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Digital Subscriptions > The Hedge Fund Journal > Issue 132 – May 2018 > The Risk Contribution of Stocks

The Risk Contribution of Stocks

Part three


In the previous two Insights in this series, we focused on the risk of various stockbondmanaged futures portfolios, and examined how much of this risk comes from each of their three component asset classes.1 Based on what we believe are some reasonable assumptions about volatilities and correlations, we first showed that most of the risk of traditional stock-bond portfolios comes from stocks.

For example, 92% of the risk of a 60/40 stock/ bond portfolio is contributed by stocks.

Diversifying the portfolio by adding managed futures yields some interesting results. As we distribute the risk of the portfolio approximately equally across the three asset classes, it turns out that the risk-adjusted expected return of the portfolio potentially improves. Among the specific hypothetical scenarios we presented, a portfolio with 20/50/30 allocations to stocks/bonds/ managed futures turned out to have the highest Sharpe Ratio among portfolios whose allocations to the three asset classes were constrained to add up to 100%.

In this final Insight, we explore the possibility and the consequences of relaxing this constraint.

Why should we consider relaxing the 100% constraint? Can this be achieved in practice?

We have shown, albeit under fairly simplistic assumptions, that a 20/50/30 portfolio may have a higher Sharpe Ratio than most others. However, the fact remains that, in the real world, it is extremely rare to find portfolios with allocations as high as 30% to alternative strategies. In our view, most portfolios continue to be significantly under-diversified, and, in most cases, stocks continue to be the biggest source of risk, their contribution often exceeding 90%. We believe the main reasons for this under-diversification are (i) the historical lack of availability of diversifying strategies, and (ii) when available, the opportunity costs, both real and perceived, of utilizing them.

Historical lack of availability

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