Simple Tests of AMJ as Diversifier

May 24, 2013 • Posted in Strategic Allocation

A subscriber suggested testing the diversification power of exchange-traded aggregations of U.S. pipeline Master Limited Partnerships, such as JPMorgan Alerian MLP Index ETN (AMJ), as a distinct asset class. To check, we add AMJ to the following mix of asset class proxies (the same used in “Simple Asset Class ETF Momentum Strategy”):

PowerShares DB Commodity Index Tracking (DBC)
iShares MSCI Emerging Markets Index (EEM)
iShares MSCI EAFE Index (EFA)
SPDR Gold Shares (GLD)
iShares Russell 1000 Index (IWB)
iShares Russell 2000 Index (IWM)
SPDR Dow Jones REIT (RWR)
iShares Barclays 20+ Year Treasury Bond (TLT)
3-month Treasury bills (Cash)

First, per the findings of “Asset Class Diversification Effectiveness Factors”, we measure the average monthly return for AMJ and the average pairwise correlation of AMJ monthly returns with the monthly returns of the above assets. Then, we compare cumulative returns and basic monthly return statistics for equally weighted (EW), monthly rebalanced portfolios with and without AMJ. We ignore rebalancing frictions, which would be about the same for the alternative portfolios. Using adjusted monthly returns for AMJ and the above nine asset class proxies from July 2009 (first return available for AMJ) through April 2013 (only 46 monthly returns), we find that:

The following chart summarizes average monthly returns with variability ranges of one standard deviation for AMJ and the EW portfolios without and with AMJ over the available sample period. During this time, AMJ generates a low positive average return with relatively low volatility. Adding AMJ to the diversified EW portfolio has little effect on return and volatility. The ratio of average return to standard deviation (return per unit of risk) is 0.35 (0.38) without (with) an AMJ position.

The average pairwise correlation of AMJ monthly returns with those of the other assets is a middling 0.38 over the available sample period. Fairly high correlations with equity funds and DBC drive this result.

Per “Asset Class Diversification Effectiveness Factors,” the high positive average return (middling average pairwise correlation) of AMJ indicates a good (middling) contribution with respect to portfolio diversification.

Sample size is small in terms of number of months, and especially, variety of market conditions.

What is the net effect on cumulative portfolio performance?

AMJ-diversification-monthly-stats

The next chart compares cumulative values of EW portfolios without and with AMJ in the mix over the available sample period. Adding AMJ has little effect on volatility and slightly improves cumulative value over the sample period.

Again, sample size is small.

AMJ-diversification-cumulative

In summary, evidence from simple tests over the available sample period supports belief that adding a proxy for U.S. pipeline Master Limited Partnerships to a diversified portfolio improves overall performance.

Cautions regarding findings include:

  • As noted, the sample period is very short in terms of market conditions (part of one bull market).
  • Including the trading frictions associated with monthly rebalancing would depress performance of both portfolios, depending mostly on portfolio size.
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