Diversifiers Stopped Diversifying?

That was a Tweet from Jeff Weniger from WisdomTree and he shared this chart.

WisdomTree has a managed futures ETF with symbol WTMF that for just about all of the first half was up a little as the bear market in equities started and now shows on Yahoo Finance as down slightly YTD. WTMF is not even close to being the best performing managed futures funds but presumably they know the space, know that a lot of the funds in managed futures are up kind of a lot this year so he knows some diversifiers are working but not the ones that people rely on most heavily; fixed income and to a much lesser extent gold.

With all the various alt strategies we look at here in these posts, I go out of my way to repeat the message of moderation with these for the times that they don't "work." If something "works" more often than not and I feel like I understand why it works as a diversifier then that will be good enough for me to use it in moderation, realizing that occasionally it won't "work." Gold is a great example in the current event of something that has a low to negative correlation to equities most of the time but it is not working in the current event. Nothing should be expected to work every time. Even an inverse fund could trip up in a down market depending on the sequences of returns and daily resets.

So if using diversifiers in moderation is prudent for the reasons I lay out above, should we treat fixed income sectors just like any other diversifier? Wrong pronoun there, not we, you, should you only have modest allocations to fixed income sectors? No wrong answer, what do you think?

To Jeff's chart, I've never considered as much as 10% in gold. Ten percent into a couple, two or three maybe, different fixed income sectors might make sense as opposed to all in on long duration treasuries like some people do. So far, the current bear market doesn't seem to have anywhere near the credit risk of the financial crisis. Spreads have widened out a little but they are not so narrow as to be a terrible value and not so wide as to be signaling doom around the corner...they're just right....no need, I'll show myself out at the end of this post. 

Short dated, high yield bulletshares which I use are certainly feeling some pain but they are down nowhere near as much long duration treasuries. We've talked about T-bills a few times, we've talked less about floating rate (I have a couple of ETFs from that space in my ownership universe) and short dated TIPS ETFs are down some in price but the "yields" are now much higher. These are all spaces that rely on different things and avoid the full brunt of interest rate risk. 

I've been talking about these for ages. Thinking these would be better than long dated bonds was a very simple top down look at the world made ages ago and finding these income sectors took just a little bit of digging. Whether you are an advisor or a do-it-yourselfer, you can do this sort of very simple assessment to avoid the worst, to avoid the riskiest. This is an example of via negativa, removing the negative. Markets are down a lot so client accounts are down too of course but anything that smooths out the ride even a little is helpful.

Hey, we're in Maui! Our first non-road-trip trip in quite a while. Here's some pictures.

Monday sunset in Kihei

   

Lifeguard tower

 

Steep hike to the windmills on the west side of the island

 

Po'Olenalena beach

It's A Learning Process

Barron's has an article titled How To Diversify Your Portfolio With Alternative Investments. It's a long read that tries to go deep but there are couple of points that I think will lead anyone who is new to the concept down an unproductive path. 

The article cites nine different alt categories, some of the names were very vague, which I think complicates the task of how research is done. I would probably narrow down to two strategies; very low volatility like a horizontal line that hopefully tilts up and things that should go up when stocks go down. 

Within each category there are many different strategies and anyone can go as far as they want to study those strategies but as an example, both merger arbitrage and convertible arbitrage both fit into the very low volatility/horizontal line that hopefully tilts up category. It is important to understand that nothing is infallible which is why you don't want to put 25% into just one. Yes, both examples will very likely "work" far more often than not but that one time they don't could be disastrous if you have a huge allocation. Diversify your diversifiers. 

Managed futures and long short the way that AGFiQ US Market Neutral Anti-Beta (BTAL) does it are examples of strategies in the category of things that should go up when stocks go down. Inverse funds would be another example and gold is an example of one that has worked in past events, it was up a lot during the financial crisis but not really this year. In the current market event it is not down anywhere near as much as the S&P 500 or a 60/40 portfolio as measured by VBAIX but still down a good bit. BTAL is a client and personal holding. Diversify your diversifiers. 

The article devoted some time to business development companies, aka BDCs, as alternatives. You can read the article for the fundamental reasons why BDCs might be alts but assuming the article's reasoning is exactly right, what does that actually look like?

 

It looks like the stock market. Not what you want for an alt in the context we are talking about nor what I think the article had in mind. Those three symbols are the BDCs that were mentioned in the article and I threw levered fund TQQQ in there because the volume number blocked the percentages for the BDCs in comparison the S&P 500. 

The article also mentioned REITs. 15 years ago, there was a lot of chatter about REITs and MLPs as diversifiers and I made the point repeatedly that they would not offer protection from large declines. The merits of owning them might make for a long list, or not, up to you, but protection from large declines is not one of the merits. Ditto BDCs.

If you're curious, the three charted BDCs fared worse than the S&P 500 during the 2020 Pandemic Crash. In the Christmas Crash of 2018, two of the three were very similar to the S&P 500 and one did quite a bit worse. 

If you're going to buy something to protect against large declines, you should have some basis to expect it will actually protect from large declines whether that means being a horizontal line or that it goes up when stocks go down. The names and strategies we've been writing about all summer provide that basis. Any of them could not work in any given event of course (repeated for emphasis) but something that has worked most of the time will probably work most of the time in the future. Still though, diversify your diversifiers for the (hopefully) rare occasions they don't. 

I would reiterate a final point which is that whenever this current market event ends and prices go back up, all of these should be expected to lag. When stocks are going up, you own too many alts and when stocks are going down you wish you had more. That is the nature of it.