Man Financial's Idea For All-Weather

Man Financial did a study about optimizing for Sharpe Ratio, my interpretation anyway. It's a good read and I think the result is very interesting. 

On the left is the asset/strategy allocation and on the the right, they believe it can be successfully levered up. Their context isn't levered up with ETFs or mutual funds, the paper is more for institutional investors but we can still learn from their idea. The levered up version could almost be implemented now but with very little choice currently so I wouldn't consider that. 

For risk managed beta I went with HEQT (more on that below). Managed futures for alternative trend. Volatility l/s wasn't obvious to me, Copilot suggested RISR which we've looked along with a couple of others but it liked RISR the most and we have some familiarity with it here. Client/personal holding MERIX works for equity market neutral and ILS stands for insurance linked securities aka catastrophe bonds so SHRIX for that. 

Compared to plain 60/40.

Well, it appears as though they are onto something here. I asked Copilot to critique the unlevered version in relation to the paper. At first it said that MERIX and SHRIX was a credit cluster that would get hurt in some sort of 2008 redux. It didn't know that SHRIX was ILS, second time I had to tell it that actually. The Merger Fund was up a little in 2008 as was the Swiss Re Cat Bond Index so Copilot backed off that worry. It said 50% in HEQT is still a lot of equity beta. It really isn't though. HEQT's beta is 0.44 so it's like 0.22 of equity beta coming from HEQT. Copilot backed off, essentially saying in protracted declines HEQT's beta could go up but still not like full exposure like from VOO or SPY. It then conceded that 50% in HEQT was the sweet spot which I'm sure Man had already figured out.

Based on the title of the paper, I assume that some sort of all-weather effect is the desired outcome. Copilot thought the portfolio was true to Man's intention and rated the components as follows.

Reminder that Copilot came up with the clever addition of RISR.

In starting to put this together, I asked Copilot which ETFs besides HEQT would fit the description of risk managed beta in the context that Man was using the term. It said HEQT would be the best choice. I asked if I skewed the result by asking the question that way and it said no, so who knows? It also said that Simplify Equity Plus Downside Convexity (SPD) would work but it preferred HEQT. 

I don't know why anyone would want SPD. The results have been bad to be sure but it turns out it is not intended to "work" for slow declines. It is more about very fast declines. It did well during the Tariff Crash last April. Where fast declines tend to snap back quickly, I don't think protecting against fast declines at the exclusion of slow declines is a productive strategy. It's nice to have some offset to fast declines but slow declines are the thing to worry about. For this reason, I wouldn't consider SPD. I use a separate line item for fast decline protection versus the SPD strategy of bundling the protection in with the index in one fund. 

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.

Valid, Not Optimal

A couple of things from Barron's. First an article about buying low and selling high not "working" during this event. There is a focus in the article about whether or not to reduce exposure to stocks doing well to rebalance into stocks that are struggling.

Included in Adam Parker's comments was to "only buy losers when you are confident that a market bottom is close at hand and a big recovery will follow." When you're confident the market has bottomed? That sounds pretty easy, amirite?

You'll find plenty of differing opinions about trimming winners to buy laggards but replace "confident" that the market has bottomed with add more net long exposure after a large decline fulling realizing you might be wrong for a while. Buying after a 20 or 30% decline won't be emotionally easy and yes you could absolutely be early on the way to a 40% decline but buying after large declines will work out far more often than not. 

Another article sought input from advisors about what they do to help clients avoid running out of money. One advisor laid out a strategy that "typically divides clients’ assets into five to six buckets based on time horizon and risk." 

Here are the buckets she uses and how she labels them;

• Cash for 1-2 year liquidity
• Short term stability for 3-5 years
• 60/40 for six-15 years (70/30 works too she said)
• Buffer fund for 15-20 years out
• Dividend stocks for 20-30 years out

What's your first reaction to that? Me too but backtesting her idea has a pretty good result.

Before any critique, here's what I used to try to replicate the advisor's strategy;

We'll get into some detail in a moment but her idea is clearly valid.

The 5 Bucket is not that far behind VBAIX in nominal terms and it has a better risk adjusted return as measured by the Sharpe Ratio. Several of the other portfolio stats are also superior. There was no info about what specifically she uses to build these buckets but there seems to be some overlap between the first two. Maybe she is using individual issues and really is differing the maturities between each of those two buckets. 

I would not expect buffer funds to capture all of the upside. That's not a problem going in as long as you realize that. Copilot says BJAN is the oldest buffer fund so I chose just to get a longer back test. Since it came out it has compounded at 11.56% versus 15.74% for the S&P 500 with about 3/4 of the volatility. Adjusting for growth rate versus volatility BJAN's return has been about the same as the S&P 500. BJAN has compounded 114 basis points better than VBAIX which is interesting but with a more volatility.

The suggestion of using a buffer fund for a long term bucket might be puzzling. I've seen one other advisor suggest this and being blunt, I don't know why this would make sense. Copilot said it really doesn't make sense other than for behavioral reasons like a lower tolerance for equity market volatility. Given how close BJAN is to VBAIX, the entire 60% (40% plus 20%) could be put into one or the other, BJAN or VBAIX, assuming confidence that BJAN could continue to be a close proxy for 60/40 but without interest rate risk. FWIW, the two have a 0.96 correlation to each other. 

The article had no info on how the buckets are weighted so I put 4% in bucket one and 8% in bucket 2 to both correspond to a 4% withdrawal rate. The other weightings are pretty much made up, thinking 40% into the 60/40 bucket would do most of the heavy lifting in terms of growth and sustainability. 

So now, let's see if we can improve the Original 5 Bucket Portfolio with some of the strategies we talk about regularly. 

Everything but SHRIX is in my ownership universe. We're replacing VBAIX with SPMO/SPHQ, ACWX and SHRIX. FLOT instead of SHY. And all-weather replaces the buffer. SCHD plus SPMO/SPHQ sort of brings in the quality/value/momentum idea we looked at the other day. 

Again, I will say it is valid. The slightly better CAGR from our version is nice but I would focus more on the volatility, drawdown numbers and other portfolio stats. Those are probably more sustainable than knowing whether it can continue to outperform. I think avoiding interest rate risk will help it outperform but that could easily turn out to be incorrect. 

I asked Copilot to critique both of them. Its initial reaction was;

I explained the context. It isolated the issues with buckets one and two in the original version, it liked FLOT a little more than SHY for example. BLNDX is way better than BJAN, it said BJAN is not "compounding machine." I would argue it is, just not like equities. My weighting to ACWX is too small to matter but I would push back that as part of a 60/40 bucket it is sized about right. It thought both versions had too much in SCHD but the attempt there was to just be true to the original suggestion about dividend stocks. 

Based on previous interactions it said that my version was "convexity-aware" but that it lacked any "fast convexity" like BTAL. My final query was to note that as I said above, I think they're both valid but not optimal and Copilot agreed with that assessment. 

One final hit. We've looked at a portfolio that was heavy on cash or cash proxies and light on TECL which is a Direxion 3x bullish fund that references to XLK. XLK is down 14% from its high while TECL is down 47%. If TECL tracked exactly for a longer period (that is not what it should be counted on to do) then you might expect it to be down 42%.

This backtest assumes buying TECL at its high.

Until it's rebalanced, if the broad market continues lower then this blend will probably be more defensive for now only having 15% notional long exposure not the 30% that it started with. Knowing when to rebalance would be pretty tough though. 

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.

Get Out Of The Business Of Making Predictions

For the last couple of days we've talked about the newly listed Fundrise Innovation Fund (VCX) which is a closed end fund that inflated to a 1900% to NAV on Wednesday, then yesterday fell to just an 1100 premium to NAV. At the open, it took another huge leg down. 

The NAV remember was reported/estimated to be about $20. The drop on Thursday is being attributed to news that Citron Research went short with the the primary thesis being "simple math." VCX holds a lot of the "right" companies so that is intriguing but with reports floating out there that SpaceX will go public in June or July and Anthropic in the fall, given the market caps, the odds that you will end up with them in something you already own are pretty high. 

The WSJ piled on to Blue Owl with questions/observations about its recent loan sale from a few weeks ago at just a tiny discount to par. It read to me like they sold the good stuff to larger pools doubling down on their existing stakes and leaving the inferior loans still in the funds. 

Regardless of whether my take is right or not, this whole thing is a complexity bourn of greed (chasing yield) that was easily avoided in real time. Dani Burger shared an anecdote on Bloomberg from some interview she did where the guest said her parents are older and need liquidity and income but that their advisor was pitching private credit to them. This is complexity that was and is easily avoidable, repeated for emphasis. 

AQR filed for an interval fund that will be called AQR Delphi Long Short Fund. The filing reads like it will have a similar strategy as client/personal holding BTAL, "...long-basis in assets the Adviser deems to be attractively valued, high quality and, low beta (lower risk) assets and on a short- basis in assets the Adviser deems to be expensive, low quality and high beta (higher risk) assets."

Long/short is a fascinating strategy for how much ground it can cover. We've used the terms long biased, market neutral and short biased to cover the space. We've looked at the Invenomic Fund (BIVIX) as one that appears to be able to go from long biased to short biased, having made one or two great calls leading to a couple of massive up years earlier in its existence. Managed futures is also a version of long/short. 

Equity long short is probably like managed futures in terms of anyone want to go heavy should probably use more than one fund. There's a lot of performance dispersion. 

I use short biased, neutral and managed futures for long/short. 

The war has become a real market event. Hard to say at this point how serious it will be in market terms but this is a noteworthy reaction. 

Eight percent in a month is kind of a fast decline. It's nothing like the Tariff Crash last April or the Covid Crash in 2020 but it is something. You might know from reading this blog that I put a lot of effort into trying to prepare clients and the portfolio ahead of time for when things get bumpy (or worse). I constantly write about the strategy and tools I use. Now that an event is underway, most of the work should be done. Whether or not I make another tweak or two depends on an unknowable future sequence of events. The point is having a process you believe in, more like have unyielding faith in, and letting it work without being in the business of trying to predict anything or (over) reacting to whatever is scaring markets at the moment. 

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.

Remember Country Funds?

Yesterday we looked at funds that offer access to private equity including Fundrise Innovation (VCX) which is a closed end fund that just started trading last week and had rocketed to a 1900% premium to its NAV as of yesterday's close. A different story today.

So now it's only trading at an 1100% premium to its NAV? This stuff is fun to look at and learn about but seriously, keep your money in your pocket. 

Eric Balchunas from Bloomberg posted this chart.

His point was that if you think the S&P 500 is concentrated, that's nothing compared to most other country benchmarks. In my time writing at thestreet.com, I wrote about many of the iShares country funds and would mention the sector composition in this context. From 20 years ago, it would have been easy to wind up with huge overweight in something like financials. Today, if you have a core of some S&P 500 fund and add iShares Taiwan (EWT) 68% tech and iShares Netherlands (EWN) 32% tech, you'd have less diversification than you might think. 

Someone wanting to go big on semiconductors and foreign could instead use ProShares S&P 500 ex-Tech (SPXT) for domestic and then EWT and EWN for their tech exposure for example. That's really just an example of how to look through to the sector level in these funds, not something I'm doing. 

Let's game this out, below. The 30% in EWT gives the overall about 23% in tech. 

Austria EWO is a source of financials, Switzerland (EWL) is healthcare and industrials and Peru (EPU) is materials. I used XLY to add the US and consumer discretionary and KXI is global staples. 

Copilot with the assist.

If you give this method more thought, I might suggest reducing the financial sector exposure a little bit. That sector tends to be big in many country benchmark indexes. The backtest for this versus All Country ex US, All Country including US and the S&P 500 was fascinating.

Calling it fascinating might be a little optimistic but the result is pretty much identical to All Country World (ACWI), that's the one that includes the US. I pulled the allocation out of the air pretty much. I had some understanding of what some of the country funds are heavy in with regard to sector composition. I just used AI to do the sector math. AI could obviously help dial in the sector weightings better and then help with diversifying risk. I tried a little bit with different types of economies like commodity based and service based and so on but I would not take today's theory as optimal. 

Quick personal note, I am thrill that baseball has started. Most afternoons during the season I am on my laptop with a game on, very much a joyful thing for me. This guy has what might be the greatest nickname in the history of sports. His nickname is The Password. 

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.

Trying To Figure Out Gold

Have you heard about the ERShares Private Public Crossover ETF (XOVR)? As the name implies, it is a mix of private companies and public ones including a large weighting to SpaceX. There has been a lot of coverage of this fund, most notably by Jeff Ptak from Morningstar. There have been questions about not marking to market and whether the fund owns too much SpaceX in terms of regulatory limits and what they're going to do about that.

The RONB ETF also owns SpaceX but per the fund page, it owns less. The Destiny Tech 100 Fund (DXYZ) is a closed end fund whose largest holding is SpaceX along with a few others that are probably familiar. It currently trades at a 32% premium to its net asset value. The structure of closed end funds is that the share amount is fixed, unlike an ETF, so market pricing is heavily influenced by investors' supply and demand, more so that with ETFs. 

Last week a new closed end fund started trading. Actually, it looks like the Fundrise Innovation Fund (VCX) has existed but is now available as a closed end fund in a brokerage account. It started trading last week at $31.50 and it closed regular trading today at $380 and is up another 10% after hours.

Grok estimated VCX' NAV to be $18.97-$20 as of March 19th. If accurate then the fund is trading at 1900% premium to NAV. 

If you gotta have this exposure and it ends up going horribly wrong, like because you bought with a 1500% premium to NAV, you can sell right away. The point is there are ways to access this part of the market without locking up your money. Similar to Cliffwater, there are ways to get most of the effect without the hassles that go with illiquid products. 

Bloomberg and the FT took runs at trying to understand why gold has sold off since the war started. There were some vague thoughts including the idea that gold was overbought coming into the war which kind of jibes with what we talked about, that the gold market might have priced something bad in already and then sold on the news. There was also a sentiment that people have been selling what they can. 

There may be no explanation that will satisfy anyone who is curious or invested but a little bigger picture is the idea that we talk about a lot which is that no diversifier is guaranteed to work in every single event which is why it is so important to diversify your diversifiers. If an investor would consider 20% in gold for times when things hit the fan, why not take that 20% and split between several different diversifiers in case gold, or something else, doesn't work out. If they all work, great. It's not impossible that none would work but that is a very remote possibility. 

Bespoke mentioned the large declines in some of the larger tech stocks.

Seems like a good time to check in on some of the crazy high yielding derivative income fund that we look at every so often. A lot images coming. 

Microsoft isn't as volatile as some of the others so it is interesting how closely the total return of MSFO tracks to the common. 

Google is a touch more volatile than Microsoft and the total return of GOOY is pretty far from the common, more than I would have guessed. 

Nvidia is more volatile still and again the total return of the YieldMax equivalent is pretty far from the common which we've seen before.

With all of these, there is path dependency risk. It hasn't been much of a problem for MSFO up to this point but has been for the other two. 

We've looked at ways to use these where small slices can add meaningfully to a portfolio's yield without being a hideous drag on returns like yellow lines in the above charts.

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.

Using Volatility To Lower Volatility

Let's follow up on yesterday's post about barbelling and capital efficiency, continuing to use Direxion 3X Bullish Daily Technology ETF (TECL) as our source of volatility and driver of returns. 

The framing for this could be thought of absolute return trying to get CPI plus some amount. A real return of 2% is generally a benchmark for these sorts of things. Plain equities of course have a much higher real return and also much greater volatility than absolute return.

The funds in Portfolio 2 were chosen so that we could get a pretty long period to study. There are of course far more sophisticated strategies available in retail accessible funds now with daily liquidity. This concept might be for someone who is ahead of where they need to be but still needing a decent real return in case price inflation does something squirrelly while avoiding the volatility that goes with a "normal" allocation to equities. Interestingly though, based on equity beta, 10% in TECL would be like having 40% in the S&P 500. Sort of. I wouldn't assume that to be a linear relationship but it speaks to this form of capital efficiency providing a decent percentage of net equity exposure with very few dollars at risk.

With that longer term context, here's a shorter period that takes advantage of some newer funds. 

For this period, inflation compounded at 3.99%. I used SHRIX for catastrophe bonds. That big dip in late 2022 came from Hurricane Ian. The market reacted like there would be big payouts but there were actually no triggering events. 

Of course, if I ever wanted to actually implement this anywhere, I'd divide the 90% not going into TECL between a dozen different things to avoid the idiosyncratic risk of having 90% in one strategy. I would want to avoid the idiosyncratic risk of having 20% in one strategy let alone 90%.

If you're wondering what the hell Cliffwater is doing there, that story is evolving inside of the bigger private credit story. Bloomberg did a very deep dive into the funds and the structure of the company itself.

The big takeaway for me is the complexity of both the funds and the company. There was no wrongdoing implied and for that matter no poor investment decisions either. They're heaviest in loans to tech companies but so is the entire industry and actually the percentage isn't so big that you'd think yikes, why so much. 

In a recent blog post mentioning Cliffwater and private assets I quoted someone as saying "no one wants to be the last one out" which seems more like what is going on. A lot of people want out at once, most funds are structured to only let 5% out every quarter and the requests for redemptions are generally exceeding the 5% caps. Cliffwater is not immune to this. Against that backdrop, if these funds need to sell and are then forced to sell to discounted bids, it can hurt fund NAVs and reduce the amount that customers get from selling. This can all happen without the actual loans going bad. 

I included Cliffwater above is to show that the issues that go with illiquidity, lack of price transparency and the expense may not justify the returns. The returns have been good but are they so good as to justify the drawbacks of the interval wrapper? We found a couple of things that have been doing a little better than Cliffwater and there will be plenty of others not doing quite as well but pretty good all the same.

Back to our capital efficiency strategy. Copilot did not like the idea of putting 10% in TECL. It made an interesting point, that with the goal of absolute return and a CPI-plus sort of outcome, no single holding should be able to take more than 3-4% out of the entire portfolio. I countered with adding 15% in BLNDX with 5% in TECL. After some back and forth, we came up with this;

Comparing it to 10% TECL/90% T-bills.

As is often the case with these, I would not focus on the performance versus VBAIX, it is a short period to study because of how long some of the funds have been around. Part of why so many of the portfolios we look at have done better is not what we add, it's what we avoid which of course is bond duration. The volatility info and portfolio stats have more information than the growth rate. The portfolio we created today has less than 25% in equity exposure so of course it will lag behind VBAIX with more time to study but the ride for this portfolio can be much steadier and be CPI-plus.

I'd add that the portfolio we built for today's post is that it violates one of our bigger picture goals which is a lot of simplicity hedged with a little complexity. This is a lot of complexity. It diversifies the risks but it is absolutely not simple. 

One thing about trying to use Copilot is that it tends to give a heavy weighting to the worst possible thing happening to each strategy at the same time in manner that would be unprecedented. Using AI is very helpful but learning how to challenge the outputs is important too. 

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.

Face Melting Volatility

Earlier this month, the CBOE launched an index that tracks the volatility of Bitcoin. Like VIX but for Bitcoin. The symbol for it on the CBOE website is BITVX but I couldn't find it quoting anywhere else yet, but I'm sure it will soon. 

And whammy

The filing indicates it will lever up 1.5x the BITVX. The volatility of Bitcoin is 50-100 according to Copilot versus usually being 10-20 for the S&P 500. If CBIX ever sees the light of day then depending on the methodology, the volatility could run 75-150. Even if the numbers mean nothing to you, you probably have a handle on how volatile the S&P 500 feels. If you're in touch with how volatile VIX is, its volatility runs 12-25. Again, all numbers from Copilot.

We've spent a lot of time trying to learn about volatility as an asset class and using it as a strategy. I feel like I've had good luck using BTAL and SH (been using SH off and on since the Financial Crisis). I've used a couple of other things too over the years with dual idea of avoiding the full brunt of large declines and generally reducing the overall volatility of the portfolio.

Volatility can play a role in barbelling a lot of return out of a small portion of the portfolio where that small portion theoretically gives the same dollar return that a normal allocation to equities would give. 

Portfolio 1 is 25% 3x Technology and 75% T-bills. It uses the volatility of technology to get market like returns with much less exposed to risk assets. While the long term result has worked out, the path going forward can't be known and as Dennis Eckersley might say, TECL goes down 40% just to stay in shape. 

TECL's volatility runs at about 40 which helps create some understanding of what CBIX might look like. The path that CBIX will take might be like trying to hold on to an M80. What's bigger than an M80? Is there some way to use CBIX to either capture returns or provide defense? I don't know but someone will figure that out.

I mentioned the other day that as the levered and capital efficient ETFs spaces continue to develop, I think the useful direction here will be funds that double up on the volatility not the daily result. They have fewer problems with the path of returns creating a terrible outcome like the 2x Tesla ETF.

 While I am comfortable using volatility for defense, I don't know about using it for offense like we're describing today for a barbelling of potential returns but it's worth studying. 

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.