We've got a lot different things to tie together related to portfolio construction and diversification.
Cliff Asness wrote a long Tweet in support of a paper from AQR that said bonds don't diversify equities, they dilute equities which I think is a fascinating way to phrase it. There's been commentary from various sources that bonds no longer diversify equities they way they used to (I have said that repeatedly) but Cliff believes "bonds never mattered all that much in 60/40" because as the AQR paper goes on to explore, there are other diversifiers can do the job that people think bonds can do.
I disagree a little bit, bonds mattered for a long time. They were reliably negatively correlated in a way that doesn't exist anymore. Compensation stopped being adequate for duration long before the top in late 2021 but they did help...until they didn't.
The actual paper starts off talking about the mistake of replacing bonds with things that actually have more equity-like risk than bonds. They cite "most buffered funds" as one example, they cite private credit as having a 0.63 correlation to equities with equity beta of 0.70. They also noted that some believe Bitcoin can function as an equity diversifier but they are very dismissive of that idea. Per the paper they favor long/short equity with a market neutral bias and managed futures.
Many of the blog posts boil down to me trying to refine my approach on how to build the 40 in a 60/40 construct. There's value in backtesting but there needs to be a grain of salt added to the process of backtesting per a paper from Long Tail Alpha. Done incorrectly, the process can lead to building around hindsight bias that relies too much on the past repeating.
How often do we backtest a heavy dose of managed futures and then contrast that to the actual experience of owning managed futures? Too much allocated to any diversifier creates risks to the portfolio regardless of whether there's ever a consequence for that risk. Managed futures always backtests beautifully but since the resurgence in popularity of managed futures starting in late 2021, there have been two very rough stretches, one in early 2023 and then going into the Tariff Panic. I've seen a couple of different sources say how bad early 2025 was but I actually recall early 2023 being worse. Managed futures are great for slower, longer declines but really a flip of the coin for fast declines.
This is a great quote from the Long Tail Alpha paper.
we’re keenly aware of the historical bleed of a typical left tail hedge, whose value does not come from a strong CAGR, but rather from smoothing out left tail events in a larger portfolio
Or, diversify your diversifiers. You can smooth out the left tail events, meaning reduce a portfolio's sensitivity to outlying, downside market events by owning several different strategies that each have their own unique risks. This approach makes the portfolio more robust in case the next long, slow decline is the one where managed futures doesn't work. Thanks to liquid alts, there's no logistical barrier to having many different diversifiers.
This chart is from Man. The way to read it is that the green combos provide better diversification than the pink combos.
The take away is not to allocate this way, I think the way to take it is as a reminder that during a draw down, a portfolio that goes narrower than broad based indexes will have things that go up. As we noted the other day, during Friday's puke down, healthcare, financials, REITs and staples generally went up. Whenever the next real bear market comes along, there will be stocks and maybe even a couple sectors that go up. If a couple of alts work as well as a couple of plain vanilla holdings go up or are even just flat, then a the portfolio has a good chance of weathering something more serious than a bad week or month.
Hedgeco.net provides rationale for using alts that aligns with my beliefs.
Investors have become more aware that the classic 60/40 portfolio can fail when stocks and bonds fall together. Inflation shocks, rate volatility, geopolitical events, and liquidity stress have all exposed the limits of relying solely on long-only equity and core bonds.
They go on to talk about alts not as "return engines" but as tools that can fill portfolio gaps. The gap in the context for today's post is how to build the 40 or whatever percentage not allocated to plain vanilla equities. There's even a shoutout to litigation finance (we've looked at this a couple of times) which at this point doesn't exist in a wrapper with daily liquidity. "Liquid alts are most useful when they are mapped to a specific portfolio role." How often do we talk about this point? A lot, because it should be an obvious conclusion.
Adam Grossman weighed in at Morningstar about his concerns for a coming lost decade. A key to success from 2000-2009 was knowing where else to look. I have no idea if we are going to have another lost decade but the process of planning in case we do should have started a long time ago.
A final note, in Friday's recap, I should have included how the autocallable funds did. We've talked about them some so it makes sense to check in when the market does poorly.
ACYN is from First Trust and pretty new. ACYN targets an 11% "yield" which is lower than the others, Copilot says that ACYN should have less sensitivity to equity declines. That panned out of Friday anyway.
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