Black Sheep Portfolio

A couple of weeks ago, we looked at a blasphemous portfolio that combined derivative income and buffer funds. It was blasphemous because while so many professional market participants hate them, many individual investors love them. The results from what we looked at were fine despite the various flaws that derivative income and buffer funds have. They do have flaws and while hopefully we can learn something from these funds, the flaws don't go away. 

Either as a coincidence or maybe prompted from the above linked post, I've been having a conversation over LinkedIn with with a portfolio manager at another firm that uses buffer and floor products somewhat heavily. As a very round number he mentioned a 35% allocation to buffers and floors. That seemed high but according to Copilot, that is well within the norm of models that use these funds. Moderate model portfolios tend to range from 30-50%. I wouldn't have guessed that but there you go. 

It's a short period available to study. BJUL is a buffer fund that we have looked at a few times. It protects the first 9% down for one year while allowing 18% upside. BJUL just reset on July 1. SFLR sort of does the opposite, there is exposure to an initial leg down but offers more protection if the S&P 500 goes down a lot. HEQT uses puts to hedge and USMV is optimized to have lower volatility than the broad market. Here's a summary from Claude;

In 2022, BJUL was down 7.38%%, USMV was down 9.42% and HEQT was down 8.25% compared to 18% for the S&P 500. 

I wanted to update the blasphemous portfolio to be even more hated with a value ETF and low volatility managed futures. In addition to the negative sentiment toward buffers and derivative income, it seems like very few people are interested in value stocks and low vol managed future is an odd ball that is worth exploring more. 

Either version really is a Black Sheep allocation but even still, with nothing I'd want to own, the results are interesting.

The intuitively weighted version yields less than 2% while risk weighted version yields about 3.70%. The compounded real returns were 6.19%, 4.60% and 6.01% respectively. 

There was no place to hide during the 2020 Covid Crash, the important thing from that event was simply not to panic. That was a fast decline and fast declines tend to snapback most of the panic very quickly. In 2022 though, both versions of the Black Sheep portfolio was dramatically better than 60/40. There was no real help in the Tariff Panic of 2025.

To the extent the Black Sheep portfolios did well, there is some equity beta to capture upside and they avoid bond duration. The blending's result is obviously close to 60/40 most of the time which is ok but differentiated when most needed in 2022. In terms of weaknesses, 85% of the portfolio has some sensitivity to equity downside which again, was fine in 2022 but not during the few fast declines that occurred during the back test. 

I have no argument about this combo being optimal but it is valid. Something could go wrong with a buffer fund or index based derivative income fund but that hasn't happened. Market cap weighting obviously hasn't malfunctioned but has cut in half a couple of times this century and while that's not a malfunction (repeated for emphasis) cutting in half is a rough thing to endure. 

Trying to apply any of this to real life, putting 35% into one value fund like VTV is not terrible. Maybe it would lag market cap weighting and other factors or maybe not, no way to know but the structural risk is pretty much null. If you want to do something substantial with buffer or floor ETFs, I would suggest breaking that up into funds from different providers. It's not that I expect something bad to happen but where there are derivatives and complexity, there's no harm in diversifying issuers. 

One last chart about managed futures that I thought was interesting in terms of capturing performance dispersion. 

The chart only covers 15 months back to MFUT's inception. QMHIX and MFUT are both relatively volatile implementations and the difference is huge. Over the next 15 months, maybe MFUT will outperform by that much, there's no way to know. Most clients have exposure to managed futures through BLNDX and another fund that is just managed futures. Managed futures is great but if you want to go heavy, use more than one fund. 

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.