I've been working on a policy manual for a DIY hedge fund concept. As part of the process, I wrote a position paper on ballast. It's my way to make sure I'm not being sloppy in my reasoning. Thought I'd share, maybe this helps some of you review your own thinking about this.
**TL;DR:**
* Managed futures make a strong case as a more robust form of ballast than government bonds for a long-term diversified portfolio.
* Across the backtests presented here, portfolios using managed futures produced higher real returns and better risk-adjusted results than comparable portfolios using bonds.
* The outperformance came outside of crises, while during crises, managed futures performed about the same as bonds.
* Adding an options-based tail hedge such as CAOS is a more experimental proposition. Its crisis gains may need to be actively harvested before they disappear during the recovery.
Bond funds have been available for a long time, managed futures and tail hedge funds, not so much. They're available now, though, thus the case for a Managed Futures + Tail Hedge combo seems worth investigating.
(By the way, I'm talking about long-term saving and retirement investing here. This isn't about cash needed next year or a bond ladder for known expenses.)
# What is ballast expected to do?
Most investors want the ballast portion of their portfolio to provide a counterweight to equity crashes. When there's a crash, their portfolio is relatively stable and resilient. This can be psychologically advantageous vs sitting through a Lehman shock type of horror show. Some - or all - of the funds preserved in bonds can also be converted into equities when they're depressed. That's the explicit rationale. Implicitly, most also want that ballast to produce a positive real return during calm markets. The more, the better.
High-quality government bonds have often been strong partners for equities. This was true for much of the period from the 1980s through 2020. Which was a secular bond bull market, at least for US government bonds, and which is all most everyone investing today remembers.
Look just beyond either bookend of that period, and the picture changes.
When inflation causes the trouble, bonds can fall with stocks. The same can happen when real interest rates rise, government borrowing pushes up the term premium, or markets lose confidence in fiscal and monetary policy. The 2022 joint stock-bond decline provides a recent nominal example. The 1970s provide a longer example of inflation damaging the real returns of both assets.
Consider the below major economic scenarios and how bonds, managed futures and an options-based tail hedge behave in each.
|**Market condition**|**Government bonds**|**Managed futures**|**Tail Hedge**|
|:-|:-|:-|:-|
|Fast recessionary crash|Strong if yields fall (they usually do)|May (or may not) enter with the wrong trend-based positions and need time to adapt|**Explosive returns**|
|Slow equity bear market|Strong if yields fall|**Can adapt as trends form**|Helps only if & when stocks fall fast|
|Inflation and rising rates|Typically poor protection|**Can short bonds and profit from commodity trends**|Helps only if & when stocks fall fast|
|Stagflation|Typically poor protection|**Broad opportunity set**|Helps only if & when stocks fall fast|
|Deflationary recession|Strong|**Can adapt, but may lag**|Helps only if & when stocks fall fast|
|Fiscal or monetary credibility shock|May fall together with stocks|**Broad opportunity set**|Helps only if & when stocks fall fast|
# A different form of ballast
Managed Futures funds obtain most of their market exposure through futures and other derivatives rather than by owning the underlying assets. They still hold collateral, usually in Treasury bills or cash-like instruments. Using futures for exposure can lower trading frictions and make it easier to short an asset. This is the most important characteristic of these funds in my quest for the optimal portfolio ballast: because they can go both long and short across several asset classes, they have a much wider opportunity set than a bond fund. The fact that they don't trade the underlying assets may deter some investors who prefer to hold "real things". My own view is that these futures amount to effective exposure to the underlying assets, and the caveats concerning this type of instrument are acceptable.
Trend-following is the primary source of alpha in Managed Futures (there are others, like mean reversion, carry, etc., but trend is the dominant aspect). A trend-following fund can become short equity indexes during a bear market, short government bonds when yields rise, and long commodities during an inflationary surge. It can also become long bonds during a deflationary recession.
The academic case for trend (aka time-series momentum) has evidence across many markets and long samples. But trend strategies can suffer when markets move back and forth without direction, and they can enter a sudden crash with positions inherited from the prior regime. A fast decline followed by a fast recovery can hurt them in both directions.
While not a guarantee for a greatly improved return during a crash, the multi-asset, long/short nature of managed futures means that fully participating in an equities crash is far less likely than with simple long equities exposure. Some managed futures ETFs, like Simplify's "CTA", don't even include equities in their universe. Nevertheless, such a fund could, with some bad luck also fall drastically during an equities crash, until a new trend regime reshapes its positions.
This initial reaction problem is where tail-hedge ETFs, in particular "CAOS", enter the picture (investors who prefer a tail hedge denominated in currencies other than the USD or tied to an index other than the S&P500, please see the note at the end of this article).
CAOS holds S&P 500 put options and cash or cash-like instruments. It's designed to produce explosive returns during a fast and severe crash. During calm or sideways markets, or even slow, multi-year declines, it tends to produce a cash-like return. At least, that has so far been the case. Unlike managed futures, it doesn't need to detect a new trend before its protection begins to work. If the S&P 500 falls far and fast enough, the puts gain value through their contractual payoff and the rise in implied volatility that tends to accompany equity crashes.
Because of this, a combination of a managed futures ETF like KMLM, DBMF or CTA with CAOS is interesting. The two funds cover different problems. CAOS is there for the sudden break, when managed futures may still be positioned for yesterday’s market. If the crash turns into a prolonged bear market, managed futures have time to adapt.
Some form of portfolio-level profit-taking or threshold rebalancing is required to capture the full benefit of CAOS. The fund can otherwise give back much of a crisis gain as markets recover - as it did following the 2020 crash.
OK, so does the combination outperform bonds in backtests?
# What the backtests show
All backtests were performed on [testfol.io](http://testfol.io) which provides simulated or reconstructed data for many funds prior to their inception dates. They're based on the index data that underlie the funds, or on roughly equivalent predecessor mutual fund data. Typically, such data series include the fees that the actual ETFs charge. To be clear: every backtest here relies on backfilled data. So these tests are based on reasonable approximations, not on live ETF data.
**All backtests in the article start with an initial investment of $10k and have no further contributions, portfolios are rebalanced annually with 5%/20% bands, and returns are inflation-adjusted**.
Unfortunately, we cannot backtest CAOS before 2013. CAOS itself only launched in 2022. Its mutual fund precursor had its inception in 2013. Simulated data that go back further aren't available. So, we have no direct evidence of how CAOS would have behaved in serious market trouble like the Lehman shock. S&P 500 puts made a bundle during the sharpest part of 2008, so a CAOS-like strategy would have had the right basic setup, and would presumably have produced a positive return in that year. Notably, the mutual fund precursor of CAOS worked as intended in the brief but drastic 2020 Covid shock.
I tested three portfolios. The first test begins in 2013 and uses a simulated history for the ETF "DBMF" to occupy the managed futures portion. It includes the managed-futures "bear market" between 2013 and 2022, the COVID crash, and the bond bear market that followed the post-Covid inflation surge.
Here's the backtest results from [testfol.io](http://testfol.io), 2013 to current:
|Name|Ending Value|Cumulative Return|CAGR|Max Drawdown|Longest Drawdown|Volatility|Sharpe|
|:-|:-|:-|:-|:-|:-|:-|:-|
|VT50 / BND50|$16,647.15|66.47%|4.01%|\-27.03%|4.13y|8.95%|0.59|
|VT50 / DBMF50|$22,947.62|129.48%|6.61%|\-20.82%|2.06y|10.53%|0.75|
|VT50 / DBMF25/ CAOS25|$20,670.64|106.71%|5.75%|\-17.79%|2.59y|9.80%|0.71|
Reference: [https://testfol.io/?s=g9sLcBV2Thj](https://testfol.io/?s=g9sLcBV2Thj)
As one might expect, since there was only a short equities crash in this period, and since we apply no profit taking to CAOS, the 50/50 VT + DBMF portfolio produced the highest return. Replacing half of DBMF with CAOS reduced the return but also produced the smallest maximum drawdown. Sharpe remained essentially equal with or without CAOS.
So the most important take-away is: managed futures did better than bonds in a period that contained both bond bull and bear periods, as well managed-futures bull and bear periods.
Next, I tested a longer reconstruction using simulated KMLM data. While simulated DBMF data is my preferred managed-futures proxy for backtesting purposes due to it representing a replicated aggregate of a bunch of different managed futures funds, KMLM - a single-index fund - has the longer simulated history. It's a reasonable substitute. Again, returns are inflation-adjusted. Since 1988, the 50/50 VT + KMLM portfolio had the highest real CAGR at \~6%, compared with 4.5% for VT + BND. Adding SHY to the VT/KMLM portfolio (instead of CAOS) reduced drawdowns somewhat but also returns. This is what I would also expect to happen with CAOS *and no profit-taking*. With a profit-taking rule, the picture would probably change quite a bit.
This is the longest test in the review, starting in 1988, running to the current date.
|Name|Ending Value|Cumulative Return|CAGR|Max Drawdown|Longest Drawdown|Volatility|Sharpe|
|:-|:-|:-|:-|:-|:-|:-|:-|
|VT50 / BND50|$55,805.24|458.05%|4.55%|\-32.80%|4.09y|9.25%|0.50|
|VT50 / KMLM50|$99,088.27|890.88%|6.12%|\-28.67%|3.18y|10.16%|0.61|
|VT50 / KMLM25/ SHY25|$67,858.11|578.58%|5.08%|\-25.05%|3.46y|8.87%|0.58|
Reference: [https://testfol.io/?s=feXGOB9mLaQ](https://testfol.io/?s=feXGOB9mLaQ)
By the way, a portfolio containing VT, KMLM, ***and*** BND (not in the table) returned \~5.5% with a smaller drawdown than either of those other two portfolios.
The simulated price series for DBMF starts in January 2000. Here's how the VT/DBMF combo with or without SHY has done since then. Same picture as above. Equities + Managed Futures easily beats Equities + Bonds. And again, with SHY in the mix, we don't get any substantial improvement.
|Name|Ending Value|Cumulative Return|CAGR|Max Drawdown|Longest Drawdown|Volatility|Sharpe|
|:-|:-|:-|:-|:-|:-|:-|:-|
|VT50/BND50|$23,885.42|138.85%|3.33%|\-32.80%|4.09y|9.82%|0.45|
|VT50/DBMF50|$35,614.72|256.15%|4.89%|\-29.55%|3.50y|10.81%|0.56|
|VT50/DBMF25/SHY25|$27,357.41|173.57%|3.85%|\-30.99%|3.69y|9.84%|0.50|
Reference: [https://testfol.io/?s=9Tyh0bFWaKy](https://testfol.io/?s=9Tyh0bFWaKy)
Next, I zoomed in on the effect of managed futures during equities crashes.
First, the dotcom drawdown, January 2000 through December 2002.
|Name|Ending Value|Cumulative Return|CAGR|Max Drawdown|Longest Drawdown|Volatility|Sharpe|
|:-|:-|:-|:-|:-|:-|:-|:-|
|VT100|$5,702.39|\-42.98%|\-17.11%|\-50.97%|2.77y|19.36%|\-0.94|
|VT50/BND50|$8,524.67|\-14.75%|\-5.19%|\-21.58%|2.77y|9.27%|\-0.66|
|VT50/DBMF50|$8,704.35|\-12.96%|\-4.53%|\-18.27%|2.83y|9.12%|\-0.60|
Reference: [https://testfol.io/?s=9EFDrk1NFvL](https://testfol.io/?s=9EFDrk1NFvL)
Toss-up. DBMF and bonds did about equally well.
Now the Lehman shock-induced mega crash. January through December 2008.
|Name|Ending Value|Cumulative Return|CAGR|Max Drawdown|Longest Drawdown|Volatility|Sharpe|
|:-|:-|:-|:-|:-|:-|:-|:-|
|VT100|$6,016.22|\-39.84%|\-39.94%|\-52.56%|1.00y|42.78%|\-1.00|
|VT50/DBMF50|$8,441.92|\-15.58%|\-15.63%|\-26.48%|0.63y|19.44%|\-0.84|
|VT50/BND50|$8,175.07|\-18.25%|\-18.31%|\-30.24%|0.99y|21.88%|\-0.87|
Reference: [https://testfol.io/?s=etbb2D7NeFE](https://testfol.io/?s=etbb2D7NeFE)
Again, basically a toss-up. Profit-taking with CAOS would presumably have produced a positive return in that year.
Overall, the equities + managed-futures combo outperforms the equities + bonds combo over time, ***mostly because of better returns outside crises.***
Whether adding CAOS with profit-taking outperforms both over long periods is an open question. For example, while CAOS would have given us a gain in 2008, it may not have done much in the slower dotcom drawdown. Also, between 2009 and 2019, it would only have produced cash-like returns. Bonds may have produced better performance given the bond bull of that period.
# Should managed futures + tail hedge replace bonds?
Before I give my conclusion, I should point out that the question asked here puts only managed futures on the spot. It suggests that bonds are the default and the burden of proof lies with managed futures. I see no good reason for this framing, and investors should also ask the reverse question: should bonds replace managed futures + tail hedge?
My conclusion is: for the long-term ballast role in a general investment portfolio - as opposed to some sort of liability-matching role - managed futures, or managed futures in combination with a tail hedge, is the more robust choice than bonds alone. It covers a greater variety of adverse scenarios, and has more tools at its disposal to react to them.
One might choose to forego the tail hedge portion, and either accept the cushioning effect of managed-futures alone as "best we can do", or look for some other, tactical risk management tool to further address equities crashes. (In my hedge-fund like portfolio concept, I do apply such a tool.)
Another option is to maintain managed futures and CAOS as the standing ballast, then add duration when some kind of macro-economic rule identifies a disinflationary regime. Such a rule could use inflation expectations, Treasury price trends, growth data, and central-bank policy. I would fund that position by reducing equities rather than dismantling the managed-futures and tail-risk sleeve.
\*\*\*\*
**Note for non-USD investors.** European investors in particular can access a DBMF equivalent through the iMGP DBi UCITS fund. I have not found a direct UCITS equivalent to CAOS. A smaller allocation to Ellipsis Optimal Solutions Alternative Hedging combined with short-duration euro sovereign bonds may offer a comparable division between tail protection and low-risk collateral. Sizing and return profile would need separate testing.
