When there is a fifth Saturday in a month, I have the day off from fire department stuff (unless there is a call for service) which means time for a lot of reading, March Madness but don't sleep on cawlidge hawkey (IYKYK), what think will be a very fun blog post and I already got some exercise in early today.
First up, Phillip Toews who runs an asset management shop and who wrote a book about about behavioral portfolio construction wrote about understanding market history and a section on how to build robust portfolio that reads like he could have outsourced that part of the article to me. It covers a lot of the same ground that we cover here. The link is a gift link, I need to get better about using gift links for these posts.
He mentions risk management, which ok yes but he doesn't get that specific. Weaving in the historical part of the essay he points out that in addition to 2022, there have been several events before 1981 where the traditional 60/40 did very poorly, he seemed to be blaming the 40 allocated to bonds. But this quote is something I could have written, "Rather than attempt to predict which crisis might emerge, prudent investors will build portfolios resilient to the full range of historical market environments—not just those they have personally experienced."
We spend a lot of time here trying learn more about how to do exactly what Toews is talking about. That I talk so much about holding BTAL is about trying to reduce volatility which it has done looking backwards and I expect will be the case looking forward. So holding that ETF then is not about trying to predict anything, it's about the effect it can add to the portfolio. Other tools that help out in different ways that have been very long term holds, merger arb is an example, are also not predictive, they are about the effect they can add to the portfolio, repeated for emphasis.
There is ongoing study though of prevailing risk factors which is something I learned from reading John Hussman many years ago, kind of like a diffusion index, at least I try to keep it that simple. I've mentioned adding ProShares Short S&P 500 (SH) around election time in previous posts. While I can't push back on someone thinking that was a prediction, that was not the mindset. I perceived risk of market volatility going up and right or wrong, I wanted to reduce portfolio volatility against that backdrop. It would have been of course better if the market had rocketed higher from the moment I bought it. You don't want your hedges to be your best performers.
Ditto, adding gold in February. Risks of the bad kind of volatility seemed to have increased versus November and so I added gold as a hedge not knowing whether that would turn out to be a good entry point or not. Right here, still down a little for the S&P 500, the consequences of the risks I think are front and center could still play out with a far more serious decline. If the current event does resolve with a 25 or 30% decline then taking hedges off in order to increase net equity exposure starts to make more sense. If that is how this plays out, that won't be a prediction either.
To dust off a phrase I used to use often, the risk of a large decline, is a lot less, after a large decline. Down 30% or whatever and selling SH or any of the others won't be about trying to time the bottom, it will be about buying (selling hedges is pretty much the same as buying) low, irrespective of whether it goes lower. Buying low isn't that difficult in terms of execution, not talking emotionally. "The S&P 500 is down 25%, I am going to buy some." That is buying low. That has nothing to do with bottom ticking which is very difficult, more a matter of luck for most of us.
Cliff Asness posted a paper about hedging and capital efficient portfolio construction in support of a filing for four new AQR mutual funds that combine equities and different alternative strategy in a 100/100 fashion similar to PIMCO's StocksPLUS suite as well as the ReturnStacked product line which he mentions by name. The branding for the four funds will be Fusion.
AQR uses leverage in many of its funds so that isn't new and I am aware of one other fund of theirs that uses leverage to own equities and just one other alternative strategy so maybe they are expanding into what I would say are some simpler funds versus the macro funds and other products that have quite a few strategies going on at once. What might be a little different is very specific volatility targeting of the alt sleeve of each fund. That's not something that most of us would be able to do on our own beyond owning more or less of the alt strategy but that isn't really the same thing as what AQR can do or what Cliff is writing about.
There was a passing comment from Cliff about how to size these. The idea was similar to what ReturnStacked talks about in terms of adding enough alt exposure to matter without giving up equity exposure. "Now imagine you take 25% proportionally out of 60/40 and put it into the uncorrelated alternative." So I take that as a good number to study for this blog post.
Each of the three portfolios allocates 67% to WisdomTree US Core Efficient ETF (NTSX). A 67% weighting to that fund equals 100% in VBAIX so the NTSX allocation allows for adding, in this case, 25% into the alternatives labeled in the names of the portfolios with the final 8% just going to TFLO as a cash proxy.
In terms of crisis alpha in rough times, convertible arb didn't really help in 2022 but managed futures and macro did. In 2018 you can see that two of them helped with just a few basis points. A year like 2018 constitutes down a little and is probably less important than protecting against down a lot like in 2022. I chose the three alts randomly, only two are part of the AQR filing. In the up years, all three were right in line with VBAIX. To use NTSX though, you have to want aggregate like bond exposure which of course I do not.
I took a different run at this using the same alts without leverage other than any leverage inside any of the alternative funds.
So with these, there is 60% in the S&P 500, the same 25% in the corresponding alt strategies, the same 8% in TFLO and I added 7% in gold. The CAGRs are slightly higher, the standard deviations are slightly lower, the Sharpe Ratios are a little higher, there was somewhat more protection in 2022 but not really for 2018.
Putting 25% into the AQR Fusion suite to leverage up could very well workout much better than the first backtest in this post, but between the two observations today, the thing that mattered more was the top down decision to avoid bonds with duration. Getting back to predictions, I have no idea whether bonds with duration will go up or down but it is a good bet that they will remain volatile.
The alts for the study done today were used in a very limited fashion, dumping 25% into just one which is not something I would do. Part of what I think Toews is talking about is trying to look around a corner at what could go wrong, not necessarily why it would go wrong. In the current event, managed futures are not really helping while plenty of other alts are. Maybe, convertible arb didn't work in 2022 but will be the star of the next bear market, there's no way to know which is a good reminder to diversify your diversifiers.
Finally, Barron's had a writeup that was a little favorable towards the latest Microstrategy Preferred Stock (STRF). Barron's was not all in but they didn't seem concerned that there isn't really much of a cashflow to pay the 10% (based on the par value) yield. The other preferred which has symbol STRK doesn't pay out but it is convertible at about double the current price of the common.

The chart is a little tough to read but it goes back just a few days to when STRF started trading. The two that are down a lot are the common stock and the YieldMax equivalent, we are talking about yield after all. You might expect that the preferred issue with the yield would be less sensitive to movement in the common stock but if Bitcoin pukes down another $20,000 then that makes it harder to pay the distribution because there will be less Bitcoin yield which is a term that I believe Michael Saylor made up. With a further nod to Toews, without trying to predict anything, what happens if Bitcoin drops to $40,000?
Giving the benefit of the doubt that Microstrategy isn't an actual fraudulent endeavor, if nothing else, there is visibility for plenty of eye-watering volatility. There are plenty of sources of high yields with nowhere near the potential volatility of these preferred stocks or anywhere near the CEO risk. I will circle back when these have some more history under their belts to see whether they've been as volatile as I think they'll be.
It looks like STRK started trading on March 3 (Yahoo Finance) and so far it is down 9%. Unless you worship at the altar of Saylor, I don't know why someone would want these.
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