A TIPS Portfolio Hedged With A LIttle Equity?

Ages ago I wrote a couple of posts about Boston University professor Zvi Bodie and his belief that stocks actually get riskier the longer you hold them and his belief in allocating a lot to TIPS, with just a little allocated to risk assets. It's similar to Nassim Taleb's idea from a while back about 90% in T-bills from around the world and 10% into high risk asymmetry. Here's a link from me from 2012. Bodie still believes in this, here's a paper he wrote in 2020, doubling down. 

He likes TIPS for their volatility profile and because they are real return and he is very concerned about what amounts to sequence of return risk hammering investors as they get close to retirement. We've written a couple of hundred posts about how to manage sequence of return risk but a big allocation to TIPS is interesting. I get the idea of being very worried about sequence of return risk but bro...

 

The real return of TIPS does not adequately compensate for the opportunity cost of a normal allocation to equities. If you need portfolio growth in order for your financial plan to work, like most people, a portfolio chock full of TIPS is not the answer. I think investors would be much better off actively managing sequence of return risk 2 or 3 or 4 years before their planned retirement date. 

A big allocation to TIPS in a game over portfolio though is a different story. Portfoliovisualizer can help here. 

TIP is the largest ETF in the segment and has a weighted average maturity of 7.66 years versus 3.13 years for STPZ. I own STPZ personally and for clients preferring the shorter maturity. Client and personal holding MERFX is an absolute return fund with very little volatility and SSO is 2x the S&P 500. Here are the results.

 

And

 

Both portfolios 1 and 2 tracked similarly with CAGRs around 7% versus 9% versus 100% allocated to Vanguard Balanced Index (VBAIX) which is a proxy for a 60/40 portfolio. Portfolio 1 mostly outperformed Portfolio 2, benefiting from the longer maturity when that was the better trade. YTD, Portfolio 2 is outperforming and had a smaller max drawdown by a considerable amount thanks to taking less interest rate risk with STPZ. 

During the 2020 Pandemic Crash, Portfolio 1and Portfolio 2 each fell the same 9.3% (weird but I double checked it) while VBAIX fell 12.5%. The YTD difference between Portfolio 1 and Portfolio 2 is noteworthy, with 2 outperforming by 281 basis points. The H1 difference is even larger with Portfolio 1 dropping 13.8%, Portfolio 2 dropping 9.3% and VBAIX dropping 18%. 

An annualized return just under 7% for a game over portfolio with a standard deviation of 6.57 for Portfolio 2 is pretty good. It relies heavily on the daily reset of SSO not having an adverse compounding effect though. The history of the daily reset is not that bad in my opinion, you may view it differently of course, but anything can happen in the future. 

This portfolio is a capital efficiency idea with a 40% notional exposure to equities. If instead you put 20% into SPY, the plain vanilla S&P 500 ETF, the CAGRs of Portfolios 1 and 2 are 4.88% and 4.49% respectively. The worst year for the lower duration Portfolio 2 was a decline of 2.9% which is for 2022. For the first 6 months of this year, the worst of the bear market so far, Portfolio 2 was down 5.5%.

Mid-high single digit growth with such low volatility is pretty good for a situation where game over is appropriate. I would note that the TIPS funds are likely to get big kickers this year because of what CPI is doing. What is most appealing is getting that type of return only exposing 20% to risk assets. Hiding out in MERFX and STPZ to avoid sequence of return risk makes a lot of sense to me but in real life I wouldn't have anywhere near 20% in MERFX, I'd diversify that out a little to have several absolute return funds that are just as boring and while I cannot envision what could cause STPZ or TIP or any other TIPS fund to blow up, I would have a tough time putting 60% into just one of them. I'd be ok with 60% into a series of individual issues but be prepared for a lot more work in that case.  

The difference in today's study is that we put nothing into funds that tend to go up when stocks go down. I will play around with that for a future post to see if we can keep the returns similar but get the standard deviation down a little more.