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.

A Different Take On Risk Parity

Risk parity has always intrigued me but I've always thought the plain vanilla way to implement it is either hard to do or not that good of a strategy with the results of the Risk Parity ETF offered up as Exhibit 1, although it did well in 2024.

Risk parity is about weighting the holdings such that their respective contributions of risk to the portfolio are the same. A portfolio of an S&P 500 fund and T-bills would have just a small portion in the S&P 500 and the vast majority in T-bills. The generic implementation is to leverage up on debt to balance out the equity exposure similar to what RAPR does but it includes commodities too. The block I was having is that it must be used in simple stock/bond portfolios but that's not the case. Playing around more with Finominal helped me figure that out. FTR, I have no affiliation with Finominal, this is more like getting a new toy to play with. 

Finominal has a portfolio optimizer that lets you optimize for various things including risk parity. In playing around with some of the others, I didn't find anything useful yet but I think I did when optimizing for risk parity. A couple of different ideas to experiment with, here's the first one;

The results of the two are very different. I threw in VBAIX for context;

Portfolio 1 has much better returns with just a little more volatility than VBAIX while Portfolio 2 had 80% of VBAIX' CAGR with less than half the downside and a 1/3 of the volatility. 

Here's another one;

And again compared to VBAIX;

In the second one, Portfolio 1 looks good of course but Portfolio 2 is more interesting, the return equals VBAIX but with less than half the volatility and smaller drawdowns. I believe the reason that the risk parity optimization gives interesting results is that the intuitive versions don't use plain vanilla bonds to manage/offset equity volatility. Putting in 60% SPY/40% AGG into the risk parity optimizer tells us to put 22% in SPY and 78% in AGG which decade to date has compounded three basis points less than inflation. SPY/AGG is not the right input for this exercise. 

The utility of the approach we took today can be a path to cracking the 75/50 code (targets 75% of the upside with only 50% of the downside). 

A cautionary note is that the optimization process ignores the risk of having enormous weightings to one fund like 47% in APHPX or 46% in FLXIX. That much in one liquid alt?

From there, anyone interested in this would need to add more funds and spend some time adjusting the weighting. No matter how great some alternative strategy/fund might be or how glorious the backtest is, it will take a turn being a poor performer and a huge weighting when that happens is an unforced error waiting to happen.

One final item is from today's ETF IQ show which included a segment on the Hedgeye Fourth Turning ETF (HEFT). The idea is to position for big changes in how things are going now and the manager said the strategy has a ten year time horizon. HEFT is a multi-asset fund that includes long/short equity. 

I really don't know anything about the fund but the reason to bring it up at all is differentiation. We've used that word several times lately and HEFT is a good example of what that looks like.

It looks nothing like 60/40, rarely looks like the Permanent Portfolio and occasionally looks similar to other long/short equity. Who knows if that can persist but it has been a good example of the concept thus far. 

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.

Here We Are Now! Unconstrain Us!

On Saturday I started to think about and then do a little research on unconstrained bond funds in relation to what we talk about here and what I do in client accounts. Then as a coincidence, Idea Farm included this short paper from PIMCO about unconstrained bond strategies in their weekly email.

The paper doesn't use the word unconstrained but it talks about trying to differentiate a bond portfolio with foreign exposures. PIMCO didn't focus on a specific fund so I am guessing the paper connects to the PIMCO Dynamic Bond Fund (PFIUX) which repeatedly says it is flexible without using the word unconstrained.

I think of that result as being differentiated. It held up much better in 2022 but still went down some. Per the paper, PIMCO thinks foreign exposure is the way to differentiate currently, the way to add alpha. Managing a bond mutual fund, I'm sure they are  trying to isolate outperformance versus something like AGG or a ten year Treasury which makes sense.

The primary objective here is to build a portfolio sleeve that behaves reliably in terms of offsetting equity market declines with a steadier result than plain vanilla bonds have had over the last few years. If prevailing interest rates go down a lot from here, then my approach would lag and if rates go up then my approach will outperform but I am very confident that the strategy of pulling together low volatility strategies each with their own risk factors and with very little interest rate sensitivity will continue to be much steadier than AGG or the ten year.  

I asked Grok for any five star unconstrained bond funds to see whether they do differentiate from AGG. The point is not to pick an unconstrained bond fund but to see if I can learn something new about my approach. It gave me T. Rowe Price Dynamic Credit Fund (RPELX), Carillon Reams Unconstrained Bond Fund (SUBFX) and Artisan Global Unconstrained Fund (APHPX) but the info about their being five star might be stale. Grok threw in MetWest Unconstrained Bond (e.g., MWCIX) with batch of secondary choices. There could be others.

The area  in the black circle is when people needed differentiation the most. A couple of the funds clearly avoided the worst of it in 2022 while a couple only had slight improvement. They have obviously all outperformed for the entire backtest which is nice of course but the volatility numbers are more interesting to me as well as the drawdowns. RPELX and APHPX have meaningfully lower standard deviations than AGG, MWCIX is somewhat lower and SUBFX isn't that much lower. 

APHPX is an obvious outlier, it looks nothing like the others, so what's the story there? I found this on the fact sheet;

That doesn't seem very bond like-unconstrained or otherwise. I asked Copilot if it really is an unconstrained bond fund or some sort of macro strategy. "No, Artisan Global Unconstrained is not really a bond fund. It is a global macro / absolute‑return credit strategy with hedge‑fund‑like tools, exposures, and return profile."

It focuses on foreign exchange, interest rates, various types of credit spread trades, has small equity exposure and can be long/short just about anything. I'm intrigued so a next step is to try to figure out how it compares to a few things. 

It seems pretty alt-ish, with some similar results to other alternative strategies we look at but with different risk drivers. Copilot says they are completely different "risk engines." A couple of the comparison outputs from Copilot;

The fund does take quite a bit of risk but that is not apparent in the numbers, just the strategies it runs. The way I think of the risks that the fund takes is that it has done a good job so far of balancing and mitigating those risks. 

Finominal weighs in on Portfolio 2;

The simplification suggestion is a little more interesting than what we looked at the other day but the suggested portfolio is clearly not superior. It has a similar result with much more volatility. 

Is there enough differentiation with this idea? What this has going for it is it gets a slightly better return with just 50% equity exposure versus 60% for VBAIX with much lower volatility. The drawdowns are generally shallower. 2022 is truncated due to APHPX's start date but I think my conclusion is that there is a decent amount of robustness without massive differentiation. The conclusion is about Portfolio 2, 50% in one alt like in Portfolio 1 is a nonstarter in real life.

The title of this post is a reference to the Nirvana song Smells Like Teen Spirit. 

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.