Managed futures can lower overall volatility while raising returns July 9, 2015It may seem counter-intuitive that a highly volatile investment like managed futures can help a portfolio to be more stable but that is indeed the case. In “The potential role of managed futures accounts in portfolios of stocks and bonds” Dr. John Lintner said ‘The combined portfolios of stocks (or stocks and bonds) after including judicious investments in leveraged Managed Futures accounts show substantially less risk at every possible level of expected return than portfolios of stocks (or stocks and bonds) alone.’Recently William (Bill) Lynn, CEO of Makefield Capital Management LLC discussed this principal at an investment workshop in Gaithersburg, MD.To understand how there are a few terms to know.Risk – exposure to the chance of injury or lossVolatility – a measure of regularity of change in amount and frequencyDeviation – a departure from standard or norm; volatility is often measured in terms of standard deviationCorrelation – how values change in relation to each otherHow can the addition of a volatile investment to a portfolio lower the overall volatility? The important thing to realize is that volatility is not cumulative. The key is to look at how parts affect the whole. If you only look at one leg while you walk it looks and acts very jerky and out of balance. Each leg is volatile in its motion. If you look at the effect of two legs walking together the action is smooth and balanced. The whole is much less volatile.A single investment X in a portfolio gives the overall portfolio the same characteristics as the investment. The addition of an investment Y with the same weighting can make the portfolio stable if it behaves in the opposite manner from X. Every time X loses a dollar Y gains a dollar. In this case, X and Y are perfectly and negatively correlated.In the past stocks and bonds had a negative correlation. When one went up the other went down. More recently the values of stocks and bonds have become positively correlated, meaning they change in value the same direction, up or down. If X and Y have a positive correlation then the addition of a third investment Z could help stabilize the portfolio. Z will have this effect if it has a lower volatility than the XY Portfolio or if Z is not positively correlated to X and Y. Z can be negatively correlated, not correlated or less positively correlated with a lower volatility. If Z acts independently it is not correlated; when X and Y go up, then Z goes up, down or sideways. Without correlation, it simply doesn’t matter to Z what X and Y do.Positive correlation - they move up and down together.Negative correlation - one moves up when the other moves down.No correlation means they act independently.Looking at a real-life comparison of this situation X is the S&P 500 Total Return Index (US stocks), Y is the Barclays Capital US Aggregate Bond Index (bonds) and Z is the Barclays CTA Index (managed futures.)In a hypothetical portfolio from January 2000 through March 2011 a portfolio of 50% X / 50% Y had an average annual return of 3.93% and a standard deviation of 6.27%. A portfolio of 40% X / 40% Y / 20% Z had a return of 4.36% with a standard deviation of 5.03%. Z by itself returned 5.92% with a Standard deviation of 7.09%.The addition of a 20% weighting of managed futures, in this case, lowered the volatility of the portfolio by a standard deviation of 1.24%. That’s almost a 20% decrease in volatility. The addition of the non-correlated asset also increased the annual return.To learn more about why decreased volatility is important you can read an earlier article “Why average is awesome.”Using monthly reallocations, Stocks are represented by the S&P 500 Total Return Index & the S&P 500 Price Index. Bonds are represented by the Barclay’s US Aggregate Bond Index. Managed Futures are represented by the Autumn Gold CTA Index.