investment/asset allocation concept put forth by those who believe in Modern Portfolio Theory. The general idea is that components of a portfolio should be selected based on what they do to the portfolio’s overall risk and reward profile, not on their own merits. Taken further, one can calculate the best possible mix of portfolio components to arrive at the highest possible return with the lowest possible risk (in terms of volatility or standard deviation of returns). That intersection of the best possible return with the lowest risk is the ‘Efficient Frontier’ point, while the entire graph of various return and risk levels at varying asset allocation amounts can also be called the Efficient Frontier, or Efficient Frontier graph.

Here’s the Efficient Frontier as the CME used to include in its educational materials detailing managed futures, as of 02/2008:

CME Efficient FrontierSource: CME

This showed us that adding a 20% allocation to managed futures increased returns, while decreasing risk (as measured by the volatility of returns). Wow…more returns with less risk, where do I sign up?   The same exercise can be done on any mixture of assets – plotting the compound annual rate of return on the y axis (the vertical one) and the annualized volatility of the investment on the x axis (the horizontal one). That may bring back nightmares of calculus curves to some, but the game is simple:  get as high as you can, and as far left as you can – on the graph.

2. How’s it look lately?

Ok, so we get the concept – now just what has the efficient frontier been telling us about asset allocation lately?  We mapped out the curve on an updated set of data including the past 3 years, and the results were a little surprising. You’ll see the typical portfolio (50/50 in the CME’s old chart, 60/40 stocks/bonds in our table below) completely switched sides of the graph – going from the lowest return/medium risk portfolio to the highest return/medium risk portfolio combination; while having 100% of the portfolio in managed futures went from being the highest return/highest risk to the lowest return/highest risk (not the profile you want exactly).

Updated Efficient Frontier_Dec 2013(Disclaimer: Past performance is not necessarily indicative of future results)
Data Stocks = S&P 500, Bonds = S&P/Citigroup International Treasury Bond Index EX-U.S Index,
Managed Futures = Dow Jones Credit Suisse Managed Futures Index

This is a direct result of the poor five year period managed futures have just gone through (with most CTA indices down slightly over that period and the compound return of managed futures over the period fell from about 6.5% to about 5%) paired with the great period stocks have had the past two years (lifting its compound annual return from 7.3% to 8.5%); and just goes to show that any such work in seeing what the optimum portfolio mix was is just that – a look backwards.

But here is another twist to the story… despite managed futures having shed some numbers in the return department, a 40% allocation to managed futures still results in the optimum portfolio mix (with 36% stocks and 24% bonds). We might have expected managed futures to lose its spot as the efficient frontier poster child after this tough 5 year period, but there is remains – firmly in place on the upper left hand of the curve.

How does it stay relevant in the risk/return conversation after its return side has struggled recently. It’s when the volatility happens, not just if it happens. And in managed futures case, the non correlation means the volatility of the managed futures part of the portfolio happens at different times than that in the stock and bond portfolio (except last month, see here).

Finally – we should note that the efficient frontier as it is usually trotted out – as return over volatility of returns – suffers from the same problems the Sharpe ratio does, in that it treats risk as the volatility of returns only. There is a lot more to risk than just the volatility of returns (downside volatility and drawdown to name two…), which led us to ‘rethink the efficient frontier’ in an old 2010 whitepaper.  If we get around to it… we’ll update those various efficient frontiers here sometime soon.

One comment

  1. The Efficient Frontier asset allocation concept looks very interesting but wouldn’t a risk parity approach (leveraging bonds) improve the volatility adjusted returns of the portfolio?

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Disclaimer
The performance data displayed herein is compiled from various sources, including BarclayHedge, RCM's own estimates of performance based on account managed by advisors on its books, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.

Benchmark index performance is for the constituents of that index only, and does not represent the entire universe of possible investments within that asset class. And further, that there can be limitations and biases to indices such as survivorship, self reporting, and instant history.

Managed futures accounts can subject to substantial charges for management and advisory fees. The numbers within this website include all such fees, but it may be necessary for those accounts that are subject to these charges to make substantial trading profits in the future to avoid depletion or exhaustion of their assets.

Investors interested in investing with a managed futures program (excepting those programs which are offered exclusively to qualified eligible persons as that term is defined by CFTC regulation 4.7) will be required to receive and sign off on a disclosure document in compliance with certain CFT rules The disclosure documents contains a complete description of the principal risk factors and each fee to be charged to your account by the CTA, as well as the composite performance of accounts under the CTA's management over at least the most recent five years. Investor interested in investing in any of the programs on this website are urged to carefully read these disclosure documents, including, but not limited to the performance information, before investing in any such programs.

Those investors who are qualified eligible persons as that term is defined by CFTC regulation 4.7 and interested in investing in a program exempt from having to provide a disclosure document and considered by the regulations to be sophisticated enough to understand the risks and be able to interpret the accuracy and completeness of any performance information on their own.

RCM receives a portion of the commodity brokerage commissions you pay in connection with your futures trading and/or a portion of the interest income (if any) earned on an account's assets. The listed manager may also pay RCM a portion of the fees they receive from accounts introduced to them by RCM.

See the full terms of use and risk disclaimer here.

Disclaimer
The performance data displayed herein is compiled from various sources, including BarclayHedge, RCM's own estimates of performance based on account managed by advisors on its books, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.

Benchmark index performance is for the constituents of that index only, and does not represent the entire universe of possible investments within that asset class. And further, that there can be limitations and biases to indices such as survivorship, self reporting, and instant history.

Managed futures accounts can subject to substantial charges for management and advisory fees. The numbers within this website include all such fees, but it may be necessary for those accounts that are subject to these charges to make substantial trading profits in the future to avoid depletion or exhaustion of their assets.

Investors interested in investing with a managed futures program (excepting those programs which are offered exclusively to qualified eligible persons as that term is defined by CFTC regulation 4.7) will be required to receive and sign off on a disclosure document in compliance with certain CFT rules The disclosure documents contains a complete description of the principal risk factors and each fee to be charged to your account by the CTA, as well as the composite performance of accounts under the CTA's management over at least the most recent five years. Investor interested in investing in any of the programs on this website are urged to carefully read these disclosure documents, including, but not limited to the performance information, before investing in any such programs.

Those investors who are qualified eligible persons as that term is defined by CFTC regulation 4.7 and interested in investing in a program exempt from having to provide a disclosure document and considered by the regulations to be sophisticated enough to understand the risks and be able to interpret the accuracy and completeness of any performance information on their own.

RCM receives a portion of the commodity brokerage commissions you pay in connection with your futures trading and/or a portion of the interest income (if any) earned on an account's assets. The listed manager may also pay RCM a portion of the fees they receive from accounts introduced to them by RCM.

See the full terms of use and risk disclaimer here.