Adapting With All-Weather

Meb Faber tweeted out a link to an old Bridgewater paper that is provocatively titled The Biggest Mistake In Investing. Their premise is that the capital asset pricing model (CAPM) is built on return assumptions that don't work out as investors expect. Too frequently, return comes from unexpected sources. 

An example of this that resonates with me is that in 2022, the two most important decisions might have been avoiding duration and including managed futures. In late 2021, you wouldn't have found too many people arguing for those two trades. Maybe that's not what they have in mind but that is good context for me to dissect their point. 

From there, according to Bridgewater,  the answer to solve CAPM's flaws is balancing risk because we can't reliably count on where we will get our return from. Balancing risk then would allow for capturing better returns because we'd have exposure to whatever the unexpected return engine ends up being. This is pretty much what risk parity is and how it works. 

Risk parity is associated with Ray Dalio and Bridgewater, Cliff Asness is also a proponent of risk parity. The Dalio version is also referred to as the All-Weather portfolio which is light on stocks, heavy on duration with a good dose of commodities. The paper we are referencing today is a slight tweak on Dalio's All-Weather if you look that up, the paper is more like 20% in equities, 55% in bonds with duration, 15% in TIPS and 10% in commodities. 

If you do look up the Dalio all-weather, you'll see adaptations that use very plain vanilla funds, especially where bonds are concerned and that it hasn't done well in quite awhile. The idea dates well back into the 40 year bull market for bonds. It worked well as interest rates kept going down. The regime for interest rates ended a few years ago but I believe the concept is still valid even if treasury bond ETFs are not the answer. 

All-Weather with alts on the left and Plain Vanilla All-Weather on the right.

I don't mention SRDAX very often, it is a Stoneridge fund that diversifies several strategies that have no strategic overlap with plain vanilla fixed income. QDSIX is a fund of AQR funds with very low volatility with fairly steady returns. SPMO is in my ownership universe (along with SRDAX). Twenty percent in equities is pretty low, using SPMO dials up the exposure along the lines of what we talked about earlier this week by being more volatile than market cap weighted. SPMO can have the effect of increasing exposure a little bit but is heavy in tech though so if something hideous happens to markets and it starts in the tech sector then SPMO will probably feel it pretty hard. 

Below, we compare them to AQRIX which used to be AQR Risk Parity but is still influenced by risk parity. RPAR is the risk parity ETF and of course plain vanilla 60/40.

The backtest goes back to before the bond market regime changed. All-Weather w/Alts was up a little in 2022 which is a big reason why it is so far ahead. Most other years it is pretty close to 60% SPY/40% AGG in terms of growth but with much less volatility.

I wouldn't count on a repeat of 2022 in terms of so much bond carnage in one year but I still do not thing bonds with duration is the place to be and the SRDAX/QDSIX combo will continue to differentiate from treasuries with duration. If I were to actually implement this, I would use individual TIPS not an ETF, I don't think ETFs capture the effect as well as individual issues. If you put 10% in broad commodities, at times there would be regret not having gold and if you put 10% in gold, at times there would be regret not having broad commodities. Also, IRL splitting 55% between two liquid alts is something I would never do, I'd carve that up into smaller slices into more alts; diversify your diversifiers. 

Back to the paper and this chart that was included.

Again, getting anything close to this sort of outperformance is not realistic with a heavy dose of treasuries with duration. The portfolio we created for this post did outperform 60/40 which may or may not be repeatable but getting a similar return as 60/40 with a lot less volatility (I believe lower volatility is repeatable) is plausible. We're using Dalio's/Bridgewater's process, we could nudge up the equities a little bit if there wasn't enough equity market upcapture and repeating for emphasis, 55% split between two alts is just to keep the blog post simpler.

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.