Let's continue yesterdays discussion about uncorrelated return streams. Yesterday, we talked about Ray Dalio's investing utopia of blending together 15-20 uncorrelated return streams in pursuit of a beefed up version of his more commonly known All-Weather portfolio. I included the following matrix of various alts and a few fixed income funds that have low to negative correlations to equities and low and negative correlations to each other.
The matrix goes a long way toward true diversification as opposed to some other ideas/portfolios/funds whose idea of diversification is to own a lot of long and intermediate term bonds. Dalio's All-Weather allocates 55% to long and intermediate term bonds.
If something is supposed to diversify equity exposure with a negative correlation and the stats back that up, then it is easier to understand why it lags when the stock market goes up a lot. When something is supposed to have a very unvolatile, fairly consistent but low return then it is easier to understand why it lags when stocks go up a lot. Same with something that is truly uncorrelated, it just does its own thing, irrespective of what the stock or bond market is doing. Alt 3 and Alt 4 in the matrix are examples of that. Bitcoin might fit into this description too.
I thought it would be useful to look at some example of diversification attempts that maybe don't work out as well on the matrix below, I blocked out the names of funds that are doing poorly, piling on is not the point.
All of the funds look to offer an enhancement on a balanced portfolio or otherwise be a core portfolio holding. They all blend different assets together with some sort of strategic goal. The timeframe is short because a couple of the funds are newer. While the products are well diversified, maybe HEQT not so much, the diversification is arguably not very effective for the three unnamed funds.
Something like the Permanent Fund (PRPFX) does look different than VBAIX but the performance is close, I'd say that if it was lagging too, and it has a lower standard deviation. PRPFX is supposed to be a substitute for VBAIX and it meets that expectation. It will not always outperform of course, nothing will but it works.
The three unnamed funds are trying to do the same thing but somehow they are coming up short. There is a lot of academic research shows large allocations to longer duration bonds leads to very good results and the three unnamed funds have that idea embedded. I frequently talk about the importance of fully understanding something before deviating away from it. The context is usually the 4% rule for retirement withdrawals but it also applies to the research that concludes we should be heavy in long bonds. Any research done on this includes a 40 year period where interest rates went from the mid-teens down to zero. This cannot be repeated. That is a simple observation to make, portfolios will not get a tailwind from bonds that is anywhere near was it was from 1981-2021. The correlation of fixed income to equities has become more volatile and less reliable. It really is that simple.
In a way, this makes portfolio construction more difficult but to the extent it is more difficult, the ETF and mutual fund industry are offering more accessible sophistication to address the issue. The difficulty is more like being able to sift through the funds that don't quite get the job done in favor of the ones that do. It is important to understand why successful funds are successful.
I write all the time about the effectiveness of using AGFiQ US Market Neutral Anti-Beta (BTAL) to help manage equity volatility.
The two portfolios have identical standard deviations but the blue line allocates 79% to equities versus just 60%, it compounded 291 basis points better than 60/40 and in 2022 it was only down 10.07% versus 16.87 for 60/40. It only takes a little bit of work to find these. As Tom Petty might have said, the sifting is the hardest part.
BTAL is a client and personal holding.
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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