It's Not Catastrophic, It's Just Not All-Weather

A while back we stumbled into an interesting blend of fixed income ETF with 50% in iShares MBS ETF (MBB) and 50%,

Backtesting to RISR's inception, it struggled a little in 2022 when the treasury market was blowing up but that was nothing compared to TLT and for the most part it has looked like T-bills. It's interesting that the price only return is almost the same as T-bills.

I asked Copilot what the story is here. It looks kind of bullet proof. I realize it's not but I want to understand the risk. MBB and RISR have been negatively correlated, almost perfectly so, which is why the blend looks like that. 

Copilot said that the negative correlation would flip positive if mortgage spreads widened dramatically, citing 2008 and 2020 examples with late 2022 as being modestly negative for the blend. Copilot theorized that in 2008 it would have been down 9-10% and in 2020 it would have been down about 8%. In 2022, there were two negative months in a row adding up to a little less than a 4% decline. 

I pushed back that "The arguments you're making seem to say it won't do very well when there is absolute calamity but even then the results aren't catastrophic. They're just not that resilient." 

"A 50% RISR / 50% MBB portfolio is not a ticking time bomb. It’s not going to implode, it’s not going to behave like high‑yield credit, and it’s not going to deliver catastrophic drawdowns even in severe stress." Then it said "it's not catastrophic, it's just not all weather." 

It's "not even particularly bad in the context of fixed income" which literally made me laugh out loud. The original response made it sound this idea was more risky with more volatility than ZROZ which is like trying to hold onto an M80.

MBB/RISR doesn't take interest rate risk but the spread risk would be unique versus the other things we talk about. Whenever the next cataclysm happens, the blend we are talking about today might feel it a little more but the rest of the time, it might look like how it's performed since we started tracking it. 

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 Diversified Isn't Diversified

Torsten Slok's Saturday email included the following chart and he said the index' concentration is moving toward 50% in the top ten if/when Anthropic and SpaceX go public.

He said the "S&P 500 basically doesn’t offer much diversification anymore."

Here's a fascinating quote from Jeff Currie at Carlyle, he said "in the 1970s, energy at 25% provided a natural portfolio hedge. At 3%, that hedge has vanished."

Mike Zaccardi Tweeted out this chart.

I think I randomly noticed the duration getting a little longer at some point but I don't really keep tabs on this the way I do for S&P 500 index composition. 

The Oregon Public Employees Retirement Fund has had its hat handed to it for getting lousy returns from its 26.5% allocation to private equity. "They appear to be after the highest-returning asset without respect to risk-return considerations and without regard to their seeming lack of selection skill." CIO Rex Kim is cited as calling the criticism myopic, the fund is focused on the long term. That would be ok except for the various budget cuts, one small school system had to make serious cuts to staff, occurring now not in the long term. 

The tie in for all of this is how to embed robustness or resiliency into an investment portfolio. Here's Bob Elliott from Unlimited Funds giving his thoughts on how important this is.

We obviously spend a lot of time here on how to do that. The balance is walking the line between kneecapping long term growth of the portfolio while not taking the full brunt of large declines or being a forced seller after a large decline to meet income needs. 

Obviously the belief here of how to best do this is to combine small weightings to esoteric fixed income niches and alternative strategies with differing attributes. 

In the past, we've frequently said putting it all in an equity index fund is valid but not optimal. Currie's observation about no built in hedge speaks to part of this, another part is the occasional enormous declines that might reasonably induce a panic sale at exactly the wrong time. The right combo of robustness and resiliency can prevent ever being in a position of potentially panicking. 

The anecdotes about AGG and OPERS are different manifestations of the same issue, not having a great understanding of how risk works. Also with OPERS, if there really are budget cuts now because "long term" investments are doing poorly, then the investment team has mismatched its assets versus its liabilities. 

Making portfolios more robust is not rocket science and it gets a little easier when you can accept that not every alternative strategy or esoteric fixed income niche will do well in every single adverse event. That is why you diversify your diversifiers. 

Don't make it harder than it needs 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.

It Just Has To Work

Barron's laid out a path to a stagflationary outcome like we had in the 1970's noting the dynamics of the oil market being the primary factor. The Friday growth revisions and inflation data didn't help to refute the argument. 

Bloomberg took up a similar conversation talking about what various investment firms are doing to help with the current equity volatility against a backdrop where plain vanilla 60/40 isn't really working.

There was a bit of a spaghetti thrown against the wall aspect to the different strategies expressed in the Bloomberg article. Bonds often work in times like this but are not for reasons we've gone over ad nauseum. What about gold? It sort of isn't working but I have a different take. Gold already worked. Arguably it priced in some sort of turmoil rising about 70% in the last year.

Are there some equities working? Yes but there are always some equities working no matter how bad it gets. For this event, defense stocks certainly have been working until the last week or so, rolling over a little. They also might have priced in turmoil ahead of time. 

There was no mention of managed futures which have been interesting in terms of the dispersion of performances. Over longer periods, performance dispersion seems more like magnitude but in the same direction. The long list of funds I track collectively seem to be doing different things on a daily basis. The differences probably come down to different types of signals used as well as risk weighting of positions. There have been times were managed futures has just been killed during equity market volatility, the first 10% down, but that isn't happening now. 

Another Bloomberg article suggested buffer/defined outcome funds instead of bonds to help with equity volatility. Buffer/defined outcome funds certainly are not malfunctioning through this, so that's good. I have no reason to think they would malfunction but the basic ones will not be proxies for equities when you want them to be. 

Inverse funds are mostly working. But client personal holding BTAL had a couple of disappointing days in there when the S&P 500 was down (good for BTAL) but software stocks had a bit of a recovery (bad for BTAL) that seemed to puzzle people but happened all the same. Going to heavy in inverse funds becomes counter productive at some weighting as too much of a drag. I'm not sure where that line is but mid single digits is not counter productive. 

REITs have been doing well which is a bit of a surprise with rates going up. REITs have tended to disappoint in times of turmoil more often than not and yieldy REITs tend to go down when people can better yields from bonds. 

The last (only?) time there really was stagflation, foreign equity markets outperformed the US. This was the case in the 2000's albeit with a different circumstance.

Foreign has had a bad week but a real stagflationary event would last more than a week or two and I would want foreign equity exposure in that instance. 

What all of this is about is diversifying your diversifiers. Forty percent in bonds, not working. Meb Faber has tweeted about how close 60/40 stocks/bonds is to 60/40 stocks/gold over long periods. Great but gold this month is not working. On the next event, maybe both will work and the things doing a little better now will do very poorly

There's no way to know when some random diversifier you believe in just will not get it done. It would be nice if gold was working this month but I don't want to put clients in a position where gold has to work just like anyone putting clients into 40% bonds is putting them into a position where bonds have to work and they aren't. 

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.

There's An ETF For That?

YieldMax dialed it way down for its new US Stocks Target Double Distribution ETF (DDDD). Instead of yielding 50%, DDDD will target twice the distribution rate of the Schwab US Dividend Equity ETF (SCHD). SCHD yields about 3.5%. DDDD owns a slug of SCHD as well as quite a few of the individual stocks in SCHD. 

The fund will overlay option combos on SCHD as well as some of the holdings using call spreads, selling puts and a couple of other strategies occasionally. The boilerplate says the fund may return capital as part of its distributions. 

Copilot said that based on the current holdings, the dividends generated before any options are implemented should be 3.4-3.7%, in line with the fund. 

I'd be surprised if it had to return much capital to find the extra 3.5% yield. I suppose it might want to do that for some reason but I doubt it would have to. The extra drag then from the higher distribution versus SCHD would only be 87.5 basis points per calendar quarter. I can't imagine it would look like any of the crazy high yielders that move down and to the right on a price basis very swiftly only to then reverse split and then repeat the swift decline toward another reverse split.

We talk about using small allocations to the crazy high yielders in some sort of depletion or drawdown strategy. DDDD simply paying a little bit more should be plenty sustainable for anyone who would rather take yield out than sell from more of a total return approach. 

For all the talk about private equity/credit firms, it turns out there is a pretty narrow based ETF tracking the space. The Van Eck Alternative Asset Manager ETF (GPZ) only has about nine months under its belt but it appears to do a good job tracking the industry which lately means the price is down a lot.

That's not all the holding but it's most of them. Not captured in the screenshot is Blue Owl with a 3.28% weighting. There's no Goldman, Morgan Stanley or any of the other multiline financials that dominate funds like the following;

While I can't see ever wanting GPZ, there is probably useful information keeping tabs on it.

I'll close out with advice from Barron's about The Best Way To Trade A Volatile Stock Market which is that investors "should do as little as possible." Maybe put differently, do less. If you've been reading this blog for a while, hopefully you recognize the pattern of small tweaks when risk factors change, not necessarily as an emotional response. That's the objective anyway.

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.

Duration Is Not The Answer

Something I don't think I've ever talked about before but I am not a fan of fixed income duration.

We have of course talked about this so often that I am sure I've lost readers for banging the same drum over and over for so many years.

The screenshot is just a nanocosm, a moment in time but it captures the unreliability of fixed income duration. 

There is some yield where ten years or 20 years is adequately compensated but four point something percent isn't it. If we ever get a yield that you think does provide adequate compensation for ten years or 20 years, just buy the individual issue, don't buy the ETF.

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.

Mr. Potter's Investing Philosophy

 Boaz Weinstein isn't selling, he's buying.

Or trying to buy anyway, distressed assets from a couple of the fund providers like Blue Owl for 65-80 cents on the dollar. We talked about this the other day. I don't think the takeaway is to also try to buy distressed private credit assets. I'm not even sure what that would look like, Weinstein is trying to assets out of funds like Blue Owl and the others, so to buy shares would appear to mean buying a fund that just sold on the cheap if that's what happens. 

What the point is that we can take away from is about not panicking when things go poorly for random holdings. If you include sector funds in your strategy, I do, a sector isn't going to go to zero. If you've sized it correctly then there should be no need to sell just because it is down. To Weinstein's point, it would be a time to buy pessimism as he puts it. The better sale would be to sell excessive optimism. In January I shaved down SPDR Metal and Mining (XME) by about 20%. It doubled in a year which is great but maybe excessive. 

I'm not a buyer of the private credit pessimism. The whole space reminds me of trying to hold onto an M80 but without the Bitcoin-like upside potential. I take that back. The common stocks of the private credit companies do have that potential but that would add a lot of volatility to a portfolio. We look at Blackstone (BX) frequently for blogging purposes. It is down to $107 from $199 in November, 2024. 

I don't think there's a reasonable risk of it failing, might not be as confident in Blue Owl, but while I don't doubt it gets back to $199 and higher eventually, maybe the path back to $199 goes through $60 first. I don't know either way in terms of price of course but in terms a volatility, I would expect the moves to be huge in both directions. Including that sort of volatility in a portfolio makes sense but again, it needs to be sized correctly and considered with something else that might be just as volatile. Having 5% in four or five holdings with this kind of volatility is going to be painful if the market whooshes down and that would increase the odds for panic selling for the investor who didn't understand what they were getting into. 

We've been talking about redemption requests impacting private credit funds and that appears to now be happening with Cliffwater. I haven't seen any reports that Cliffwater's assets are impaired so assuming they are not impaired, a bad outcome could just simply be a sort of contagion effect. People believing the entire space is in trouble could be looking for liquidity anywhere or as we quoted in a different blog post, no one wants to be the last one out.

"Hi there, it's Cliffwater. I need to sell some paper right now to meet redemptions."

"Hi Cliffwater. How's 85 cents sound?"

These things are complicated and expensive in addition to being illiquid. 

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.

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.