401(k)s allow long-term participants to invest in asset classes with long-term expected positive returns in a tax-free format. Sounds like a winning combination.
If it were only that easy.
As it turns out, there are two significant risks in any long-term investing scheme. Both of these risks relate to the same core issue – that investors don’t have an expiration date. In order to meet future obligations, investors attempt to match their assets and liabilities by including equity risk in their portfolios.
Mismatches are bound to occur, of course. One example is sequence of return risk. A retiree that experiences a large market sell-off at the beginning of their withdrawal period will have a significantly worse cash flow than a person who lives through a similar sell-off later in retirement. Why? Because the beginning of the withdrawal period is the point at which retirement accounts are at their largest, and therefore the most susceptible.
The second major risk is variance drain, and exists due to the presence of market volatility. In essence, increasing volatility results in returns not matching average annual return expectations. Research indicates that typical stock market volatility will result in the average annual return will appear larger than the actual compounded return by about 2 percent per year. As a result, it is important to incorporate this differential in one’s asset allocation decision.
How can certain asset classes—namely liquid alternative mutual funds—help mitigate these risks? In reality, any investment that adds diversification to a portfolio can help reduce volatility and increase returns. But as it turns out, there is one liquid alt strategy that offers both negative correlation to traditional asset classes and a positive expected return–managed futures.
Managed futures funds typically employ a trend-following strategy to capture returns. This gives them a unique “long volatility” profile, which can translate into big gains when equity markets drop. As a result, managed futures funds have performed admirably during significant equity market declines. Managed futures aficionados typically allocate 10-20 percent of their portfolios to the asset class.
There are about 35 managed futures mutual funds currently available – and a bunch more that Morningstar places in the same category that don’t use the same methodology described above. If there’s enough interest I’ll do a deeper dive on the strategy in another blog post.
Ben Warwick founded Quantitative Equity Strategies (QES) in 2002 as a platform for implementing his quantitative investment strategies. The firm advises on assets with traditional long-only equity and fixed income, private equity, managed futures, and alternative investment mandates. Warwick is the author or editor of six books on investing, including Searching for Alpha: The Quest for Exceptional Investment Performance (Wiley, 2000).