A New Narrative on Asset Allocation

How does AlphaSimplex use futures contracts to implement its strategies?

Given the volatility in the markets over the past few years, the need to manage risk allocation has become more crucial for investors. The volatility of volatility can change rapidly and this would be reflected in the VIX. Andrew Lo, MIT professor and alternative money manager, mentions that in the investing arena, there are new rules to abide by. The first is that markets are not stable and you cannot be reasonably assured of the volatility in your traditional 60% stock / 40% bond portfolio. The second rule is that while most people think they are well diversified amongst different asset classes, it is not true. There is a need to diversify across stocks, bonds, currencies, commodities and interest rates. The third rule is that we have to be aware that while stocks provide good returns in the long run, we are dead in the long run. Hence we have to be able to manage the short term swings.

These rules lead to the new narrative that we cannot allocate funds to asset classes without looking at their associated volatility. AlphaSimplex seeks to cater to the need for risk allocation for portfolios. The fund takes an approach where they establish a volatility goal, for example 8%. They invest in futures contracts across a variety of asset classes in order to maintain that level of volatility. They rebalance on a daily basis. For example, if the volatility of the underlying asset spikes, the fund will reduce exposure in that asset class via futures. When the volatility subsides, the fund will increase exposure in that asset class via futures. The act of managing this volatility on a daily basis is something that individual investors would have a difficult time replicating. The fund has established a goal of 8% volatility.

This method of risk allocation comes in contrast to the traditional asset allocation approach, which does not account for wild swings in volatility which have been omnipresent over the past 4-5 years. 

Lo discusses that it would be difficult for an individual investor to replicate this sort of daily rebalancing. However, he mentions that investors should still be knowledgeable about correlations amongst asset classes and cognizant of risk not only when markets are volatile but also during calmer periods.