Gila Monsters & Personal Finance

We're in Tucson this week and this guy paid us a visit this morning.

It's a Gila Monster, they pop up on our ring camera every so often.

The second volume of How I Invest My Money is out. I read the first one, it is interesting to hear how various people invest ranging from sounding complicated in some cases to surprisingly simple in other cases. Surprisingly simple is not a criticism. 

Sort of related, the WSJ posted Readers Share How Much Cash They're Keeping In Portfolios. Most of the readers in the article range from sort of a normal range of cash like 5-10% while the youngest guy at 40 years old said he was 90% cash. The comments are worth reading. A log of people lean heavy to equities, several talked about leaving X number of months worth of expenses in cash, similar to how we frame it, and quite a few tried to warn the 40 year old who is 90% in cash that he's being too conservative. 

I've shared  some of this over the years. The most unusual part of how my wife and I invest is that we have very high percentage in cash. Meb Faber has talked about advisors being leveraged to the stock market already before investing anything. I stumbled into this concept for myself before Meb talked about it publicly with the added wrinkle beyond Meb's context being that my spending time constantly tinkering and trading my own accounts would take away from what I should be doing in terms of my fiduciary obligation. I have seen other advisors unable to sit still in their own account, pretty much defying every tenet of good investing even if my fiduciary comment is too harsh.

If I get to the point where I am stressed out about my accounts, either because of large declines or fomo induced by greed, then I could see where that emotion could drive decisions made for clients. I've never gotten anywhere close to that point so maybe this theory is wrong but I have seen advisors both panic and get greedy. Note that making a decision that turns out to be incorrect is different than making a decision out of fear or greed. Managing portfolios is a series of decisions and not every one will be correct. 

I used to have about 25% in risk assets and that has probably gone up to 35% (mostly equities and a little Bitcoin) as a function of growth and withdrawing money last year for the down payment on the Tucson house. We have maybe 10% in alts including managed futures, 20% in short dated paper and fixed income substitutes and the rest in cash. Most of what we own, clients also own other than Bitcoin (one or two exceptions) and one oddball mutual fund. The asset allocation is different, the holdings are not. 

It is still my intention to continue to work but as I've mentioned before, it is likely that my income will go down, clients are generally older than me and I don't spend time prospecting for new clients. Assuming I am correct about my income going down, it should still be enough to cover our basic expenses for quite a while which would hopefully allow me to stick to my plan of waiting until 70 to take Social Security. If I make it past 69 before taking it, I will consider that as going to plan. 

Right now, we are not contributing meaningfully to retirement accounts so we can quickly pay off the Tucson house. We took a 30 year loan with the intention of trying to pay it off in four years +/-. The interest over the entire term would be more than the principal. At this point we've paid off about 20% of it so we're mostly on track even if we end up off by a year. If I am 64 or 65 when we pay it off, then we'd be able to make meaningful contributions to retirement accounts. This year will be small contributions. 

If you're not taking money out and can avoid overtrading, then whatever you have in equities will double over some time horizon or maybe even triple. I have to take RMDs in 15 years. Over the last 15 years, testfol.io has SPY going up 787%, $10,000 grew to $88,000. If over the next 15 years if it has 1/4 of that growth rate, that's still better than a double. Is that meaningful for you? It would be for us, even with our low percentage.  

I go very long stretches without making any changes other than investing contributions. Usually, the best thing is to just let the market and your portfolio work for you without constant tinkering and trading (sort of repeated for emphasis).

The final point to make is that resiliency and optionality, or at least the pursuit of them, is embedded in everything we do from a personal finance perspective. I don't want to be overly reliant on one narrow outcome that hopefully goes the way it should. 

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.

Should We Fear Mean Reversion?

Bespoke had a short blog post about rebalancing plain vanilla 60/40 portfolios. It noted that with no rebalancing, a portfolio implemented at 60/40 right after the financial crisis would now be 92/8 which represents massive outperformance by equities. Yes, equities will outperform the vast majority of the time and probably by a lot but I think they were saying the result that took 60/40 to 92/8 was especially strong for equities. 

Always remember that nothing lasts forever, though. There’s an old saying that the market exists to cause the most amount of pain for the most number of investors, and if that’s the case, the over-exposure to stocks is bound to cause a lot of pain when the trend of the last 17+ years comes to an end.

They closed out the post with a warning about mean reversion. 

Testfol.io says that for the last 17 years, the S&P 500 as represented by the SPY ETF has compounded at 14.83% compared to 10.87% for SPY's entire 33 year history. So yeah, equities have been on a heater. They might mean revert, or not there's no way to know. We've devoted some time lately to gameplanning if there is some sort of mean reversion but we've talked in terms of a lost decade for equities but it's the same idea.

I don't want to try to guess what or when, just be ready if. 

It's not clear that Bespoke is saying to rebalance into bonds but I think Morningstar is saying that here. It's a remarkably shortsighted piece from Morningstar. The basic argument is that bonds can help you lose less. Ok, maybe there's something to that and maybe that's good enough but they cite a lot of backward looking data that includes decades of unrepeatable bond market performance. It literally cannot be repeated which incorrectly skews their premise. There might be a way to make their point with data that's actually useful, or not I don't know but wow, it misses badly. 

I've posted essentially that same chart many times and asked, what do you want your equity offset, bonds in Morningstar's context, to look like? There are countless alts and combinations of alts to get a result that is similar to the blue line in the above chart.

One question we've been trying to answer is whether a small allocation to autocallable funds should be part of the the solution for offsetting equity volatility or adding yield or both.

Those are what I believe are the three oldest funds in the space. I highlighted the volatility numbers. SBAR and XV are pretty close to TLT by that measure but with much more yield. Yes the total return numbers stand out too but if equities revert to some mean then I would expect the that column to be less impressive. If the equity market doesn't implode, then the autocallable funds will still pay out but keeping up with their distributions might be more difficult. 

As more of these hit the market, we can learn a little more about them. Based on the following on a day when the S&P 500 was down 69 basis points, there was plenty of downside sensitivity. 

IACL just started trading today and the last four listed started trading last week. I have no idea yet whether I will ever use an autocallable fund but I think it is a mistake for advisors to not make some effort to try to understand them. 

If you are considering them, I would suggest a small allocation, using different fund providers and making sure you're not duplicating the counter party banks. 

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.

Build Your Own Annuity With Daily Liquidity

A few days ago I mentioned this passage from a Barron's article

A popular choice is a fixed indexed annuity with an income rider. Fixed indexed annuities offer protection against market downturns by limiting upside in a bull market. With an income rider, there’s the option to turn on an income stream at any time and collect guaranteed income for life.

And then I quipped

Or, instead of an annuity, someone could use a buffer strategy for a while and then flip that into derivative income when they are ready to take income (it may not last for life though).

I've been thinking about that I think there might actually be something to it. A few times over the last couple of years I've talked about the idea of circumstantially annuitizing part of the portfolio, not buying annuities, more like creating your own annuity (annuitizing) without the complexity or expense. 

After that post last week, I plugged it into Copilot for a second opinion on the idea expressed in my quip. It liked the idea a lot but there needs to be a grain of salt taken with that sort of feedback, it also said I was tall and unusually handsome (joking). The strategy underlying the first half of the fixed indexed annuity (FIA) reads like a buffer fund. Here's a quick study of buffer fund strategy.

BUFR has more equity market sensitivity than BALT. Just using BALT without any BUFR, has compounded at 6.05% since BALT's inception with a volatility reading of 3.27%. The blend I am trying to create would come close to what bonds used to do before interest rates bottomed out in late 2021.

I'm going to circle back to the treasuries backtest in a minute so disregard the dollars and focus on the growth rates and volatility numbers. They're close to the buffer blend numbers.

Let's set up an example. An investor in 2005 is 55 and wants to retire in 2015 at 65. In 2005 he has $500,000 in his 401k in a balanced fund like VBAIX and $250,000 in a taxable account. He puts the $250,000 into 7-10 year treasuries and leaves it alone while he continues to work. After ten years, the $250,000 becomes $429,476.

At year end, 2014 he is ready to activate the "income rider" from his self created annuity and he puts the entire $429,476 into SPXX with the plan of taking out $5000/mo. That's not sustainable but it can function as a bridge to taking RMDs at for him would be at 75, from the 401k that was subsequently rolled into an IRA. SPXX is a derivative income closed end fund with a long track record. 

At $5000/mo, the original $429,476 invested in SPXX depletes in the summer of 2025 as he is about to start taking RMDs.

Back to the balanced fund in his 401k which we said was $500,000 in 2005.

When SPXX depleted last August, the 401k>>Rollover IRA if untouched, grew to $2,301,887 which allows for $92,075/yr in withdrawals or $7692/mo assuming a 4% withdrawal rate. The $7692/mo is a little bit ahead of inflation. Starting at $5000/mo in 2015 would now equate to $7110/mo accounting for inflation. 

The ten year depletion of SPXX is worth digging into a little more. According to Copilot, the "lifetime income from an FIA usually averages out to 12-14 years" for those who take the income. Not everyone does. So the ten year window fits into individual circumstance we created but falls short of 12-14 years. However, starting this exercise in 2005 and then the SPXX income rider in 2015 was all done when there was far fewer choices available. 

A combination of different strategies with completely different risk factors can be blended together to nudge up the "yield" and very likely extend out the depletion date. Things like catastrophe bonds, closed end funds, derivative income funds, autocallables (a different kind of derivative income fund) and so on, even Annaly Mortgage that we looked at recently, can be sized and managed to mitigate risks in case something bad happens. We've built out this yieldy concept before. 

Let's see if I can articulate this point clearly but with some of these products that are starting to build a longer track record, yes there is absolutely risk but at some point you go from looking out for and managing risks to looking for a ruinous Black Swan event. Not the same thing. We might be at that point with buffer funds. Here is a long read from Morningstar about how well investors are doing in buffer funds with the implication that those investors have the correct expectations.

There's now a wide swath of buffer funds. The arguments against them are valid and generally correct but they haven't malfunctioned, broken or needed to invoke any sort of immediate termination. So using them might be better thought of as dealing with something that is suboptimal. AQR says instead of a buffer, investors would be better off with less equities. If someone is looking for an equity strategy with less volatility, then sure, just own less equity. I don't think that's what we're talking about here. Can a combo of buffers be put together to replace what treasuries used to do? That seem plausible to me, we just did it. 

Similar story with derivative income funds. If you buy AMZY, you are not going to get what Amazon does. Thinking you're getting the stock is the wrong framing. For AMZY to be successful, yes, the common needs to not blow up but AMZY is about harvesting the volatility of Amazon for a different outcome, "yield" not growth. And doing that comes with its own risks including depletion at some point if all the distributions are taken out. 

Is any of this worth it? Gemini says that every year, there are between 850,000 and 1.3 million FIAs sold every year and notes the annual fee for the income rider is 1.2% and the surrender costs (that is where the commission gets paid) is typically 8% but I should note I thought the surrender charges were more like 7%. 

That many people buying FIAs (it does seem high but who knows) tells us there is demand for positive compounding that doesn't have full exposure to the equity market's volatility. Assuming no malfunction with the product or the insurance company, FIAs before the income rider do that and so do buffer funds. The income rider pays income for life and there is demand for that too but as we saw, that isn't necessarily a long time based on averages. The next question is whether a bridge strategy or depletion bucket can last sufficiently long until the next relevant financial milestone. Taking 10% out per year from a very high yielding portfolio that lasts for 12 years seems plausible but there can be no certainty. 

Some sort of idiosyncratic risk to one type of alt can be pretty easily diversified away which leaves us back to worrying about some sort of macro Black Swan that would derail the concept. But that can happen to insurance companies too. My brother used to work in the industry and he put our mom into some sort of annuity in the late 80's and the insurance company went bust in 1990 or 91 so insurance companies are not immune. That might be a contributing factor to my bias against annuities.  

There are some complex details to drive by quickly that should be delved into if you go down this road. Return of capital as part of the distribution lowers cost basis so there's no tax on that part of the payout until the cost basis goes to zero. At that point all ROC distributions are taxed as capital gains. If you put $10,000 into a crazy high yielder and over a period of many years taking out the distributions leaves the value of the position at $1000, the the capital gains tax at that point would be quite low. Including a narrow slice of your "income rider" portfolio to a crazy high yielder seems the most likely way to run into this issue. 

Also, whatever faith you put into an insurance company guaranteeing anything for life, that does not exist for building your own annuity with buffer funds and then moving to derivative income and other high yielding niches.

Annuitizing yes, annuities no. I've said before that the fund space will figure this out and there are some product lines that sort of go down this road so I think it will happen but in the mean time, this is interesting to me.

Copilot said no one else has written about this but if you know about anyone else who has looked at this idea, please drop the link in the comments.

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 Challenges Of Multi Factor Funds

Blending several equity factors into one fund can be difficult to pull off in terms of capturing the intended effect. A good example/microcosm from Friday with the Invesco S&P 500 Multi-Factor ETF (QVML). The ticker symbol tells you the factors; quality, value and momentum for large cap stocks. 

The first three fund target quality, value and momentum respectively. I did a quick review of QVML in March. The combo of quality, value and momentum is intriguing and has had the tendency to outperform market cap weighting but when I wrote about the fund in March I noted that it's huge weighting to tech wouldn't allow it to differentiate a whole lot.

The above chart is very short of course, below is 2022.

For 2022, using three separate funds worked much better than QVML.

For the longer period, the three individual funds blended together lagged SPY and QVML because it owns less tech than SPY and QVML. Is any of this worth it? That's up to the individual of course but for anyone trying to diversify at the factor level, a multi-factor fund might not be the answer. 

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.

Model Portfolio Watchouts

Finominal did a review of the Russell Investments Growth Portfolio. It's a model portfolio consisting entirely of Russell's mutual funds. The review came via email so no link to share.

Some of their funds are shockingly big. The first two listed have $3 billion and almost $4 billion respectively. The Morningstar ratings for the various funds are mixed. 

Finominal notes general underperformance and a slightly lower Sharpe Ratio versus the All Country World Index which can be tracked with the ACWI ETF and is suggested as a one fund replacement for the entire Russell Portfolio. There is quite a bit of overlap/duplication between the two largest funds which I believe makes for poor model construction.

Arguably, the 79% split between RUSTX, RGDTX and RNTTX could just all go into RGDTX, the global fund. 

The concept of building model portfolios is very useful but too often, models are more about fund sales than providing robust or even just differentiated solutions. 

Portfolio 3 is close to what we looked at recently, using factors (dividends and quality) to get sort of broad exposure to global markets while being intentionally light on tech. EMXC is very heavy in tech that is volatile but adding 10% in still leaves the portfolio underweight versus the model and ACWI at about 15% versus 30%. Portfolio 3 tracked pretty closely for most of the backtest but in 2022, at its low it was 500 basis points better than the model and ACWI so it differentiated when you'd want it to. Going forward, if something bad happens with tech I would expect Portfolio 3 to do a little better than the model and if tech continues to do very well then Portfolio 3 should lag. 

Models really can be a good way to go but owning more funds just to create the appearance of complexity is something to watch out for and another one is when all the funds are from the same provider like in the case of Russell using only their funds. That's pretty common but there's no reasonable way that can be optimal. 

False complexity and just one fund provider are pretty simple filters to narrow the field and then better focus on more useful models and what they likely to do. For example, the SCHD/IQLT dominated model should lag if tech takes another big move up as I said. The model, simple as it is, is valid and potentially robust, at a least bit, but eventually the regime will change and it would need to be updated. If the model is well constructed, it shouldn't need to be changed constantly though, frequent changes is a different type of strategy than a model portfolio. 

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. 

Blasphemy, BLASPHEMY!

Let's start with the following.

The long term result of the mystery portfolio and plain vanilla 60/40 are identical. There's really only two years with meaningful differentiation. The mystery lagged by a lot in 2020 and went down much less in 2022. The stats in the fist screen grab do favor 60/40 but mystery has a lower standard deviation and slightly better excess kurtosis reading. 

The 60/40 does better in fast declines but the mystery portfolio did quite a bit better in the one slow decline available in the study period. I might prefer the mystery portfolio but I think the time frame is long enough to say they are both valid, returning CPI plus more than 6%. 

Quick detour. Goldman Sachs is buying Neos Investments an ETF provider that specializes in derivative income funds. SPYI references the S&P 500, QQQI references the QQQ, BTCI references Bitcoin and they have other funds which gets them to sneaky high $32 billion in AUM. Back in April, Goldman closed its deal to buy Innovator Capital which is known for its buffer funds. Goldman moved heavy into derivative income and buffer funds because investors like both types of products a lot. Really a lot. 

Back to the mystery portfolio which is 70% buffer fund and 30% derivative income fund. The buffer fund is Innovator (BJUL) which I chose because AI thinks it is the first buffer fund. Despite it being older and newer funds presumably having improvements, Portfoliolab, via Gemini, ranks it above 83% of the buffer field.

The derivative income fund isn't even an ETF, it's the Nuveen S&P 500 Dynamic Overwrite Fund (SPXX), a closed end fund, which has been around for about 20 years. Right now it trades at about a 9% discount to NAV and yields 8.8%. The mystery buffer/derivative income portfolio's price only return was 7.66% annualized. 

When I first built the buffer/derivative income portfolio I used Invesco Buywrite (PBP) which I believe is the oldest covered call ETF and the CAGR using that fund was 9.14% which is still pretty good, still CPI plus 5.54%. 

Since I've mentioned Portfoliolab a couple of times recently, here's part of how they evaluate portfolios. 

This tells us there is nothing especially bad or good about the BJUL/SPXX blend, it's very ordinary. To the same point, here is the same analysis for 60% SPY/40% IUSB.

Yes, BJUL/SPXX scores a little better but the free version of the website only goes back one year and for the last year, the buffer/derivative income portfolio outperformed by 98 basis points with slightly less volatility. 

Both covered calls and buffer funds get a lot of bad press. Here's AQR on covered calls funds and here they are on buffer funds. Many times I've said "just don't with buffer funds." I concede most of the negatives about these funds but the outputs can be just fine, they can be ordinary and ordinary can get it done. 

Gemini took data from a report by Commonfund that calculates the collective CAGR for endowments for the last eight years was 8.92%. The time frame isn't exact to our BJUL/SPXX study but it gives some context of the validity of the result by building a portfolio with two of the most hated (by the smart money) types of products there is. The lesson here, for me too, is to not be so snooty. If an investor has taken the time to actually understand the pros and cons of buffer funds and derivative income funds and they still want to use them, then why not? I'd never thought about the type of portfolio we looked at today so I feel like I learned something. 

We'll close out with a quote from a Barron's article about managing stock market volatility.

A popular choice is a fixed indexed annuity with an income rider. Fixed indexed annuities offer protection against market downturns by limiting upside in a bull market. With an income rider, there’s the option to turn on an income stream at any time and collect guaranteed income for life.

Or, instead of an annuity, someone could use a buffer strategy for a while and then flip that into derivative income when they are ready to take income (it may not last for life though). No need, I'll show myself out. 

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. 

Put It All Into FMAGX And Forget About It?

Yahoo had an article about....wait for it....people 55 years old and up retiring early because they feel emboldened by portfolio growth over the last few years. They post an avalanche of retirement doom and then this. Both can be true. The vast majority of Americans of all ages could be woefully undersaved while those who are not undersaved could easily have enough to retire earlier than they planned.  

Make of it what you will but there was this comment which is constructive for digging into sequence of return risk and maybe a couple of other things.

Well congrats on your good 'TIMING,' recent retirees; you just got LUCKY! I was in the Magellan fund in the early 2000's and my 10-YEAR return at one point was -0.5% !!! Yes, you heard it!!! You got lucky and I didn't!!! Timing Timing Timing!!!! And watch out below; these returns are NOT sustainable. Especially when the left get power again.

Gaming this out, if he retired on Dec 31, 2000 with $400,000, here's where he stood after ten years taking 4% per year.

The time period comes pretty close to capturing his experience. Carrying it forward to today, if he stuck at 4% withdrawals, he's about 25 years into his retirement and he has more than double what he started with. 

Yes, he would have been better off in SPY but back then, Magellan seemed like a good bet. This reader's bad luck for timing is a great example for defining sequence of return risk, it was a terrible time from a market standpoint to retire. I'm not saying there wouldn't have been real fear in this scenario, the scenario bottomed out at $152,000 in March 2009 but markets worked over his long term.

Above, I said Magellan was a good bet which it was and maybe is now, not sure about that but no matter how good something might appear to be, the comment implies he put it all into Magellan. No matter how good something might be, it should be obvious what a bad idea that is. Maybe the fund would have done very badly versus the market (not the case for this guy) or maybe the market itself would do badly (that was the story with this one). Back then, bonds were fine to invest in. 

Same scenario with 60% Magellan, 40% in intermediate treasuries.

He would have compounded at 3.7% which of course is not so hot but not negative. At the low, he'd have been at $265,000 not $152,000 and at the end of this ten year run, he'd have been down a couple of hundred bucks in nominal terms not $100,000. Being 100% Magellan wouldn't have caught up to 60/40 until late 2021 all the while running at about half the volatility of 100% Magellan. 

For a little more context for unlucky timing versus lucky timing, if he had put his $400,000 into Magellan at the end of 2009, taking out the same 4% along the way, he'd now have $1,578,000.

Back in 2000/2001 it was obvious we were in some sort of serious market event but no real sense that something like a lost decade could be coming other than probably Grantham or Hussman. The market action of the financial crisis wasn't as collectively new because stocks had just cut in half a few years earlier but the real estate aspect and the rest of it was new. 

Most events have a combination of some familiar aspects with some that seem different and it's not that events don't all end at some point leading to new highs but that each path might be different. This is why you diversify equity exposure and why you diversify your diversifiers. 

This example is also why I always talk about optionality and resiliency both in life and in the portfolio. For anyone believing in the importance of this in a similar manner, the path to their ideas for optionality and resiliency will probably be unique. I think it is easier now to add portfolio resiliency thanks to dramatically improved access to sophisticated strategies that didn't exist when this guy loaded up on Magellan. Creating optionality and resiliency in life probably needs to come from within. Success comes from being motivated for whatever reason versus the outcome of being forced to take whatever part time job you'd least want to take.

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.