Most investors are familiar with the concept of an absolute return portfolio. As the name suggests, an absolute return portfolio strives to provide positive returns over any distinct time period, regardless of the performance of the relevant index, such as the S&P 500 Index.

Clearly, constructing such a portfolio requires asset classes that exhibit return and volatility characteristics that are not correlated to other assets in the portfolio. The earliest attempts were made to construct such portfolios with a mix of long-only assets such as domestic stocks and bonds. Then global securities were added to the mix as well, including developed markets, such as in Europe, emerging markets, and even frontier markets of Africa or South East Asia. Later, alternative strategies were also added to the mix using hedge funds, managed futures, real estate and other esoteric classes such as art and wine.

But none of these asset classes have been able to provide consistent positive returns in all market conditions. Research has also shown repeatedly, that a portfolio of only hedge funds or only managed futures does not produce alpha on a consistent basis.

In our research, the most robust absolute return portfolio we found had systematic beta, in the form of actively managed S&P 500 sub-index ETFs and a portfolio of multi-manager managed futures strategies.

Here is the completeresearch paper, but we offer a synopsis of it below.

At a fundamental level, there are three types of market environments:

This market is defined as one that is made up of a series of smaller periods with a relatively constant rate of return.

This market is one that is made up of a series of smaller periods alternating between high and low volatility.

This market is one that is made up of a series of smaller periods with a relatively constant volatility. A noise market bears no trend.

Once the S&P 500 Index was segmented into market types, we started with four asset classes to construct our absolute return portfolio.

BTOP 50, Barclay Hedge CTA Index, as a proxy for managed futures

HFR Global Hedge Fund Index and the Equity Hedge Index as a proxy for hedge fund returns. (Note: data prior to 1998 for the HFR Global Hedge Fund Index was not available).

We found the following return characteristics per asset class and market environment.

We were expecting one of the hedge fund indices to be a good hedge in shock or noise markets, but this was not the case. Not even the HFR Equity Hedge Index proved to be a hedge in shock markets. In fact, it turned out worse than even the Global Hedge Fund Index, which is a mix of all hedge fund strategies. No alternative asset class proved to be the best performer in all three market environments.

We found that stocks were the best performers in trend and noise periods, while managed futures were the best performers in shock environments.

To further test the robustness of the portfolio, we took our analysis a step further and analyzed each asset under different market environments. For further analysis, we dropped the HFR Equity Hedge Fund Index, and stuck with the HFR Global Hedge Fund Index only as it was the better asset as per our initial results.

Source: MA Capital Management, Barclay Hedge, HFR, Yahoo! Finance

In a trending market, the best performing asset is clearly the S&P 500 Index. S&P 500 Index has the highest average return, Sharpe ratio and percentage of positive months. Additionally, it is liquid, transparent in price and holdings and can be accessed with very low fees through an ETF or futures contract.

As a shock market, based on our definition is defined as a bear market, we are looking for an asset class that has low beta to the S&P 500 Index, high average returns and high percentage of positive months.

Source: MA Capital Management, Barclay Hedge, HFR, Yahoo! Finance

The above analysis shows that BTOP has the lowest beta to S&P 500 Index (-18%), highest average monthly returns (+1.49%) and also the highest percentage of positive months (72%).

This helps us conclude that managed futures are the best asset class to have in a portfolio for shock markets.

Interestingly, in a shock market, hedge funds do not seem to provide any hedge at all.

The beta of the HFR index is positive to the S&P 500 Index (22%) with a very high confidence level (99%), which is exactly opposite of what you would like to see in a shock environment.

Noise markets are defined as those that exhibit no trend but a constant level of instantaneous volatility. These markets are very difficult to extract positive returns through active trading.

Source: MA Capital Management, Barclay Hedge, HFR, Yahoo! Finance

None of the asset classes have outstanding results in a noise market. Given the lack of a better alternative, it makes sense to stick with the S&P 500 in a noise market as well.

The above analysis shows the best assets to hold under different market volatility environments. But there are some practical challenges to implementing this portfolio:

1. Determining the upcoming volatility period correctly on a consistent basis

In our above analysis we had the benefit of hindsight in determining the volatility of that period, but in reality, this would have to be done using a forecasting model on live data.

2. Weighting the portfolio appropriately depending on the volatility environment

Once the systematic approach has determined the upcoming volatility period, the portfolio will have to be weighed appropriately to allocate to the assets that are expected to perform the best in that particular volatility environment.

The ideal portfolio would look like the following, based on the expected returns of each asset class as determined in the above sections.

So, what if we decided to create a static portfolio of S&P 500 Index and managed futures that was weighted by the expectation of the percentages of each volatility period. Our results would look like the following:

Past performance is not necessarily an indication of future performance.

Clearly, simply holding a constant portfolio of S&P 500 Index and the BTOP Index does not create an absolute return portfolio. In the past 13 years, there have been 2 large drawdown periods that would have caused the investor to lose faith in this portfolio.

Rotation between S&P 500 and managed futures is important to have the highest exposure to the best risk/reward ratio assets during a given volatility period.

For our analysis, we have used the Barclay BTOP50 managed futures index, but there are several other options available to investors, some of which have produced better results, both in terms of absolute performance as well as a hedge to the S&P 500.

There are two variables that cannot be determined with a 100% certainty in constructing an absolute return portfolio: 1) determining the volatility period and 2) the expected performance of the asset class in that period. Both these variables are dependent on the accuracy of the forecasting model.

Therefore a stop-loss mechanism needs to be in place at the portfolio level to prevent against steep losses in case of model shortcomings.

1. A portfolio of only alternatives, like hedge funds or managed futures, does not create a robust absolute return portfolio.

2. The most robust absolute return portfolio we found has S&P 500 sub-index ETFs and a portfolio of multi-manager managed futures strategies.

3. A static portfolio is not enough to create an absolute return portfolio. The risk on the S&P 500 portfolio as well as the managed futures portfolio has to be managed to get the best results.

You can access the completeresearch paperfor more information.

Disclosure:I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.