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Portfolio Construction

portfolio-constructionLevel 2 — Intermediate

Prerequisites

Edge IdentificationRegime Detection

Unlocks

Behavioral Portfolio Construction

What It Is

Portfolio construction is the process of combining individual strategies or assets into a portfolio that maximizes risk-adjusted returns by exploiting diversification — including risk parity, equal risk contribution, and all-weather frameworks.

Correct Execution

  • Measure diversification in terms of independent return streams, not just correlation buckets
  • Weight positions by inverse volatility as the baseline; add return expectations only where they are robust
  • Use futures and leverage to express the portfolio you actually want, not the portfolio your capital base forces on you
  • Explicitly model crisis correlation — assets that look uncorrelated in normal regimes often converge in tail events
  • Buy-and-hold equities blend better with managed futures than with long-short equity programs because the simplicity eliminates interaction effects

Progression Levels

Diagnostic Tree

Coaching Cues

  • "Managed futures is not primarily a hedge — it's a structurally uncorrelated return stream. When it works in crises, that's a feature, not the reason to own it." — Eric Crittenden, FWM S3E7
  • "The permutation risk of crisis alpha is real — I can build scenarios where trend doesn't work in an equity downturn. Don't promise it as a guarantee." — Eric Crittenden, FWM S3E7
  • "When you have two assets with similar expected returns but zero correlation, blending them is strictly better than either alone. That's the whole game." — Adam Butler, FWM S1E1

Common Errors

  1. Diversifying by asset class names rather than return drivers: Bonds and equities can be correlated in inflationary regimes; "diversification" across stocks, bonds, REITs, and credit is mostly the same equity beta → Map every position to its fundamental return driver before assessing true diversification
  2. Sizing managed futures too small to matter: A 5% allocation to trend-following won't move the portfolio during a crisis → Size alternatives to 15-25% for them to have portfolio-level impact
  3. Blending long-short equity with managed futures instead of buy-and-hold: Long-short equity has equity correlation embedded — pairing it with managed futures creates interaction effects that reduce the diversification benefit → Simpler buy-and-hold equity + managed futures blends more cleanly

Edges

⚡ Conventional Wisdom Is Wrong

A 5% Managed Futures Allocation Is Decoration, Not Protection

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Institutional and retail investors routinely add managed futures at 5-10% of portfolio as a "crisis hedge." At this size it cannot move the portfolio during a crisis — a 30% gain on 5% allocation produces 1.5% portfolio-level benefit while equities drop 40%. The sizing decision is the actual decision; the manager selection is secondary. A 5% allocation is not diversification — it is dressing up an equity-dominated portfolio to look more sophisticated.

What most people do
Allocate 5% to managed futures, feel diversified, and wonder why the portfolio still fell 35% in the next equity crisis.
What the best do
Allocate a minimum of 15-25% to achieve meaningful portfolio-level impact; then select the manager. Accept that this means structural underperformance in sustained equity bull markets.
Why it's an edge: Most investors and advisors optimize for psychological comfort (feeling diversified) not mathematical impact. Understanding the minimum effective dose of a crisis alpha strategy is rare.
How to exploit: Simulate a portfolio with managed futures at 5%, 15%, and 25% through 2008 and March 2020. Calculate the portfolio max drawdown at each weight. Let the math determine the minimum size where the allocation matters. Then make the allocation decision knowing the real trade-off.
Cross-domain parallel
In algorithmic trading portfolio construction, an uncorrelated strategy at 2% of risk budget has essentially zero impact on portfolio Sharpe. Kelly sizing theory makes the same point: the position must be large enough to move the needle.
Eric Crittenden, "All-Weather Portfolios with Trend Following," FWM S3E7, 2021-04-10
🔑 Hidden Causal Lever

Long-Short Equity Ruins the Managed Futures Diversification

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The natural pair for managed futures is buy-and-hold equity — a simple, clean diversification of two structurally opposite return streams. When investors replace buy-and-hold with a long-short equity program "to reduce equity risk," they introduce correlated exposures that appear diversified but interact with managed futures in complex ways. Long-short equity still has substantial net long equity beta; the short side creates sector-level correlations that contaminate the futures program. The result: the combined portfolio has more moving parts and less diversification than the simpler combination.

What most people do
Replace buy-and-hold equity with long-short equity in a "more sophisticated" portfolio blended with managed futures.
What the best do
Keep buy-and-hold equity for its clean structural simplicity; let managed futures do the diversification work without interaction effects from the equity allocation being more complex than necessary.
Why it's an edge: Sophistication-seeking investors pay higher fees for long-short equity and destroy the diversification benefit they were trying to achieve. The simpler combination is mathematically superior.
How to exploit: Before adding a long-short equity manager, run a factor decomposition of their returns to identify the true net equity beta. If above 0.4, model the combined portfolio's crisis behavior. Compare to a simple buy-and-hold + managed futures combination at the same expected return level.
Cross-domain parallel
In systematic trading, adding a second correlated alpha signal does not improve the Sharpe in proportion to its standalone performance — the interaction term matters.
Eric Crittenden, "All-Weather Portfolios," FWM S3E7, 2021-04-10 — "Don't have too much onion in the meal."
⚡ Conventional Wisdom Is Wrong

Every G7 60/40 Has Had a 60%+ Real Drawdown — The All-Weather Portfolio Exists for a Reason

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US investors assume the 60/40 portfolio is a safe long-run strategy based on 40 years of strong nominal returns. This recency bias is dangerous. Every G7 country has at some point experienced a 60-70% real drawdown on a 60/40 portfolio — including Germany, Japan, Italy, France, and the UK. The US has been uniquely lucky. A genuinely diversified portfolio is not a hedge against underperformance — it is survival insurance against scenarios that seem improbable but happen to every developed economy eventually.

What most people do
Judge all-weather / diversified portfolios on their underperformance relative to US 60/40 since 1980 and conclude they're "not worth the drag."
What the best do
Evaluate a portfolio's function through the lens of tail-risk survival across regimes and countries, not relative performance in the best 40-year bond market in history.
Why it's an edge: Survivorship bias in portfolio construction is institutional — most managers only have careers that span one or two regimes. Understanding the full cross-country evidence changes the framing from "performance drag" to "survival cost."
How to exploit: Look up the real (inflation-adjusted) drawdown history for a 60/40 portfolio in Japan (1990-2000), Germany (1920s), and the UK (1970s). Use these as stress scenarios for your current portfolio. Define the maximum real drawdown you can tolerate over any 20-year period and work backward to the portfolio that achieves it.
Meb Faber, "Just Survive," FWM S1E4, 2021-04-10; Jason Buck, "All Weather and Cockroach Portfolios," 2022-06-25

Sources

  • Eric Crittenden, "All-Weather Portfolios with Trend Following," Flirting with Models S3E7, 2021-04-10 — buy-and-hold + managed futures blending; equity sector exposure in futures programs; all-weather portfolio theory
  • Adam Butler, "The Ultimate Gift," Flirting with Models S1E1, 2021-04-10 — diversification mechanics; independent return streams
  • Meb Faber, "Just Survive," Flirting with Models S1E4, 2021-04-10 — real drawdown history across G7; trinity portfolio concept
  • Jason Buck, "All Weather and Cockroach Portfolios," 2022-06-25 — inflation regime diversification; real vs nominal return distinctions
  • David Berns, "How Do You Build Portfolios for Human Beings," Flirting with Models S4E16, 2021-08-16 — behavioral constraints in portfolio construction