Risk & Diversification

Here's a doozy of a Tweet.

It's not a joke (nice timing on the screen grab). That's the CEO of Strategy pumping one of the company's variable rate perpetual preferred issues. 

It shows a yield on Yahoo of 11.5% at the current price. Nothing bad will happen until it does. Or put differently, risk happens fast and if the whole Strategy story crumbles, STRC might drop like a Wylie Coyote cartoon. Isolating that risk isn't too difficult, knowing when it will happen is pretty much impossible. Once you really break a risk down to simple terms, you can then make an informed decision about whether it is a risk you should take. I am surprised how steady it has been.

Larry Swedroe wrote about risk, diversification and risk adjusted returns. He hinted at this but if you have a diversified portfolio, you are going to have a few things that will "make you want to puke" as Jason Buck said. Once an investor realizes it's not in their interest to try to optimize for one week but for long periods of time, it becomes easier to endure a period where something is simply lagging or to endure when a diversifier that is intended to offset equity volatility does just that. You don't want your diversifiers to be your best performers. 

This was interesting;

We've looked at this a little bit with the Unlimited Long/Short Equity ETF (HFEQ) which targets not twice the return of long short but twice the volatility. At some point I may have mentioned the Unlimited Managed Futures ETF (HFMF) which targets twice the volatility of regular managed futures. 

I think this sort of idea for now anyway is a better way to add capital efficiency than the far more common twice the return levered funds that reset every day. But using something like client personal holding BTAL to leverage down, as we've described it previously, into slightly more equity exposure also works. 

To point number 1 about the allocator needing to do the rebalancing, I'm not sure why that it a problem. It's a task to be done but I don't think it's a problem. For point number 2, I think there is an embedded assumption that variance drain (volatility drag) can be modeled or predicted but it's path dependent. 

Anytime we've ever done some sort of long term study with the 2X S&P 500 ETF (SSO) it tracks 2x the index pretty closely most of the time. It delivers the general effect most of the time. Levered funds tracking narrower things or more volatile indexes tend to deviate more. SSO may not be close enough for you and just because it is pretty close most of the time, the wrong sequence will cause a lot of pain.

In 21 full and partial years since SSO started trading, I would say that 2020, 2018, 2015, 2011 and 2007 are when the deviation might have been uncomfortable certainly but not catastrophic. The way to use it, if there is any way in this context would not be to put 30% into SSO and think you've got 60% equities. More like, 50% into plain vanilla equities and maybe 5% in SSO to get to 60 exposure leaving 5% left over for some sort of diversifier or maybe 45 and 7.5 leaving 7.5 left over for a diversifier. 

Does it work when doubling the volatility in managed futures like HFMF?

The sample size is limited but based on first impressions, not really. Looking at long/short equity, there are more successful months than with managed futures.

But then this gets interesting.

The 2x volatility works in this comparison.

The period is too short to draw a conclusion about the performance but the volatility numbers are close and although you can't see it, the standard deviation numbers are even closer to each other. 

The concept is valid and yes there would be work to do but unless you're putting it all in one target date funds (not bagging on that), then any portfolio strategy you implement will require work. 

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.

A Citrini Gloomsday Portfolio

The other day I said I'd try to put something together that might work if Citrini Research's prediction possible outcome stemming from AI plays out. As a reminder here's what they spelled out for two years from now.

• Unemployment rate hits 10%
• 30% decline in the S&P 500
• Home prices fall at least 10% in some big markets including NYC, LA and Chicago
• Labor income drops below 50% of GDP
• CPI goes negative

I came up with this;

Instead if QLEIX which is leveraged up here, I plan to monitor this idea using 15% in HFEQ which is long biased L/S that targets 2x volatility. I used JEPI but I would swap out that equity beta for BTYB that we looked at on Sunday. Since that fund is only a month old, it makes no sense to back test it yet. NFLY is a crazy high yielder yes but it avoids crazy CEO risk like a couple of the crazy high yielders have and I think would be an important piece of this puzzle but without completely selling out the portfolio for yield.

The managed futures is split as you can see but doesn't have a big weighting. We know it can take a bit for managed futures to adjust during regime changes. 

I wouldn't focus on the returns looking back. It is designed to be less volatile than 60/40 which it is, with smaller drawdowns which has also been the case. Much smaller drawdowns. It gets a lot of yield from just three sources/25% of the portfolio but there would be a little interest rate risk using BTYB, less though than with VBAIX in case rates go up. Yes, in a deflationary environment, the book says yields go down but I don't want to bet on too much normalcy from the treasury market. If yields do go down then 10% in BTYB should get some benefit.  

One thing I did not model in was asymmetry. I'm not sure Bitcoin is the answer in this context. I'm still holding as I outlined recently but if you want to model in a small slice to asymmetry I would look elsewhere like maybe uranium or something that might benefit from the AI gloomsday that Citrini is talking about. 

Infrastructure as a theme might makes sense. Client personal holding CBOE might benefit if VIX trading and a few other things see outsized trading volume growth.

Going 100% cash is probably a bad way to go. It's suboptimal at a minimum in case Citrini turns out to be completely wrong about this or it kind of plays out the way they suggest but with a much smaller impact on the equity market. Even if they're exactly right, after stocks bottom out, they will start to go up and eventually make a new high. Guessing on when the bottom is in has a low probability of success. The first draft of this portfolio we created for this post has holdings that have the opportunity to go up, even be antifragile, in the face of Citrini's AI Gloomsday scenario. 

BTAL, ARBIX, MERIX and NOC are in my ownership universe.

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.

This Derivative Income ETF Might Not Be Horrible

Quick hit Sunday.

A few weeks ago we mentioned the Vistashares Bitbonds 5 Year Weekly Income Fund (BTYB) which had just started trading. The fund is 80% long five year treasuries and 20% in a Bitcoin synthetic covered call with the objective of generating twice the yield versus just owning a five year treasury.

Obviously it's been a rough run for Bitcoin since BTYB listed but the result is far from horrible. The chart is price only, so adding back in the 15 cents it has paid out so far and the drag from Bitcoin has been less than 100 basis points compared to the UFIV ETF. YBTC is a crazy high yielding covered call fund tracking Bitcoin. It's only a month but I like the idea of harnessing volatility to add a little bit of yield. Maybe BTYB can actually achieve that. There is still interest rate risk though even with just five years. In 2022, IEI which tracks 3-7 year treasuries bottomed out with just over a 12% decline at it's still $12 below its late 2021 high.

From Torsten Slok. No immigration is economically serious. 

Here's a link to the Citrini Research piece that really upset markets a couple of weeks ago. Here's the TLDR from Bloomberg.

• US unemployment rate exceeds 10% 

• S&P 500 declines more than 30% from its level at time of launch

• Zillow Home Value Index declines more than 10% YoY in any of: NYC, LA, San Francisco, Chicago, Houston, Phoenix 

• Labor share of gross domestic income first-release value for any quarter falls below 50% 

• CPI falls below 0% in any monthly release 

Citrini leads off saying this is not a prediction, it's merely one possible outcome over the next couple of years. Bloomberg added that Kalsi currently shows a 13% probability of three of the five happening by July of 2028. 

When I see any sort of gloomsday (play on words of doomsday) predictions possible outcomes, my inclination is to think about resiliency of not just the portfolio but also my various income streams. Portfolio resiliency could come from small exposures to inverse strategies, managed futures (after the first 10% down), a mix of different long/short including absolute return, gold can work in a deflationary environment and there will be some others including defense contractors based on the current geopolitical environment. A crazy thought is that funds like BTYB could work too. Higher yield, not crazy high yield. 

Later this week I will try to put together an anti-Citrini Portfolio, could be fun.

Resiliency of income streams involves learning new things, making sure current income streams can adapt if needed and not being over reliant on any single income stream. I'd also encourage working on trying to add an additional income stream. I think a related point is to start to build into your planning the idea that Congress will not actually be able figure out the Social Security problem. As crazy as it sounds, they might actually screw this up. 

I bet you saw the headline from the WSJ about The Crossing Guard Making $14,000 A Month Mailing Out Her Musings From The Job. The article says she took the crossing guard job to better "connect with her community" for 50 minutes a day without implying she gave up her day job. Then her day job sort of withered shortly thereafter though. It reads like the opportunity found her but she took on the crossing guard gig expecting nothing, then had an idea and was able to monetize it very successfully. It's a great example of what we've been talking about here for a long time. 

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.

When Does A Crappy Deal Become Good?

First this.

We've made this point before. There is an element of private equity/credit firms needing retail bag holders' via 401k plans to soak up deal supply. I do not think 401k plans have any shot of getting in on the "good deals." 

How did Robinhood's private markets retail fund do on day one?

The $4 dollar drop isn't as bad as it first seems. The first print was at $22, a $3 drop. That is likely the sales charge paid by people who bought on the offering. Never buy closed end funds on the offering. There is a process where the sales charge gets worked quickly off in the market. If the sales charge was $3 then people buying the offering were paying $25 for $22 worth of assets. It doesn't look like the sales charge is publicly available but some or all of the $3 drop is the market discounting whatever the actual sales charge was and doing it very quickly. 

A funny story that I've told before. I worked at Morgan Stanley for about ten minutes in 2002/2003 and there was some sort of closed end fund offering and of course there was a sales credit available to us for any shares we placed. Knowing how these work, I stayed away. I got asked about it by a senior guy in the office, I explained the sales charge issue, he got pissed and told me I was wrong. Of course that is exactly what happened but he never brought it up again. From back then, I remember the sales charge being more like a buck and half but maybe it was more for RVI due to it being riskier....or crappier. 

Boaz Weinstein from Saba is partnering with Cox Capital to try to buy a lot of Blue Owl's distressed assets. Blue Owl was able to sell some of the good stuff for more than 99 cents on the dollar to meet some redemption demand. It looks like Saba and Cox are trying to buy assets from Blue Owl between 65 cents and 80 cents on the dollar. 

I saw a comment somewhere about this noting that if Weinstein is trying to buy, retail investors should not be so quick to sell. There is logic to that of course. I am glad I don't have to try to make that decision but there is a price where what was originally a crappy deal becomes a good deal. Buying RVI at a big premium wasn't a good idea but buying at some whopper of a discount might be.

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 About The First 10% Down?

Today I moved clients to be a touch more defensive by buying a little of an inverse fund. The risk of this event going from stocks being down a little to being down a lot has increased based on the private credit deterioration that appears to be under way and the disruption in the oil market being caused by the war in Iran which could cause economic problems here. The US doesn't get oil from the middle east anymore so supply won't be disrupted here but price has already been disrupted. Additionally, this morning's job report showed a job loss of about 90,000 people which was far below consensus yet price inflation is still running a little hot.

We should hope that the trade today proves out to have been unnecessary and that the market rips higher from here but this is insurance in case it does go down a lot. If stocks drop, the inverse exposure will grow to protect more of the portfolio (convexity) and if stocks go right back up, the inverse exposure will shrink to be less of a drag (negative convexity).

The above passage is most of what I communicated internally to the advisors who outsource portfolio management to me. To my clients reading this, you'll get an email tonight covering a lot of the same ground.

For a little more color, the point isn't to try to predict anything. Risks have increased so I am reducing the portfolio's equity beta without selling. Twenty years ago, there were far fewer ways to buy protection. The way that product sophistication has evolved, I think it is better to buy protection than sell beta. What if today was the bottom? If so, the stocks exposure I didn't sell has the opportunity to go up with the market while the slice I added today would shrink in relation to the rest of the portfolio. 

Slight pivot, Simplify has a short paper up in support of its new capital efficient ETF CTAP which is 100% equities and 100% managed futures similar to RSST. The argument for using CTAP is similar to what the ReturnStacked guys say to support their funds. The big idea is that you can maintain a 60/40 portfolio and then add managed futures exposure to help reduce tracking error.

The idea of reducing tracking error doesn't really click with me in the context they mean it. We've talked about this before. Clients don't seem to care about fixed income performance unless bonds are tanking. I had a new thought that I might have some sort of bias here. Long time readers might recall that I've pretty much never had any exposure to duration, very very little. I didn't word it this way back then but the compensation for duration hasn't been adequate in ages. I have some understanding of the distress caused by bonds tanking from when I started subadvising for the other advisors I mentioned. Absolute carnage. 

This was an easy thing to observe. How is 3% adequate for ten years let along two years let alone 58 basis points? If you were reading my stuff back then you read this from me in real time. The new thought is that since I've never relied on duration in any kind of meaningful way, clients had a small position in TOTL for a while, I don't miss it in constructing portfolios, I don't need to find a way to make room for AGG-like exposure. 

Here's a podcast from RCM that goes into great detail about managed futures in this context and related topics. One point made very plainly is that we should not expect much from managed futures during the first 10% down. Think about last April, managed futures got pummeled. It was a crash that ended quickly. A managed futures program would need to be heavily weighted to hourly signals to have had a shot at doing well during that bad week. 

Thursday of this past week, pretty much everything went down except inverse and oil. Gold down. Managed futures down. Defense contractors down. Even CBOE which is often a proxy for VIX when the market drops was down. Oh, and bonds were down. 

At this point, if you're a frequent reader you already know whether you agree with me or disagree with me about duration now being useless as a reliable diversifier but if you agree that duration has become less reliable then leveraging up to own equities, duration and managed futures has a high chance of doing much worse during the first 10% down than some sort unlevered combo of those three.

This is last April. Is it much worse? That might be in the eye of the beholder but the leverage in Portfolio 1 is certainly noticeably worse. Part of the pitch for the new generation of capital efficient strategies is that they are not levering up one asset, equities on top of equities. They are levering up with what should be uncorrelated assets. Uncorrelated except for the first 10% down.

I place great importance on figuring out what to avoid (or underweight). If you can do that every so often then you are inviting tracking error and I don't think that's a bad thing. Quite the opposite. 

It makes sense to continue to study capital efficiency, it's fascinating and the space is evolving which hopefully means better products or better ways to build it yourself. The concept we've gravitated for now is leveraging down where including strategies that have a reliably negative correlation to equities or no correlation can allow for slightly nudging up exposure to equities (the thing that goes up the most, most of the time). Another application of the concept is what we've been talking about this week with the two long short funds that sort of lever up but in different ways. HFEQ targets 2x volatility. A 20% weight to that fund would be 40% of your equity exposure in terms of volatility (maybe returns, it depends) leaving 20% to collect some low volatility yield so something similarly boring (boring is good in this context).

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.

"The First Major Test For Private Credit"

Making my usual rounds on Thursday, I stumbled into this item.

Yikes! Here the two Cliffwater funds I've heard of.

Here's me in May, 2005;

Here's more from the New York Times posted on Tuesday. The title for this post came from the NYT article. The Times really hit on the idea of a potential "mismatch between assets and liabilities" as more people would want to get out than there would be money coming in. The interval fund concept works in part because money comes in at some rate that might generally balance out redemption requests. The risk is that the money in/money out dynamic is at immediate risk of unraveling. Someone was quoted saying "no one wants to be the last one out."

To my excerpt, is something going horribly wrong? Obviously there is no way to know. We've repeatedly looked at companies like Blackstone (BX) and the rest as being proxies for whatever is going on in the private asset space. The stocks are collectively down a ton from their highs. They appear to be capturing something going on with private assets and these various anecdotes from Blue Owl and any others out there could very well be the canary in the coalmine as alleged by David Rosen in the above Tweet. 

Navigating various types of adverse market events, I guess this one is a credit event, is difficult enough, putting yourself into a position of not being able to sell due to structural reasons would seem to make matters far worse. 

As we have seen in previous events, it's not realistic to count on completely avoid the thing, exposure to credit in this instance, but it can be realistic to effectively limit the amount of exposure. Clients own Blackrock whose alternative division swims in these waters so the stock is feeling it some but that division isn't very big, it's not insignificant but retail products are far larger. I have a bank loan fund and short term high yield fund in my ownership universe and they are pretty much flat on the year for now. 

If you know my style of portfolio construction, you know the allocations are very small, like 8-10% of the fixed income sleeve when the client has a "normal" allocation to equities. So 10% of 40%. I certainly would never want to explain to a client why some fund that was 4-5% of their account imploded but that would be nowhere near as bad as to trying explain why 1/4 of their account vaporized.

Repeated for emphasis from hundreds of previous posts, keep allocations small and don't load up on the same type of risk. Putting your 40% fixed income allocation into ten different funds that are all vulnerable to the same risk is not diversification. 

I doubt this event is in the first inning but it's probably not in the 8th or 9th inning either.  

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.

Not Nest Egg, Paycheck For Life

Andrew DeBeer who manages the iMGP DBi Managed Futures Strategy ETF (DBMF) as well as having involvement with the Simplify DBi CTA Managed Futures Index ETF (SDMF) sat for Barry Ritholtz' podcast. There wasn't a lot that was new but one item that I would pass along from it was Andrew's suggestion of allocating about 3% to managed futures. Barry led into that by saying it's not something you backup the truck on. 

Yesterday we looked at long biased long/short funds. WTLS is 90/90, 90% S&P 500 and then 90% long biased long/short. HFEQ seeks twice the volatility of regular long biased long/short. Yesterday, both funds were down more than the broad market and today they were both up more than the broad market even if not by that much in the case of WTLS.

At this point, I am not saying they are good funds or not, just that based on a first impression, both days the funds were behaving the way I think they should behave. Plenty of funds don't pass this test and maybe with a longer sample size these wouldn't either but when I talk about a fund doing what they say it will do, this is how to see, very simple but it is very important point. A fund is offering something, does it actually do it?

Don't think of your 401k and then when it becomes your Rollover IRA as a nest egg, think of it as "paycheck for life." That is part of the pitch from Blackrock to provide access to private assets for retirement plans. While I am a no on private assets due to lack of liquidity, high fees and volatility laundering, the idea of annuitizing a portion of assets intrigues me. Not annuities. Annuitizing with brokerage account accessible products that have daily liquidity. 

We've played around with this idea in various ways a few times. The way I framed it, a window of like five years where someone wants to retire but not take Social Security right away. Maybe this person has a piece of money in a taxable account, separate from their 401k/IRA that they are willing to deplete over something like four or five years to let their retirement account and Social Security benefit grow.

I sat in on a webinar from NorthernTrust today. They have a suite of funds that sort of do this, annuitize an income stream from funds that deplete in 2030 TIPA/MUNA, 2035 TIPB/MUNB, 2045 TIPC/MUNC and 2055 TIPD/MUND respectively. The symbol starting with T buys TIPS and the symbols starting with M buys muni bonds. 

We looked at these briefly when they first listed. Given the intended use, I'm not sure why the suite goes beyond 2035. If you can retire right now at 47, are you going to buy TIPC or MUNC so you can delay SS until age 66? It doesn't make sense to me. 

The webinar included a use case of someone 62 today wanting to retire now and use the 2030 product to hold out taking SS until 67. Here's what TIPA owns.

Every October, a tranche matures and get distributed. During the year, the fund pays a "dividend" periodically. I thought they said monthly but that must have been incorrect. Here's what Yahoo shows for distributions.

I spent a lot of time looking to see if there were more distributions and couldn't find any evidence of more and neither could Grok. The fund's webpage doesn't have any info about the distribution history. 

The idea is to collect income and principal back to live off of for a finite period expecting to deplete the piece of money just as you start to collect Social Security. The example from the webinar assumed that the guy had $200,000 to commit to the income bridge strategy. I like that name better than depletion strategy I came up with. 

The price of the fund is around $100/share for now. The dividends seem lumpy as hell. Next fall, the use case investor would get about $40,000 shortly after the first tranche matures. Let's say the yield from actual dividends is 3% (very little confidence it would be that high) spread sporadically over the year, that would be $6000 and then in the fall you get $40,000. It would take a lot of planning to make that work. You'd essentially need your first year's worth of expenses set aside and not include in the $200,000 purchase of TIPA. 

This idea will evolve into more useable funds. There are a couple of others out there, LifeX has a couple of funds that do something similar. If fund companies are creating these, there must be some sort of demand but like a lot of strategies, the first couple of attempts might not be the final solution. 

For now, I think with a little research work, people can build this themselves. Sticking with the $200,000 example, I bet we could find 10-15 disparate strategies with varying degrees of kind of high to crazy high yields that take disparate risks. Then set a schedule of taking paychecks that are a mix of accrued distributions and principal. With a five to seven year time horizon would this strategy last longer than just spending it out of a money market yielding 3.5%?

You'd really want to spread the risk around but we've looked at this before, yes this strategy can last a little longer than just straight cash out of a money market. Putting 6 or 7% in a crazy higher yielder or two is less crazy when the expectation is that the account will deplete. 

I spent two minutes coming up with 12 holdings. Maybe someone actually applying themselves would come up with something better. (hint, take my list, put into whatever AI you use and ask it to make improvements)

The "yield" annualized out to 12.29% so call it $24,000, take another $16,000 out by selling down positions and one year in, $183,000 with four years left until Social Security. If someone wanted wait ten years, then they'd only take out $20,000 which was less that the "yield" for year one. 

For the period studied, just owning VBAIX and selling it would have been better. It's an interesting theory that I think could work but may not always be optimal. 

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.