Diversify And Chill Part 2

On Sunday we looked at a simple diversification of 1/3 each in the S&P 500, gold and emerging market equities. Then in another version we sprinkled in a little managed futures. Today, let's take a little more of a quadrant inspired mix of 25% each into those four.

First, here's as far back as we can go, which is a good long time. Note that I used VBINX for 60/40. It's the retail version of VBAIX that we usually use and it goes back just a little further. 

The 31/31/31/7 blend is a holdover from Sunday. The period studied includes plenty of good times and bad times for the four asset classes in the two versions on the simple diversification. 

Here's just the lost decade for stocks ending 12/31/2009.

The two versions of the simple diversification did ok during the internet bubble and a little better during the financial crisis but the overall growth rate was good or maybe better described as normal when considered against the S&P 500. A CAGR of 8-9% and you'd never know it was a lost decade.

The 2010's were weak for gold, managed futures and emerging all compounded in the threes.

Not a lost decade but certainly weak in the context of the Peter Oppenheimer article that was the prompt for these posts. For the 2010's, price inflation ran at 1.75% so still a decent real return and very little distributable income for anyone wondering about taxes. I actually think compounding above 6% with three of the four muddling along is pretty good.

Finally, the 2020's.

Of course nothing was going to keep up with the S&P 500. No surprise that both versions of the simple diversification held up much better in 2022. Despite having no bonds, the equal weight version had very similar volatility to VBINX in all periods studied. That piece of the result is about blending together assets with low to negative correlation as captured by Portfoliovisualizer.

Diversification can be simple but as we saw, there could be long periods that demand patience. 

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.

Diversify And Chill

We're going to go all over the place with this one. 

First a a couple of quick hits starting with concierge medicine in Barron's. I don't have a ton to say about it. It's expensive but if someone needs to engage kind of frequently with the healthcare system and can afford it, then sure, why not? There was a comparison to concierge medicine being like old time medical care from you small town doctor which is interesting. 

This quote was right up my alley, "patients are typically screened for grip strength and gait speed, metrics of well-being that insurers typically don’t cover." I don't know about those things being covered or not but grip strength and retaining the ability to walk fast are very telling benchmarks. This is where I say to lift weights (deadlift, squat, farmer's carry, landmine twists) and get out and climb some hills. 

The Streetwise column took a look at what's going on at Robinhood in terms of offering prediction markets (betting) along side crypto and more traditional stocks/bond/funds. I think this is a positive step for the long term. I have zero interest or intention of speculating on who scores the first touchdown in the Patriot's game or whether Sarkozy ends up staying in prison or not but this can be a bridge to doing more things inside the typical brokerage account as we now know them. Different types of assets will at some point be tokenized to provide access to different types of assets for investors. 

Art and collectibles come to mind in this context but there must be others. These types of assets tend to be uncorrelated, I say tend but that is not always the case. I told this story once before but early on in the pandemic I bought a 1970 Bobby Orr hockey card for $20 that has a 6.5 grade. A year or two ago when I looked, there was a 6.5 for sale on eBay for about $300. Sure the return is great but aside from having no idea it would go up like that, even if I somehow knew, there's no way to buy 1000 of them for a portfolio allocation. Tokenizing either a collection or some very expensive card would be a way to allocate to an asset class, collectibles in this example, that is not easily accessible. That is a positive but there will probably be bumps and bruises along the way.

Peter Oppenheimer of Goldman Sachs is expecting a weak decade ahead for domestic equities versus other markets. Not a lost decade though, he thinks the US will compound at 6.5%. If he's right about relatively weak returns and the 6.5% part of the guess, that doesn't sound so bad to me. 

The real lost decade we had is captured below.

You can plug in your own dates to play around with it but you can the S&P 500 compounded at a negative 82 basis points. Despite that average, there were of course a few big years in both directions. You can see that emerging markets, as measured by VEIEX, and gold did just fine and blending all three together compounded at 8.7% despite the lost decade for domestic equities. 

If the US ever does have another stinker of a decade, there will be markets and asset classes that will go up. If you don't want to guess what those might be, then there's your argument for broad diversification. 

Testfol.io has simulated DBMF and KMLM which are both managed futures funds. While there should be a grain of salt with this, simulated DBMF compounded at 8.44% in that period while simulated KMLM checked in with 12.06%. Again, grain of salt but I do feel comfortable taking them as being indicative of managed futures doing relatively well even if the exact numbers they came up with need some faith. Other forms of long/short could probably also do well under Oppenheimer's scenario. 

I am a big believer in defense industry stocks and in the period studied, client holding Northrop, Lockheed and General Dynamics compounded at 9%, 12% and 15% respectively. While there's no way to know whether they would again do well despite a weak or lost decade, if anything the demand in this niche is greater now than it was 25 years ago. 

As opposed to lamenting this sort of prediction or outcome, I would think of it instead as a challenge to overcome. Putting it very simply and sort of repeating for emphasis, we had a lost decade not that long ago and the thing that worked was simple, broad diversification. Looking back at the last few years, simple, broad diversification might have caused some frustration at times, over the long term, it of course works. 

Maybe not that frustrating. The second backtest has the same start date, running through to this week. Broad diversification again worked. 

Diversify and chill.

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.

Friday Volatility Harvesting

Dave Nadig reports shot fired by SPDR at JP Morgan.

SPIN is a new one to me and sort of new, it started in early 2024 and oddly for a SPDR ETF it only has $61 million in AUM. SPIN picks individual stocks and sells index calls as does JEPI.

SPIN has had the upper hand since it launched but JEPI has had strong years along the way too. Anyone who believes JEPI is great is simply enduring a relatively weak period. At some point SPIN will do likewise. Even if SPIN is great or turns out to be generally better than JEPI it will have periods where it does poorly. Using funds that sell volatility as anything beyond a small diversifier at the margin is a tough way to make a living. 

But as a small diversifier, I am a believer that there are ways to sell volatility even if the most popular way, the single stock covered call ETFs is a very flawed way to do it. I've talked about client/personal holding PPFIX as a very low leverage way to sell volatility, the other day we looked at OCTH and OCTJ in the same context but they're a little more volatile (Innovator has other funds running the same strategy with different reset months).

Mathew Tuttle hosted a webinar on Friday titled Covered Call ETFs Suck. YieldMAX took a beating in the webinar.

The chart compares the price only return of the Tesla YieldMAX and the Netflix YieldMAX. It shows a point we've touched on here but that Tuttle seemed to really hit on which is that selling calls on very volatile stocks in the manner that the ETFs do isn't a great trade. The more volatile, the worse it will probably be as seen in the Tesla/Netflix comparison. 

Tuttle's firm is working on some interesting things. They have a "no bleed" tail risk fund coming that I may have mentioned before and they are working on a fund that would be 100% S&P 500 and 100% their tail risk strategy. The other idea is ETFs that sell put spreads on individual stocks. Selling put spreads is bullish and of course would be a derivative income strategy. Again, as a small diversifier at the margin, this might be interesting. 

We spend a lot of time studying volatility as an asset class and a strategy because I think it is an important diversifier but there are probably more ways to use it incorrectly than correctly. 

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.

Does AQR Read Random Roger?

No they don't but their latest paper ties in with our approach here very, very closely. The title is Diversifying Alternatives and the Rearview Mirror and the paper looks at how to use alternatives, how they can help smooth out the ride and what the emotional challenges of holding them can be. 

From the summary:

Diversifying alternatives—investment strategies whose gains and losses occur at different times to those of major markets—are beloved by portfolio optimizers seeking to maximize risk-adjusted returns. But for human investors, it’s more of a love/hate relationship. Stock markets go up most of the time, which means that diversifiers are often likely to feel like a drag on returns—even if they improve long-term wealth accumulation.

It's almost the identical way we phrase these ideas here. This is why I say to have an equity-centric portfolio hedged with a little alternative exposure not the other way around. Client and personal holding BTAL is a remarkably reliable first responder defensive which means it is going to be down most of the time. On Thursday, with the S&P 500 down 1.66%, BTAL was up 3.25%. You never want BTAL to be you're best performer, there have been several times since I first bought it where it has been the best performer and that was because the market was in some sort of nasty drawdown. 

The paper looks at various types of long/short strategies of which BTAL is one, BTAL is short biased. Any sort of arbitrage is long/short, you could argue that managed futures is long/short too and of course long biased like AQR Long Short (QLEIX). I don't use any long biased long/short. 

They talk a little about hedge funds and include this chart.

The weighting of the combo wasn't quantified but the effect captured in the chart makes the same point that we do all time about smoothing out the ride. Our blog backtests, and what I do in client accounts don't involve actual hedge funds but a similar effect can be introduced with mutual funds and ETFs. Look at 2004/05 in the chart. The combo lagged badly for that short stretch the but long term has been much smoother with far less violence during big drawdowns. 

The part on myopic loss aversion is pretty important. It also delves into line item risk. The basic of myopic loss aversion is losses hurting more than gains feel good. It can be a little trickier with line item risk. I don't know who first said it but "if they all go up together then they're all going to do down together." What matters is the bottom line number of the portfolio. Is that bottom line number doing what you intend it to do. 

If someone decides to put 100% into a single tech sector ETF they probably are expecting it to go up a lot more than the S&P 500 which it probably will do with the understanding that the drawdowns will be much worse. We looked at Amazon in this context the other day. The upside has been phenomenal and declines have been enormous. That's not likely to change. 

So a portfolio that needs to be diversified, not all of them do, probably owns a few things that do a lot of the heavy growth lifting and a few things that one way or another help with that volatility like how some people use bonds or maybe consumer staples stocks. It won't be too often that your laundry detergent stock will be up 30% when the index is up 15% but your tech fund very well could be. And if you use believe in diversifiers in the context we talk about here or from the AQR paper, then the right expectation is that the thing that protects against the bad kind of stock market volatility is going to look different than the stock market, maybe a lot different. 

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.

What Is Total Portfolio Approach?

Have you read anything about 'total portfolio approach' that institutions including CalPERS are starting to adopt? Here's a paper from the Thinking Ahead Institute that dives in too. It's pretty nebulous (so far). Copilot suggested the following "reference portfolio" to make up 35% of the portfolio;

• 40% Global equities
• 30% Global bonds
• 30% Inflation linked securities/real assets

And for the "completion portfolio" 65% divided as follows;

• 15% Private equity/venture
• 10% Thematic public equities
• 10% Opportunistic credit
• 5% Trend following/managed futures
• 5% Equity long/short or volatility arbitrage
• 5% Tail risk or macro hedge
• 5% Multi factor equity
• 5% Alternative risk premia 
• 5% Cash or T-bills

Here's how I built it out in the exact order listed above.

We usually use BX as a proxy for private equity but 15% is too much and PSP reduces the favorable skew that BX adds.

The back test is of course compelling but it's a portfolio that requires patience. Of the six full and partial years available to study, it lagged in four of them but to be fair, two of the years it lagged it was by only 3 basis points both times. 

It's certainly not a simple portfolio however. I think it can be simplified. 

Still not that simple but simpler with the biggest change probably that we took out the fixed income duration.

Sticking with domestic factor rotation with DYNF means it probably means it would lag if foreign equities go on a long run of outperformance. 

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.

Protecting Against Mag 7 Upheaval?

Here's an interesting one they talked about ETF IQ this week, the Tema S&P 500 Historical Weight ETF (DSPY). What that means is allocates to current constituents based on its "average monthly weighting since December 29, 1989."

The effect of that process is DSPY is less concentrated than the S&P 500. The Invesco Equal Weight S&P 500 ETF (RSP) came up in the conversation, the Tema CEO quipped, do you really want Campbell Soup to have the same weighting in your portfolio as Nvidia? I thought that was funny.

Here's a comparison between DSPY and one of the S&P 500 ETFs.

There's clearly differentiation there. 

Not surprisingly, DSPY has lagged, it has less of the group of stocks that have been leading (carrying?) the broad market. I am surprised that DSPY didn't do slightly better during the April panic. SPXT is the S&P 500 excluding technology.

With less exposure to the Mag 7 and the rest of Big Tech, I would assume DSPY to be less volatile but only slightly so from testfol.io.

This is an interesting idea so the question is will underweighting the Mag 7 and the rest of Big Tech work if there is some sort of upheaval in the AI space. 

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.

What Risks Should You Avoid?

I stumbled into a couple of new (to me) ETFs. Innovator who might be most known for BALT and more generally buffer ETFs actually has 157 funds with $29 billion in AUM, I didn't realize they were that big. 

The mindset for this post is funds that use equity stuff to create an intended outcome that looks nothing like the equity market. BALT is long a call spread on the S&P 500 and a put spread such that the outcome, the intended outcome is a horizontal line that tilts upward. When the S&P 500 is up, BALT lags, and in 2022 when the S&P 500 was down 18%, BALT was up 2.45%. It is not a proxy for equities. There is a sensitivity to large equity declines though. If the S&P 500 drops by 20% in one calendar quarter, BALT should be expect to feel any further decline beyond 20%. Back in the April panic, the S&P 500 didn't quite fall 20% but BALT did wobble a little bit with a fast 5% decline that was recovered quickly. 

I do not know about too many of Innovator's funds so hopefully I can learn but I did stumble into a couple that do something similar to client/personal holding Princeton Premium Income Fund (PPFIX). PPFIX sells S&P 500 Index puts that are very far out of the money. There's a little more nuance than that but the effect is that PPFIX also looks like a horizontal line that tilts upward. It uses equity index derivatives to create an effect that is not intended to look like an equity index. 

The two funds I want to mention are the Innovator Premium Income 20 Barrier ETF (OCTH) and the Innovator Premium Income 30 Barrier ETF (OCTJ). The high level description for these is that they are short out of the money S&P 500 put spreads along with another short position in puts that is not spread off as well as owning T-bills. OCTH protects up to a 20% decline like BALT and OCTJ protects up to a 30% decline. 

BALT doesn't have distributions, OCTH yields about 7% and OCTJ yields about 6%. It looks like the distributions are characterized as ordinary income. It is important to note that there is a lot of complexity to these that would take far too long to explain here. Anyone interested in these for real should learn those complexities. 

Here's how they did in the April panic. 

In certain fast declines, PPFIX sometimes has to mark their positions to market in such a way where the NAV can drop more than expected, only to bounce back a day or two later. Is seems plausible that OCTH and OCTJ have to do something similar.

All five of the portfolios are 60% in the S&P 500. The backtest doesn't go far enough to look at 2022 but where BALT and PPFIX did much better than AGG in 2022, I would guess that the strategy underlying OCTH and OCTJ would have also held up better for not taking interest rate risk.

There's not much differentiation between the five portfolios and that is the point. Getting the fixed income effect without taking on interest rate risk. Allocating 40% to a strategy that sells volatility, even vol that is very far out of the money, is a very bad idea. The way to use something like this, is in a small slice as a differentiated return stream from other fixed income proxies also used in small slices. 

A fund that sells volatility in this manner would take on different risks than some sort of arbitrage or some sort of credit risk. Catastrophe bonds have their own unique risk factors. Some sort of blending of different risk factors only to get a very similar result to AGG is not a bad outcome. If AGG never has another down year again, underweighting it avoiding it still avoids the risk is poses. I choose to avoid its risks. 

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.