Put It All In.....Long Short?

NEPC posted a short paper about how to choose the right alternatives to diversify a 60/40 portfolio. The introduction covers the same ground we have been covering here forever.

Investors can count on a broad array of strategies to incorporate diversification into their portfolios. These approaches—often overlooked in an upmarket—help diversify away from equity risk which is the most prevalent risk in investment portfolios. They also help stabilize the portfolio over the long term and improve risk-adjusted returns. Gains originating from diversifying strategies can serve as a source of liquidity during/post a market downturn, serve as dry powder to reinvest following periods of stress, reduce volatility drag, and/or increase the terminal value of the portfolio. At NEPC, we think it is critical to establish clear goals and expectations when building a diversifying allocation. If investors are unclear on the goals of the allocation, they are more likely to abandon the strategy. In our view, a diversifying allocation is meant to complete portfolio construction, not compete with the return-seeking portion of the total portfolio. While many investors utilize a mix of strategies to create a diversifying allocation, we believe that the optimal approach should have two main characteristics: provide complementary attributes in various market environments and include strategies with a low correlation to each other and a portfolio consisting of stocks, bonds, and private investments. As a result, in this paper, we focus on global macro and trend following, fund-of-hedge-funds, multi-strategy, and event-driven approaches. We believe that when these five low-correlated approaches are combined and customized to meet the individual investment goals of our clients, they can efficiently achieve the required level of diversification while earning returns over a full market cycle.

The conclusions weren't new for what we've studied here other than sending me down a bit of a rabbit hole for long short equity. We've talked about there being different types of strategies within long short, well it turns out there are proper names for these types. Some of them below;

• Market Neutral- Vanguard Market Neutral (VMNIX) as an example
• Long Biased- AQR Long Short (QLEIX)
• Variable Biased- Invenomic (BIVIX)
• Event Driven- could include merger arbitrage
• Quantitative/Statistical- I would include client/personal holding BTAL in this group

That got me to thinking that these could be the building blocks for a portfolio. Where some people have talked about putting it all in trend/managed futures, what would it look like to put it all in various forms of long short? Long biased could be a substitute for plain vanilla equity, market neutral and merger arb could be substitutes for plain vanilla fixed income and the use of BTAL is pretty similar to how we discuss it in other posts. For the record, putting it all in trend/managed futures is a terrible idea.

Portfolio 4 is VBAIX and Portfolio 5 is price inflation.

Portfolio 1 does not keep up with portfolios that have close to a normal allocation to equities but that portfolio was less volatile, did have an adequate real return and had much smaller drawdowns except in the 2020 Pandemic Crash. Another important observation is that Portfolio 1 is truly differentiated from 60/40. In the 11 full and partial years studied, it was plus or minus more than five percentage points from VBAIX five times. Sometimes that was a good thing and sometimes it wasn't. And it case it's not obvious, Portfolio 1 would be very expensive. 

Combining equity momentum and managed futures in Portfolio 3 is a step closer to putting it all into trend which is something we've looked at several times before and the backtests usually look pretty good. Portfolio 3 was plus or minus five percentage points from VBAIX six times and again, sometimes that was a good thing but sometimes it wasn't.

That was a pretty rough showing for the four managed futures funds. The choice was sort of limited for the number of funds that were around back then but it was a rough stretch for the strategy, pretty much just tracking inflation. 

Seeing a strong backtest is one thing but living through a year where you own Portfolio 1 and it was down 6% like in 2020 while VBAIX was up 16% that year would be very difficult to endure. 

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.