Closed End Funds Are Complex

This is an important chart from Bespoke in today's premarket email. It captures something I've mentioned just a couple times over the years because it is a rare occurrence. When markets get up to 20% above their 200 day moving average it isn't sustainable. At that level the underlying is very over extended and some sort of reversion becomes extremely likely. 

This really is rare. The last time it happened to the S&P 500 was late 2021. I heeded that signal and added an inverse fund which helped in 2022. The chart shows a similar over extension for the South Korean market driven primarily by SK Hynix and Samsung. Currently, the S&P 500 is nowhere near this far above its 200 DMA. Bear markets or large declines can still occur with being this extended, this is just a simple and I believe reliable indicator for the rare occasion it happens. 

Next is an interesting story about the XAI Floating Rate & Alternative Income Trust (XFLT) which is subadvised by Octagon Credit Investors. The fund is doing poorly and Bloomberg reports that Octagon is in danger of being removed as the manager. There is a lot to the story but the very quick summary is that the "problem is not the asset mix, but XFLT’s structure, execution, and governance." Here's the allocation mix per CEFconnect. 

Another tab on the CEFconnect page says the leverage is only 40%.

XFLT is currently at a 20% discount to its NAV. The fund pays out 15% of its market price, historically, very little of that has been ROC. Distributions have been trending lower for a little while. There was some sort of distortion in the data in March so the back test stops at 3/1/2026. Since that date, XFLT has had a very volatile ride to a 2% gain on a price basis. The total return is negative of course but not catastrophically so. If an investor took out all the distributions, they'd only have 1/3 of their money left which would be a catastrophe if they didn't understand how going ex-dividend works and how closed end fund NAVs tend to erode with high yields. 

Closed end funds are more complex than they appear to be. Here are a couple of very old CEFs. Very little volatility price only but they both end up losing the vast majority of their NAVs if the dividends are not reinvested. 

If you want to dig in more to CEF complexity, you can look into Saba's and Matisse's respective strategies.  

If XFLT is a poorly run fund then it might fail as part of a bridge to some financial milestone but the fund is eight years old and there's still 33% of the original investment left after taking out a lot of yield. Eight years is a very long time in relation to bridging to something like Social Security or starting RMDs. 

Again, this outcome is only catastrophic for people who don't understand how these work. People often are seduced by big yields not realizing the tradeoffs. 

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.

Crazy Allocations

James McIntosh wrote How To Invest When The Global Crises Never Stop. Catchy title, I'm in. 

Here's the premise;

More war. More political conflict. More weather disasters. The future looks grim, and for investors there’s worse: The standard ways to protect against such shocks might not work.

Many of the comments just tore into him over this, especially the part about the weather, there's a little more about weather further on in the article. He notes that bonds haven't been working because of shocks that are either causing price inflation or threaten to cause price inflation. I've talked about bonds not working ad nauseum for years so I won't relitigate that one other than this quote which is almost identical to what we've been talking about, "plenty of investors agree that bond yields need to be a lot higher than they were to compensate both for the newfound volatility of inflation."

There is also an acknowledgement that gold hasn't been working as a defensive or hedge since the war started. This is exactly when gold should be working; whatever is going on with the Iran War plus the concerns about inflation, gold should be working. Maybe we can find an explanation for why gold isn't working but whether we can or not, it won't change the reality, it's not helping. It is a perfect microcosm for why you diversify your diversifiers. After only a few months, maybe a 25% weighting in gold wouldn't be too painful, the Permanent Portfolio Mutual Fund (PRPFX) is only down 3% in the last three month. If this extends for a while though, a huge weight to gold looks like an unforced error.

“If you just need to buy and hold something for the next decade I think you just have to accept that it’s going to be a bumpier ride than in the past.” 

That's an interesting point. The hold for the next decade is not anything new for my approach, I have quite a few client holdings that have been in there for more than 20 years but preparing for a bumpier ride is probably something more people should do. A lot of our study focuses on how to build and prepare for a bumpier ride in case the scenario the WSJ is framing actually happens. 

Hopefully the writing here is clear that when you diversify your diversifiers you increase the odds of having something or a few things that are working when something like gold is not. There's a quick mention of hedge funds in the context of being diversifiers in the article. It's a vague term but things like managed futures, various forms of arbitrage and systematic macro that we talk about here are hedge fund-like to be sure and are easily accessible through ETFs and mutual funds. That shouldn't be taken as short cut to learning what these funds actually do, but many of them do function as differentiators, as legitimate diversifiers. 

We play around with all sorts of crazy allocations here. The following "Crazy Mix" has no plain vanilla equity or bond exposure.

For all the worry expressed in the article, of course equities might do great. Someone not wanting or needing a "normal" allocation to equities might build out with more alternatives but for people who need something close to "normal" equity exposure, if they try instead to build a portfolio just with alts, I think their portfolio needs to work much harder to get close to plain-vanilla equities' return. A lot more needs to go right for the funds in the "Crazy Mix" portfolio to keep up with plain vanilla. 

This is a different way of articulating the point we regularly make about not getting too far away from equities if you need equity market growth for your numbers to work. 

Here's one comment from the article;

50% Stocks / 50% Bonds / I can’t think of anything else

A 50/50 mix is valid and can get the job done but you can't think of anything else? I am guessing this guessing this guy is his own advisor. Guy, take a little time to learn about some other things. If nothing else, it might embolden your beliefs but can't think of anything else? Yikes.

Another reader had thoughts about equities and TIPS with allocation percentages depending on the age of the investor and suggested a couple of ETFs. If TIPS appeal to you, go for it but I would strongly suggest individual issues not ETFs.

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.

Deep Portfolio Theory

We've looked at the Cambria Trinity ETF (TRTY) a couple of times lately. I am intrigued by the allocation at a high level which is 35% trend, 25% equities, 25% fixed income and 15% alternatives. We've looked at the asset mix many times, and I think it works. Cambria's research supports that it works of course, the fund wouldn't exist if they researched it and it floundered. 

A similar backtest to what we've done many times.

The results are consistent with what we usually see.

A consistent result is that the strategy works better than the actual fund most of the time. TRTY has had a couple of very strong years mixed in but as a long term hold, TRTY lags a long way behind Portfolio 1 but with much more volatility. 

So, what's missing? I asked both Copilot and Claude. At first, Copilot blamed TRTY's lag on the mechanics of managed futures trading. That answer made no sense since Portfolios 1 and 2 have the same weighting to managed futures. It took quite a bit of back and forth to convey the point. 

Claude seemed to blame it on heavy equity factor weightings with a lot to shareholder yield. The way the fund is put together, Claude says it is complexity without a clear edge and that the way the factors are assembled makes it overly vulnerable to certain market environments.

When I figured out how to tell Copilot it was looking at this incorrectly, I told it I believe TRTY is too complex relative to the concept. It replied that TRTY is over engineered with too much structural friction. Both Portfolios 1 and 2 are simpler it said. The "too complex" answer felt more genuine coming from Claude because it was unsolicited versus my telling Copilot what I thought. 

Related to managed futures, iM Global Partners filed for an ETF that would leverage up to hold 30% in US equities and 100% in managed futures. This is the firm that runs the DBMF ETF. I saw one comment on the Tweet that brought this to my attention, it described this as being risk parity. That's a good observation, there's something to it, maybe it's risk parity influenced or risk parity adjacent?

On testfol.io, we can simulate DBMF back to 2000.

I am very surprised the result is so good. 

This second look includes a more diversified mix of managed futures funds instead of 77% in one fund (yikes) and AQRIX which used to be AQR Risk Parity and still is risk parity influenced.

There have been some long stretches where managed futures really was a pain trade but it's hard to argue with the underlying premise of the filing. 

A final iteration in Portfolio 3 which takes the filing, reduces the managed futures/equity sleeve down proportionately to 60% of the portfolio and combines it with 40% in fixed income.

Portfolio 3 is pretty close to a 75/50 version of VBAIX. The way it weighs out, Portfolio 3 is risk parity adjacent or inspired which along with Trinity's allocation is another idea that I find very intriguing. 

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.

Is The World Ready For Betting Market ETFs?

A couple of quick hits tonight. 

I stumbled across a generic asset allocation from a huge firm ($100 billion AUM) that no one's heard of. The mix isn't radically different from other large asset managers and they use private assets to round out the mix but as is often the case, we can rebuild their idea using brokerage accessible funds. 

The build out of their idea includes the usual suspects of funds we use for blogging purposes.

With a little more time to spend, I think this could be improved but it is still pretty interesting. 

We've talked a couple of times about an ETF idea whose strategy would be to place many bets, talking thousands, on various betting markets, not necessarily seeing each bet out to the end but more like moving in and out as pricing changes. I imagine this as some sort systematic implementation that if it went well, might have an absolute return sort of result that would be a little better than T-bills.

This filing isn't exactly that but it's a step in that direction. 

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.

Compound And Chill

We'll start with a success story from the Wall Street Journal about a 60 year old Costco employee who has accumulated $1 million in his 401k. He says he could probably retire but doesn't want to yet. I'd say he could probably make it work if he was desperate to retire but it would not be stress free unless his wife has at least half as much in her 401k. 

The way I read the article, he just contributed every pay period (still does), left it alone and it compounded. It doesn't sound like he did anything brilliant to get to this outcome and more importantly, it doesn't sound like he did anything stupid and it compounded into a lot of money. 

There's no mention of how he invested, presumably just index funds but it's just a 401k and most 401k plans' fund choices are far from optimal for various reasons but that's ok, it got the job done, he has far more money than he ever expected just by getting out of the way and letting it compound. 

An investment portfolio doesn't have to be optimal, it just needs to have some valid and reasonable basis to believe it can get the job done. I am not a fan of any product that includes AGG like bond exposure or bonds with duration (VBAIX and target date funds), they are far from optimal but they are valid and can get the job done. 

Here's an interesting study I put together that I think speaks to compounding with suboptimal allocations combined with a slightly higher withdrawal rate and beginning retirement at an unfortunate time.

I went with replicating the Cambria Trinity ETF (TRTY) because I attribute "XXX and Chill" to Meb Faber tweeting about TRTY. The study starts January 3, 2000, starts with $1 million and assumes a 5% withdrawal rate (1.25% every calendar quarter). 

Each portfolio has its pros and cons. The TRTY replication has obviously had a much smoother ride but with Portfolio 1, the investor is today almost $250,000 ahead of the TRTY replication. The starting date is about as bad as it could have been. The stock market cut in half twice in eight years but despite even taking 5% out, each portfolio has a lot more than when they started. If these people retired at a normalish age in 2000, then 26 and half years in to their retirement, they probably don't have another 26 and half years in front of them. In terms of dollars and cents, this is a successful retirement outcome.

Each portfolio clearly had drawbacks, repeated for emphasis, but the compounding worked. The drawbacks didn't invalidate the allocations and the results got the job done. 

Just compound and chill. 

And because I think it's related, an anecdote about a bridge strategy that a client is using as part of their early years retirement plan involving an inherited IRA. The law changed a few years ago requiring inherited IRAs to be emptied out in ten years (does not apply to spouses). If the inherited IRA is even sort of large, it makes sense to spread the withdrawals out over at least a few years to probably pay less in taxes. 

Taking out $300,000 all at once for example would probably kick many of us into a higher bracket versus spreading that $300,000 over five or six years. When the client was 64, he's 67 now, he started taking out a monthly distribution that annualized out to 19%. He's at the same distribution amount after three years and one month and his distribution now annualize out to 33% of his remaining inherited IRA balance. 

There's of course a sequence of return issue looking forward. We're attempting to manage the risk, getting a few months in front of his distributions but if the market does something hideous then his balance might not last three more years, if the market does something heroically great, then maybe he gets 4-5 more years out of the account. 

When we talk about bridging to a milestone like Social Security with an account that has to deplete (inherited IRA), the roughly six years we're working with in this example is a successful outcome. The client already takes Social Security so it is simply an example but his story is a template for how this can work. 

If this could be you, trying to plan what you believe is the best time to take Social Security, an inherited IRA that is bigger than an emergency fund gives you some optionality that maybe you didn't have. 

I'll pivot to my Social Security numbers to explore the optionality. My age 62 amount is $2725/mo. If I could sustain $3000-$3500 monthly distributions for three years from my inherited IRA (I don't actually have an inherited IRA) with that amount being sufficient for my needs, in three years my SS payout would have gone up to $3456/mo by waiting. 

Taking it at 62 still might be the answer you come up with but having the optionality is pretty handy, I always want more optionality if possible.

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.

75/50? AI Has Thoughts

I spent some time in Copilot exploring the 75/50 portfolio which seeks to capture 75% of the market's upside and only 50% of the downside. It suggested the following to create 75/50;

• 55% Hedged Equity
• 25% Convexity (like managed futures)
• 20% Market Neutral

To build this idea, I used JHEQX for hedged equity, for managed futures I wanted higher volatility so I used QMHIX and for market neutral I went with MERFX.

The backtest is almost exactly on target.

I typically say that over the longer term 75/50 works out for the better. For the entire backtest period available, that wasn't the case but if you look at different time periods you can see where that would have been the case and either way, it's been a much smoother ride. In Portfolio 2, I threw a 1% weight to TECL which is 3x technology. That pushes up the CAGR slightly more than it does the volatility which causes the Sharpe Ratio to improve very slightly. 

For a little context to Portfolio 1, and 2 to a lesser extent, over the same period, throwing it all in AGG would have compounded at 1.86% with a volatility reading of 5.11%. AGG's standard deviation was actually quite a bit higher than either 75/50 combo.

Copilot thinks the mix of hedged equity, convexity and market neutral is durable going into the future because none of the three are new strategies. They've all been around for a while and endured many types of adverse market events. 

I tried a slightly different version with lower vol AQMIX instead of QMHIX and cat bonds instead of merger arb and that improved the results very slightly. 

In any real world application of something like this, I would want to carve up the three segments to use more than just three funds. To the extent that Copilot is right about this being durable, a 4% real return with such low volatility can probably work for someone who is ahead of where they need to 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.

Pristine Fire

We had a small wildfire late Monday afternoon into early evening and the follow up today altered my regular schedule so very short post today.

The circumstance of the weather, proximity of structures and fire behavior was such that I couldn't get any neat pictures. We got there, had to pull hose and get water flowing quickly. It was a great outcome, we knocked it down quickly. The red engine on the right, 41 is from a neighboring department. We also had help from Prescott National Forest Engine 330.