Tracking Error Palooza

Some fun stuff today with a look at GMO's Benchmark Free Allocation Fund/Strategy and Meketa's thoughts on risk parity. 

GMO's paper talks about a "total portfolio mindset;"

Because Benchmark-Free focuses on generating real returns instead of beating a particular benchmark, it naturally has a different view of risk than most traditional portfolios.

The paper chronicles the various changes under the hood of the fund/strategy and the result of the fund seems to walk the walk it has looked much different quite frequently, painfully different to be blunt about it.

It did well early on thanks to getting the internet bubble right. Since inception the fund has compounded at 7.67% versus 8.30% for VBAIX with significantly lower volatility. 

That is a very rough 13 years in the middle of the fund's existence. The paper makes many references to real returns. Adjusting for inflation, the 4.18% comes down to 1.62% in the period charted. There's a balance between building a portfolio targeted to the outcome you need irrespective of what the broad market is doing but still giving yourself a reasonable shot at a decent growth rate. 

A similar sentiment from Meketa regarding risk parity;

...since these strategies are not widely implemented, institutional investors that adopt this allocation methodology need to be comfortable being “different” from peers, that is, having high tracking error relative to broad peer portfolios.

A big pillar to what the ReturnStacked guys offer with their funds is ability to add alternatives without introducing tracking error into the portfolio. It is ok to have tracking error. Certainly for you, managing your own portfolio, who cares? Again, are you giving yourself a reasonable shot at a decent growth rate if that is what you need? 

We have a lot of fun here with all sorts of crazy allocation ideas but if you need something beyond a T-bill rate or CPI plus 2%, then you probably need some sort of close to normal allocation to equities. Even just 35-40% can serve as a reasonable growth engine inside a portfolio for people who do not want the ups and downs of having 60-70% in equities. 

Yes some sophisticated combo of different asset classes with very light exposure to equities could get it done but anyone pursuing that kind strategy will probably have to work a lot harder for their return versus just having a close to normal allocation to equities. 

Finominal has a portfolio optimizer tool that we've used before. It can optimize for several things including risk parity. Depending on what inputs are used, the result might be interesting or not very helpful. If you include a T-bill or short term bond fund, the output will be to have a huge weighting to the T-bill or short term bond fund. A 15/85 portfolio won't be the answer for too many people. 

The following study starts with 35% in SCHD, 30% in IMTM, 15% in KMLMsim and the rest in SHRIX for Portfolio 1. Portfolio 2 allocates those four at 19%, 16%, 19% and 44% respectively (rounded off) inline with Finominal's risk parity optimization.

Portfolio 1 at 65% in equities is pretty typical while the managed futures and cat bonds could cause tracking error which is fine with me, I probably want that, you probably know whether that is ok for whatever money you are managing (just your own or for clients). Portfolio 2 is a tracking error palooza. The 35% in equities is at the lower end of what we talked about above as being a reasonable growth engine inside of lower volatility portfolio. It obviously has not kept up with VBAIX but nine years is a reasonably long time and it's not that far behind but with much less volatility and much shallower drawdowns.

If someone was interested in something close to this version of risk parity but wanted more traditional bond exposure, instead of building that into the Finominal portfolio optimizer, it would make more sense to figure out how much they want in more traditional bonds like 20% or 25%, whatever, then plug the rest of what they want for the portfolio into an optimizer (Finominal or someone else), get those weightings, reduce accordingly to account for the allocation to more traditional bonds. 

Long time readers probably know, there is no scenario where I am putting 44% into a cat bond fund. More realistically, I would split that 44% sleeve between five or six disparate strategies to avoid loading up on the same risks. Those five or six different strategies could themselves be risk weighted and then slotted into the more diversified version of Portfolio 2. Nineteen percent in managed futures is probably more than I'd ever want too but at a minimum, I would split that large of a percentage across two or three funds, not just one. 

I think the underlying premise of Portfolio 2 is valid, gives a reasonable chance of a decent growth rate while still differentiating effectively versus VBAIX's volatility. 

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.

HSA Optionality

Barron's had a short writeup on health savings accounts (HSA). If you are familiar with HSAs there probably wasn't anything new but it did prompt me to think about a use for HSA money that I hadn't thought about before for how my wife and I could or would use our HSA. Hopefully this is useful for anyone else in a similar circumstance of having an HSA and starting to look around a couple of corners at how Medicare works. 

The cost of Medicare Part B is deducted from your monthly SS check. Part D for prescriptions is usually paid directly by the individual. Both expenses are considered qualified for HSA withdrawals, meaning you can reimburse yourself out of your HSA account. This year, Part B is $202.90 (more for people paying an IRMAA surcharge).

This creates some optionality for people who have HSA accounts. In addition to Parts A, B and D, it is common to get some sort of Medigap coverage which has costs and coverage above and beyond A, B and D. According to Copilot, Plan G which is one of the more robust Medigaps averages around $250/mo in Arizona (that is a general number). The $250, or whatever dollar figure you find, Medigap cost is not a qualified expense in HSA terms. 

Part B is qualified, Medigap is not. A little bit of mental accounting here but money taken out of an HSA as reimbursement for Part B goes into your checking account to be spent on whatever you like. The Part B reimbursement is what lets you withdraw tax free from the HSA. From there, that $202 can be spent on anything repeated for emphasis including Medigap coverage. Like I said, mental accounting but nice little hack. 

Someone who is paying IRMAA can pull more out of their HSA if they want for their reimbursement. If they are paying $281 in 2026 dollars for Part B then they have access to $281 which more than covers the $250 Plan G figure we are using as an example. 

I expect to still have a decent earned income for the first few years of Medicare eligibility (self-employed there's no employer plan for me to stay on) so I doubt I would pull from my HSA for a while in this context, maybe at 70 or a little later?

Maybe I am the last person to have thought of this but either way, it adds a little optionality to the Medicare process. The more optionality we can find, the better.

Another new thing for me is that Plan N might make more sense and be cheaper for people who are not managing chronic maladies and going to the doctor frequently for their chronic maladies. Copilot and Claude conflicted a little on how much cheaper Plan N is versus Plan G. Copilot thought $1000/yr cheaper for a couple versus $1200 from Claude.

For now, it is useful for me to be aware that Plan N is an option if our good luck with health continues. Is saving $1000-$1200 worth it? That is up to the end user and we'll see where we are when the time comes.

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 Parity That Works?

The Beacon Tactical Alternatives Risk ETF (BTA) just started trading a few weeks ago and it is a variation on risk parity. Instead of  more typical asset classes like stocks, gold/commodities and bonds, the sleeves for BTA are gold, broad commodities, managed futures, digital assets but I don't see any in the fund currently and US dollar exposure which means the USDU ETF and a lot of different short term fixed income.

Part of the pitch for this fund is that it can be a "third independent return system to the classic stock/bonds mix." The fund is actively managed so the above holdings can change but the list above is easy to backtest. To create a longer backtest, I combined all the managed futures funds into KMLMsim on testfol.io and I used DBC which is the older cousin of PDBC.

Looked at as a standalone, the results are uninspiring compounding at 3.82% for almost 13 years. While those results really are meh, the replication does something interesting when paired with equities.

Risk parity has generally been difficult to implement in a mutual fund or ETF, look at how poorly RPAR has done. AQRIX is an AQR fund that used to run a risk parity strategy, it changed a while back but I think of it as still being risk parity adjacent. 

Also in the BTA literature is a mention of 50/30/20 replacing 60/40 where the 20 is alts and I think they are suggesting the 20% go to BTA. But with all that USDU and the short term debt, the fund has about 50% in fixed income or fixed income substitutes so allocating 50% to the BTA replication like we did in Portfolio 4 gets kind of close to 50/30/20. 

Portfolio 4 did better in just about every drawdown in the backtest, both fast and slow, except the tariff panic of 2025. In 14 full and partial years, Portfolio 4 outperformed VBAIX seven times so that's kind of a push but in a couple of the years that it lagged, it lagged VBAIX by a lot. In periods where managed futures and commodities both do poorly, obviously BTA as currently constituted should also be expected to struggle. 

The fund going forward could be different and like I said, it doesn't appear to me that there are any digital assets in there but if BTA uses risk weighting then the allocation to digital should be small enough that a catastrophe in something like Bitcoin wouldn't wreck the fund, it seems like potentially an asymmetric kicker if/when they actually add it. 

For now though, this seems interesting to me. It is only a month old (backtest is long enough to set some expectations) but it makes a good first impression. 

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 Was An ETF For That

More tidbits today that I hope will be interesting. 

First, I sat in on another autocallable webinar from ProShares and something clicked. I've talked about feeling like I don't completely understand the risks with these. Kind of a repeat comment but I have a better understanding than I did. Autocallables generate yield from equity risk not risk taken in bond markets. 

That an autocallable yields 18% or 9% tells you that the 18% yielder will be more volatile and probably be riskier than the 9% yielder but the risk relates to equities going down a lot not yields going up a lot. There could be a second or third order effect from interest rates' influence on pricing volatility but the story is equity risk and volatility. The way most of them are structured, down a little isn't really a problem for the funds. At varying points of down a lot for equities, some or all of the distributions can be disrupted if the "barrier" level is breached. Down 35% becomes problematic for ProShares ACSP for example. 

If you use a covered call or put selling fund, you think about equity market risk, funds like JEPI or WTPI create yield from equity volatility and risk. In that way, autocallables do the same thing. Zoom in and you will see there are structural differences and I would say more complexity but as one webinar said, derivative income and autocallables are cousins. 

Some of these funds are very volatile and some not. As a generalization repeated from above, I would expect that the higher the yield, the more volatile but I am still working on these, trying to learn. Certainly ProShares ACSP which targets 18-19% is more volatile than CAIE yielding 14% which are both more volatile than JELM from Janus which targets a 9% yield. 

ACSP is brand new which is why the chart is so short. I said this the other day, a 9% yield is fantastic and for me, it's not worth burning my fingers trying to hold onto ACSP. To be clear, I don't own JELM anywhere, I'd like to see the market go through some adversity before considering JELM or any other less volatile autocallable fund. I will reiterate though that some pay ROC like ACSP and CAIE and some don't--pretty sure JELM will be ordinary income but please leave a comment if you know otherwise.

If we're talking about harnessing volatility (which we are), this chart is interesting. 

ANV is the GraniteShares Nvidia Autocallable ETF, so it is a single stock autocallable. NVDY is the YieldMax NVDA ETF, and then the common stock in yellow. NVDY "yields" 38% versus close to 14% of ordinary income for ANV. Fourteen percent is a fantastic yield. ANV hasn't deteriorated because the stock has gone up a good amount. ANV doesn't capture the common's volatility the way NVDY does.

Things have gone very well for ANV but I am still not sure that single stock autocallables are a good idea, just pointing out that these are not automatically NAV incinerators. The chart is also quite clear that buying ANV is not buying the common stock, there should be no expectation of any sort of significant upcapture, six months of trading tells you there might be zero upcapture. The fund owns a lot of different autocallables on NVDA but in some sort of hideous decline for the common, eventually ANV would start to go down with the common. 

Yesterday we took a look at a paper from AQR about protecting a portfolio against inflation. There was a reference in there to long/short quality equities. AQR has mentioned that a few times and at some point I said there wasn't really a way to access that effect in an ETF or mutual fund and there still isn't as far as I know but there used to be. It closed a few years ago but QMJ was the Direxion Quality Minus Junk ETF. I guess the fund was ahead of its time. 

Corey Hoffstein posted a fun article on Twitter that compared and contrasted adding buffer funds to a portfolio versus managed futures and concluding there is room for both. I took it as a prompt to play around with a few different things related to combining buffers, managed futures as well as PPFIX which is a client holding that sells puts that are very far out of the money such that the fund is a horizontal line that tilts upward. The reason to include PPFIX is that Corey talked about buffers being equities with an option overlay on top. That's probably correct but I don't really think of them that way.

I use BJUL in these backtests because I believe it is the oldest buffer fund so we get the longest backtest. None of these ideas helped much during the various fast declines along the way but did help quite a bit in 2022. 

Buffers and managed futures as presented is an interesting combo that I will try to dig more into in future posts. 

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.

Whatever Keeps You Invested

Quick hits today.

AQR has a paper with some ideas about how to protect against inflation.

They involve leveraging up by 15% as you can see. I replicated the three ideas with URTH for global equities, IEF for bonds, STIP for US TIPS, ARCIX for commodities and DBMFsim for trend following. Portfolio 5 mimics AQR's Portfolio 2 but eliminates the leverage by reducing IEF from 19.2% to 4.2%.

They all outperformed 60/40 but an interesting observation is how little differentiation there has been from year to year with a couple of exceptions including 2022 when inflation first flared up. It's remarkable actually. 

Man Institute wrote about buffer funds. The TLDR is that they do help (work the way they are supposed to) on the way down and still help part of the way up as the market recovers but then gradually fall behind plain vanilla equities. 

The article's conclusion supports their 100% Equities/100% Managed Futures ETF that has symbol MATE.

The results are adjusted for inflation so the CAGR numbers are CPI plus whatever the result. The first three funds are obviously not market cap weighted, they all have a defensive element to their respective strategies and the volatility and beta numbers bear that out versus SPY and the MATE replication in Portfolio 5. Looking back, SPY was CPI plus 10% which is great. Will it be that strong going forward? Who knows but if SPY does half as well over the next eight years, cool, but BJUL, JHEQX and USMV very likely will not do that well. Once that is fully understood and accepted, they are not likely to capture the full gains of the stock market, if the lower volatility profile they offer make it easier to stay invested then go for 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.

Regret Waiting To Happen

In response to yesterday's post about Matt Tuttle's take on the Permanent Portfolio, a reader Tweeted that his preferred version is to allocate 1/3 each to ReturnStacked Global Stocks and US Bonds (RSSB), gold and KMLM which is a managed futures ETF. RSSB is 100/100 so the mix has four quadrants, each at 33 1/3%.

A few days ago we looked at a similar portfolio to what the reader suggested that used PSLDX which is a much older 100/100, domestic equities and long bonds. Then I removed the bonds, just equities and the results were better so that was my first thought today, peel out the bonds and what does that do?

To be clear, Portfolios 1 and 2 are equally weighted between those three funds.

I took PRPFX out to declutter the drawdown chart. In the bigger events, both 1 and 2 went down less but you can see a long stretch of meandering as both gold and managed futures struggled through much the 2010's. There were also a few very difficult individual years in there too. In 2013, Portfolio 1 was down 4.59%, Portfolio 2 was down 0.99% while VBAIX was up just over 18%.

If we shorten up the original backtest to go back to KMLM's actual inception, the results for Portfolio 2 look a little better versus Portfolio 1.

The improvement is likely attributable to managed futures and gold doing much better in this decade versus the previous decade. If we just look at the 2010's, the idea would have been almost impossible to stick with.

After gold peaked in 2011 it trended lower for awhile and became more of an afterthought. Managed futures was not something that too many people even knew about. In fund form back then, managed futures never was, let alone becoming an afterthought. I stumbled into managed futures by accident in 2007 and bought RYMFX, then came AQMIX in what I believe was 2010 and the a few others in 2013/2014. I stuck with RYMFX for quite a while but that was much easier at 3% or so versus 1/3 or 1/4 of a portfolio.

Owning this portfolio would be very difficult the next time gold and managed futures both struggle. It happened in the 2010's so it can happen again. There's a lot to be said for quadrant-like sleeves but going so big is regret waiting to happen.

We haven't isolated it out this way before, looking at just the 2010's. Having some gold and having some managed futures is a good idea for portfolio robustness but at some point it is too much because the risks/vulnerabilities overlap some. The risks/vulnerabilities are not identical, but there is a lot of overlap. 

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 New Quadrant Portfolio

Matt Tuttle from Tuttle Capital/T-Rex was profiled talking about a Permanent Portfolio-inspired update to the 60/40 portfolio that Tuttle says is 60-70 years old implying it needs to update to navigate modern realities of a different world and vastly broader fund/strategy choices.

The four, equally weighted quadrants from Matt are stocks, "beyond bonds" which includes pre-merger SPACs and property & casualty insurers, debasement trades like gold and Bitcoin and finally tail risk which Matt defined at managed futures and short term government bonds like T-bills. 

For stocks, I just used SPY, Copilot said merger arb is the best proxy for pre-merger SPACs, Chubb (CB) for P&C, for debasement I put 20% in gold and 5% in silver and for tail risk I put 12.5% in managed futures and 12.5% in T-bills. I did not use Bitcoin for debasement to leave out any potentially unrepeatable result.

The return of the Tuttle Quadrants is close to the Permanent Portfolio (PRPFX) with less volatility and the backtest obviously looks quite a bit better than 60/40.

Matt has written a couple of times about P&C companies in this context, his theory seems like it more relates to the operating business and risk transfer than how the stocks actually behave because using the Invesco KBW Property & Casualty Insurance ETF (KBWP) as a proxy, the space looks nothing like fixed income but you may draw a different conclusion. I also do not know whether pre-merger SPACs actually look like merger arbitrage, Copilot offered that, so grain of salt that idea.

The first lookback allows for a long period of study by using the Merger Fund. This next one swaps out the Merger Fund and adds a SPAC ETF that has symbol SPCK and gives us almost six years. The second look back is reasonably consistent with the first one. 

Anyone so interested can replicate the concept pretty easily but I wouldn't make any forward looking assumptions about returns. As if often the case, I think the volatility numbers can stand up and if bonds with duration continue to do poorly then this mix has a pretty good shot of continuing to outperform. To the extent P&C companies are or are not bonds proxies, both Chubb and KBWP are negatively correlated to IEF and TLT. 

It might not be visible on the chart though but there is a lot of differentiation of returns between the Tuttle Quadrant and the others. In the first back test, Tuttle quadrant was best performer in eight out of 27 full and partial years and 6 times it was the worst with four of those six coming since 2019. The updated version using SPCK fared a little better on that score though.

One takeaway is that like me, I don't think Matt is a fan of bonds with duration which leads us to this.

I would venture to say that the 30 day SEC yield is closer to the yield that investors will get. The portion highlighted by Ben is if all the bonds are held to maturity. I've never owned AGG but I don't think that is what AGG does but please leave a comment if I am wrong about that. 

If you have fixed income, what are you trying to do? Some want to offset equity volatility, some want yield and some want a combo of both. Whatever someone is hoping to get out of AGG or BND for that matter, there are ways to get it with less volatility and more yield. 

BOXX replicates T-bills but pays no interest so it is tax efficient. The price accretes at the rate of whatever T-bills are yielding. ACBAX is the investor class shares of the Pioneer Cat Bond Fund. It's the class A shares but self-directed investors should be able to buy it without the load at Fidelity or Schwab but ask them first. 

The 75/25 combo is structured for total return with a little yield. If the T-bill ETF BIL is swapped in for BOXX then the total return CAGR was 6.36%, the yield was 5.64% versus 3.87% for AGG and the volatility dropped a tick to 1.76%. 

There is no need to take on AGG's volatility and interest rate risk to get 5.XX%.

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.