The ultimate risk - covariance to bad times

The ultimate risk for any asset is based on the simple fact on whether it goes down in bad times. This is the most important risk that any investor faces. Investors want to be assured that their portfolio can maintain or improve their consumption pattern in bad times. What is the purpose of wealth if it not to hold onto our consumption patterns? Hence, any investor want to have some assets that will smooth their growth in wealth.

Investors always hold a wealth portfolio that will move up or down. This is the definition of   portfolio volatility, but the real portfolio risk is that your wealth will decline in bad times when your income may be negatively affected by a poor economy. Income changes with growth  which will then impact consumption. Investors want to call upon their wealth to smooth income and thus allow for smooth consumption. Call upon your wealth reserves so you don't have to change your consumption behavior.

A wealth shortfall when income is declining will impact your consumption pattern. A very valuable asset is one that will do better in bad times, or at least not as poorly. Investors should be willing to pay a premium for those types of assets. Their expected return may be lower than other assets. For those assets that are highly correlated with the business cycle, investors should receive a higher return or risk premium. 

The value of low correlation is very strong with portfolio diversification, but the static bundling of assets does not tell us the true risks and benefits of covariance with bad times. So what assets will do well in a market decline. We know that bonds may be a safe asset. Rates go down when their is a recession. We know that defensive stocks and non-cyclicals will also do better in bad times. A strategy that can go long and short and exploit market dislocations will also be valued. Hence, managed futures will have the right covariance to bad times.

One of the key reason for the benefit of managed futures is this specific property of negative covariance when times are bad. Some have called this crisis alpha. The benefit is actually very simple. A diverse portfolio with asset classes including equities, bonds, commodities and foreign exchange with the  ability to go long or short will have an advantage over a focused long-only asset. The focus of following the trend may do better than a strategy based on forecasts that may prove wrong. If you want true diversification look for the asset that may thrive in bad times.