I stumbled into an old podcast from Resolve Asset Management that looked at the lack of differentiation from most factors and how to seek out "orthogonality" to get better diversification.
Looking at the above factors, they would argue that it is difficult to get true diversification from these factors and others. There's maybe some diversification benefit to dividends and equal weight but they are all shades of the same color. It has been a patience-trying two years for anyone who built their core equity position around a dividend ETF though.
Although the way we articulate these ideas has changed we've basically been having the same conversation about trying to learn how to better diversify the portfolio without giving up too much of the equity market's ergodicity, it's inertia from going up more often than not.
Solving this puzzle has led us away from relying on longer term bonds and into small allocations to various types of diversifiers but it is productive and fun to continue to dive deep into other strategies that could help.
So where we are looking for differentiated return streams, does the blend of equities and managed futures in one fund do that?
The chart is unfairly short so it is too soon to draw a conclusion for the ReturnStacked US Stocks and Managed Futures (RSST) but if it works, I don't know if it will, there should be differentiation the next time stocks have a prolonged decline. Trying to assess whether something will work comes down to first understanding the premise, then the process and probably a matter of patience after that.
I saw that Tweet today. I don't have any idea if GNMA will work. A strategy that goes in or out based on whatever metric or process is intellectually appealing but hard to pull off. The Pacer Trend Pilot ETF that I used ages ago worked a couple of times but there were market events where the signal it used wasn't right for a particular market event and so it did very badly, this was in the 2020 Pandemic Crash. The ATAC US Rotation ETF (RORO) relies on a signal from gold compared to lumber. Gold outperforming means risk off, RO, and lumber outperforming means risk on, the other RO. It just about got cut in half between October 2021 and October 2022. How about that symbol for GammaRoad, wow!
A similar fund that could be intriguing is the Cambria Tactical Yield ETF (TYLD). When yield spreads are narrow, it will own T-bills and when spreads widen out it will diversify into fixed income sectors and REITs. It just listed at the start of the year and has only owned T-bills so far. The logic is certainly simple to understand and I have no doubt that there's plenty of research behind the fund launch but it's not the sort of thing that most people can backtest on their own and spreads are cable of doing the unexpected but I do follow this one, I want to see if it can "work."
And because I think it's related, I wanted to put another simple, Permanent-inspired portfolio on the table to discuss with Portfolio 2.
The portfolios are clearly defined and the result for Portfolio 2 is valid but of course there are tradeoffs. The ride is obviously very smooth over a decently long time frame. It also avoids interest rate risk and what I've been calling unreliable volatility from longer duration fixed income.
In the 11 full and partial years we can see that Portfolio 2 lagged by a lot in 2016 and 2020. It was the best performer four times and it was also middling in four different years. You can also see a long run from 2016 to 2021 where it was pretty far behind 60/40. In that stretch, Portfolio 2 compounded at just half the rate of 60/40. Much of the lag can be attributed to a dark winter for managed futures. Managed futures' best year in that window was a gain of 1.93%.
With T-bill rates around 5%, I believe managed futures will do better than when interest rates were at zero. Managed futures has a good track record for being a diversifier, for being orthogonal. Not infallible mind you but good, the track record is pretty clear. To the notes above about the podcast, managed futures and several others we look at have differentiated return streams as opposed to being a different shade of the same color of large cap equities. Obviously the risk to a huge weighting into any alt, including managed futures, is the one or two instances it doesn't differentiate when investors need it to.
In 2018 the S&P 500 was down a little over 4% and managed futures was down about 8%. Those aren't big numbers so a portfolio that was 80% equities and 20% managed futures that year would have been down 5.4%. Ok, no big deal, it happens. We can backtest RSST and in that year it might have been down 15% in a down 4% world. But what if the numbers were bigger? What if the capitally efficient blend was down 25% in a down 10% world? Yes, that is unlikely but not impossible.
I'm pretty sure ReturnStacked is not positioning the fund for anyone to put 100% into it but it is a very common behavior for investors to get overly excited about a good idea and allocate too much to it. Then they don't find out they had too much until something bad happens.
The information, analysis and opinions expressed herein reflect our judgment and opinions as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation.
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