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In previous research, we highlighted the diversification benefits that can be obtained by investing in assets with low correlation and how risk reduction can be monetized via leverage.1 Building on this research, we are introducing the Merrill Lynch Multi-Asset Strategy (MAST) Index, which implements a rules-based and objective model that is designed to be investable.
MAST seeks to make two improvements on "standard" allocation models such as those that follow the 70% equity and 30% fixed income mix.2 First, the strategy uses commodities and currencies as two additional assets. All four assets (as measured by the component indices) historically had a close to zero correlation and provided important diversification benefits. Even with three uncorrelated assets one can obtain a greater risk reduction than an infinite number of 0.5 correlated assets.
Second, the objective of the asset allocation model underlying MAST is to generate the highest possible portfolio Sharpe ratio, i.e., the highest portfolio return per unit of risk after accounting for the financing rate. Investors with access to leverage can then increase (or decrease) their exposure to MAST by borrowing (or lending) funds to target their desired risk level. According to our back test, using leverage to target risk is significantly more effective than overweighting high-risk assets. Results may vary depending on the cost of leverage.
MAST is implemented using the Merrill Lynch (ML) Commodity eXtra Index, ML Foreign Exchange Arbitrage Index, MSCI Developed World Equity Index, and ML 10-year USD Treasury Futures Index. The strategy is rebalanced semiannually, and the weights are obtained by applying the capital asset pricing model. Because we assume the Sharpe ratios of all component indices are equal, the MAST Index weights in our application depend only on the historical standard deviations and correlations of the four component assets. (See Exhibits 1 and 2.)
Based on back-tested data, Exhibit 3 illustrates the value of using four uncorrelated assets and having the explicit objective to maximize the portfolio Sharpe ratio. The dotted line plots the efficient frontier, representing allocations that give the highest return for a given target risk according to the capital asset pricing model.
According to our back test, using four uncorrelated assets added a 3.2% return per annum compared with the 70% equity and 30% fixed income...