What If It Blows Up?

 Like we were saying the other day, bonds should be boring. 

I used this chart to ask what do you want your fixed income holdings to look like.

To the Kelly quote, which lines look boring to you?

Simplify put out a paper that digs into the Simplify Currency Strategy ETF (FOXY) that we touched on the other day. If you have curiosity about it, the paper is worth reading. I said I was interested enough to start following it, having no idea what to expect. This chart from the paper doesn't paint a rosy picture. 

Two of the three strategies have traded sideways in the 2020's. Where FOXY is not intended to be a first responder defensive with a high negative correlation to equities, a prospective investor should have some basis to believe the strategy will compound positively and this chart doesn't provide that basis. 

This next chart from Bloomberg compares just the carry component of the FOXY fund to the S&P 500 and T-Bills.

The black line for carry looks like it is somewhat uncorrelated which is different than negatively correlated. Simple math, it looks like the carry index has compounded at less than 3%. The red line for T-bills is price only. I'm not bailing on following the fund so quickly, but my expectations are now less than the first impression that the fund made. 

The ReturnStacked guys posted a paper titled Margin Management In Return Stacking. The Tweet I saw promoting the paper said "how does it blow up?" We've looked at it from the perspective of what can go wrong and as the paper said, where stocks plus managed futures are concerned, both of them going down a lot at the same time could cause margin problems. 

From the paper, "a 15-20% drawdown in managed futures might deplete available cash collateral and trigger a call." If you use the fund in the manner that I think they intend, a blow up for the stocks and managed futures ETF would be a setback for a portfolio but not a catastrophe. The odds of a big enough decline in managed futures, not captured in that quote by the way is that it would have to be a very fast 15-20% decline, at the same time as stocks are low. No question, the odds are low but it's not impossible. 

If you've ever heard the cliche that in a crisis, all correlations go to 1, in the face of some sort of market spasm it is possible that stocks and managed futures get hit in the same manner at the same time. I think the paper is saying this could be problematic for the fund. 

If you look at the holdings of RSST, you will see 25% in cash, which is a buffer of sorts. If you look at Cambria Chesapeake Pure Trend ETF (MFUT) which is just managed futures, it has 80% cash. The notional value of some of the positions in MFUT are huge relative to the size of the fund but those three positions are overnight currency rate futures where a 2% move would be huge meaning those positions triggering a problem is extremely unlikely. The more volatile futures contracts like gold have much smaller weightings. 

The complexity of combining equities and managed futures adds a risk that isn't there if you build it yourself. 

The results between the three aren't very different. The first two did slightly better because of the leverage. RSST relies on the relationship between equities and managed futures staying uncorrelated or negatively correlated and that is a good bet the vast majority of the time but one spasm could be problematic. If you gotta have the leverage, using a 2x S&P 500 fund like SSO to create the same portfolio has its own risks but relying on equities and managed futures to maintain its normal relationship isn't one of them. And why do you think you need the leverage?

White shoe ETF provider Tidal posted a paper about what might come next for ETF innovation. The only point that really jumped out was that "the appetite for complex active ETFs is high." I'm sure their assessment is correct but it's very easy to add in too much complexity. Some complexity used correctly can improve long term, risk adjusted results but too much complexity just becomes more risks of things that can go wrong. 

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.