Monday, June 27, 2022

Old Concept With New-ish Name

Quite a few years years ago, like maybe 15, I wrote several posts about an idea for portfolio construction from Nassim Taleb where he said he put 90% of his money in T-bills from around the world and then put the remaining 10% in very aggressive holdings with great potential for asymmetric returns. If he had 10 names in the very aggressive tranche and one them was a 10-bagger while the others had some normal return dispersion then that one name that went up 10 fold could add 900 basis points of return which could "stack" on top of the T-bill yields for a market equaling return for the entire portfolio while only risking a small amount of the portfolio.

Another example of this from my past, working at Fisher Investments 20 years ago, a couple of my smarter co-workers were intrigued by the fact that allocating 2% to a position shorting Nikkei futures, putting the rest in cash provided a return that was inline with the S&P 500. I don't know whether they were right about that but the idea of equaling the return of the S&P 500 with just 2% of investment capital is fascinating. 

It turns out there's a name for this, capital efficiency. The simplest example of an investable product I know for capital efficiency is the WisdomTree US Efficient Core Fund (NTSX). If you engage in ETF Twitter at all, you might know this one as the 90/60 ETF. Using futures, it allocates 90% to equities and 60% to fixed income. That is the same ratio as 60/40 equities/fixed income.

If an investor had $100,000 to invest, they could put $67,000 into NTSX and capture $100,000 worth of the Vanguard Balanced Index Fund (VBINX) which is a benchmark fund for a 60/40 allocation. Does it do what it's supposed to? According to this white paper from ReSolve and Newfound, it does.


This year, VBINX is down 18% while NTSX is down almost 24%, the math appears to check out. If you only put 67% into NTSX, with the rest in cash you'd be down 18% but you'd have earned a few basis points of interest on the cash not invested. 

What you do with that cash is where the conversation gets more interesting and more complex. A potential benefit of the capital efficiency offered by NTSX is return stacking. The link above goes into greater detail, talking about the construction of a very sophisticated return stacking index. Here is a simpler example from Seeking Alpha. In the Seeking Alpha post, they talk about capturing all of a portfolio's notional equity exposure from a long position in futures contracts. The SA article says a position in futures might only require 5% margin. So to get $60,000 of equity exposure (sticking with 60/40 for $100,000), an investor would put up $3000 to get their full equity allocation. Then put $40,000 into a normal bond portfolio and have $57,000 to put somewhere else. The conservative thing would be to buy $57,000 in T-bills that hopefully have a decent yield. This sort of return stacking is more like leveraging down as opposed to leveraging up. You should not be taking any more risk with that and you'd be getting a few more basis points in yield stacked on top.

A way to do something similar with ETFs would be to put 20% into a 3X leverage S&P 500 ETF, 40% into a regular bond portfolio and then do something else with the other $40,000 like T-bills. In theory this would not take any more risk than 60/40 and would earn a few more basis points of yield. This one is a little trickier if the daily reset of the 3x funds works against you. That is unknowable of course but as an example, it explains it pretty easily. 

Back to the white paper linked above from ReSolve and Newfound who built a return stack portfolio that is far more sophisticated than my examples. 


The columns starting at 'equity' and moving to the right give the attribution of how much exposure each fund gives to the entire portfolio. NFDIX gives the portfolio/index 11.2% of equity exposure out of a total of 62%. The total notional exposure is 161% so it is leveraged but leveraged such that it is blending different correlations in an attempt to deliver a similar, but better return than plain vanilla 60/40 and do so with less risk taken. 

Getting some disclosures out of the way; BLNDX is a client and personal holding, I am test driving RDMIX for possible use in client accounts, in the past I test drove MBXIX and SPYC and decided not to use them. 

I am more interested in the capital efficiency aspect of this versus the concept of leveraging up. Dialing back from a 3X ETF to maybe a 2X, 35% to Proshares Ultra S&P 500 ETF (SSO) works out to a 70% allocation to equities (a similar daily reset risk exists). I am seeing a different way to use risk parity which is listed at the TYA ETF in the table. The TYA fact sheet implies it provides 300% exposure to longer dated treasuries. If an investor wanted long bond exposure, I do not, then 7.5% into TYA provides a 30% bond exposure thanks to it's leverage. So between SSO and TYA we now have a 100% allocation and still have 57.5% of our investment capital in cash. That's capital efficiency Holmes. 

The remaining 57.5% into T-bills maybe. Maybe a percent or 2, no more, goes into Bitcoin or something else with similar asymmetric potential. If you were intrigued at BTC $50,000 or $60,000, you should be more so down here at $20,000, of course Bitcoin-zero is still a possibility. 

The mix so far would be pretty volatile, you'd feel a full 100% with this allocation. If you work in some managed futures and tail risk you would mute some of the volatility and build in something of an all-weather outcome, or at least potential outcome. The allocations to managed futures and tail risk would be small in the context I am talking, like a combined 7-8%, mostly in managed futures. Then instead of all T-bills, I might add in a little bit of short term TIPS exposure and a small bit to gold. 

As it stands now, I am not going to do this. It is fascinating to study and take influence from and I am thinking about risk parity a little differently too. There are elements of this being too academic/theoretical and it relies a lot IMO on how things should work. I don't want to be overly reliant on a complex portfolio with many moving parts that needs things to do what they are supposed to do in order to not blow up. 

One way to perhaps ease into return stacking could involving going back to NTSX. We know 67% into NTSX equals 100% of 60/40. What about leveraging that up slightly to get 110% exposure to 60/40 or 66/44? That would mean putting 73.7% into NTSX. We know from above that 100% into NTSX this year is down just under 24% so you'd be down less than that, down close to 20% this year. That by itself is not dangerous leverage. Putting the remaining 26% in a 3X fund would be dangerous leverage, putting it all into a mix of lottery ticket biotechs and uranium miners would be dangerous leverage but some mix in there of managed futures, tail risk, maybe merger arbitrage which we haven't talked about yet in this post, TIPS, gold, cash/T-bills and a percent or two in asymmetry and I think you have an all-weather-ish portfolio with the potential to deliver a market like return with less risk.

Although it closed a couple of years ago, there was a 1.25X levered ETF, the PortfolioPlus S&P 500 ETF (PPLS). For me, this is all a theoretical exercise but there's a wide contingent of very smart portfolio managers who seem to be all in on this. If I am too skeptical about this and people like the guys at ReSolve and Newfound are right, then funds like PPLS coming back is likely to happen. 1.25X and 1.5X leverage would be useful pieces of the capital efficiency/return stacking puzzle.

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