You Need More Bonds! No You Don't!

Robert Pozen wrote an essay for the Wall Street Journal arguing for 90% in equities/10% in a money market after having carved out some sequence of return mitigation in a separate account. The simple reason underlying his premise is how much better stocks do than bonds. 

Cliff Asness has been on the other side of this trade for at least 30 years. Asness' firm is of course a big believer in risk parity which the most basic version means leveraging up the bond exposure such that the risk from the bond allocation equals the risk of the equity portion. Cliff notes that the Sharpe Ratio for 60/40 is better than 90/10 which pans out in this backtest.

Pozen is obviously correct about stocks returning more than bonds which shouldn't be a surprise. For what it's worth, the AQR Multi Asset Fund (AQRIX) which is risk parity-ish shows a lower Sharpe Ratio than 60/40 or 90/10 per testfol.io since its inception in 2011. The data I show above goes back to 2003.

I tried to build a do it yourself risk parity strategy. I started combining Direxion 3X Tech (TECL) with TLT but the result wasn't compelling. I asked Copilot for an assist saying I wanted to approximate AQRIX and it gave me 36% in 3x S&P 500 (UPRO) and 64% in EDV which is Vanguard Extended Duration. 

The result looked almost exactly like 2x AQRIX so in Portfolio 5 I cut the numbers in half and added 50% in the Merger Fund which is a client and personal holding. 

The result for Portfolio 5 was actually helped by path of daily resets for UPRO which of course cannot be counted on to repeat in the future.

I can't imagine too many people would build and run Portfolio 5 in real life, I think it would be difficult to endure large drawdowns and of course there is no scenario where I am using an ETF like EDV. If interest rates ever go up to a point where the compensation for the volatility is adequate, I would buy individual issues, not ETFs.

But this was a good exploration leading to this quote from Ben Carlson;

"As long as you understand the trade-offs, there is no optimal portfolio. In fact, the sub-optimal portfolio you can hold onto is much better than the optimal portfolio you give up on."

Looking for the optimal portfolio even if it doesn't exist is certainly entertaining and the act of looking allows for occasionally refining what we actually do. I try to be consistent to bring up this point about some portfolios not being ones that investors would want or be able to hold on to.

I agree with Ben about the importance of people figuring out the portfolio that is optimal to them. That's a combination of giving a reasonable chance of reaching whatever the goal might be but that also ensures not succumbing to panic. We all have emotions, the important thing is not succumbing to those emotions. 

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.