Can Return Stacking With NTSX Work?

WisdomTree Head of US Research Bradley Krom wrote a short paper about the firm's US Efficient Frontier Core Fund (NTSX), aka the 90/60 ETF, that we've looked at a couple of times over the last month. As a quick reminder, a 67% allocation to 90/60 generally equates to a 100% allocation to a 60/40 portfolio like you might get from Vanguard Balanced Index Fund (VBAIX). That potentially leaves 33% to return stack as some call it or leverage up or down, depending how that remaining 33% is allocated. 

Put that 33% into 2 year T-bills yielding 3% and you're leveraging down, you'd likely get the 60/40 return plus the yield on the T-bills; extra return without really taking extra risk. Put that extra 33% into a series of lottery ticket stocks then you're really rolling the dice. Put that extra 33% into plainer vanilla equities you are definitely still increasing your risk, either way you'd be leveraging up not down. Of interest to me is how to leverage down, adding a little extra return and if risk and/or volatility can be lowered by leveraging down, all the better.  

Krom makes this point, without specifics, toward the end of the paper he says he "would argue that modest amounts of leverage can actually reduce risk in a portfolio" which is a point we made the other day. In that post though I used a hyperbolic example with a 5x leveraged S&P 500 ETF that trades in London, yes 5x leveraged. For this post I assembled a less dramatic portfolio more in line with Krom's thinking. He says the investment capital left over could go into alternatives to create a better risk adjusted result citing managed futures and long only commodities as examples. 

Where this might be considered a pursuit of an all-weather portfolio comprised of very few funds, I would not use long commodities in the context Krom suggests. Yes, commodities do tend to have a lower correlation to equities but to me that dynamic relies too much on how things should work. Commodities can easily go down with equities or in the case of the pandemic crash, the Invesco DB Commodity Tracking Fund (DBC) dropped more than the S&P 500 during the Pandemic Crash of 2020 and took longer to snap back. DBC also went down in the 2018 Christmas Crash again, taking longer to come back. I imagine the effect there is both stocks and commodities are both pro-cyclical. Not that long commodities exposure is a bad thing, I just don't think it works in this context.

I built portfolio that is 67% NTSX, 20% Forum Funds Delaware Absolute Mohican Convertible Arbitrage Fund (ARBIX) and 13% AGFiQ US Market Neutral Anti Beta ETF (BTAL). Those names certainly are a mouthful. Convertible arbitrage goes long the convertible bond and short the equity of the same company to deliver more of an absolute return result kind of like merger arbitrage. There's a little more work related to the convertibility price in running that strategy. BTAL is of course a client and personal holding, it goes long low volatility stocks and short high volatility stocks. 

The first chart is the portfolio as outlined above dating to NTSX' inception compared to VBAIX.

 

First I will say that somethin ain't right with that VBAIX result. If NTSX was up 32%, VBAIX would have been up 21.8% and that is the number I will assume. For the period studied the NTSX/ARBIX/BTAL combo weighted as mentioned above was up 22.9% or 110 basis points more than VBAIX. Here's the YTD chart for the same mix.

  

The math shows the NTSX/ARBIX/BTAL combo would be down 14.7% versus a decline of 17.58% for VBAIX or 288 basis points of outperformance. Would that be worth it to you? If so, when would you rebalance? There's no wrong answer to either question. If you rebalanced a couple of months ago, you'd have eaten into the 288 basis points of alpha. If you rebalance right now and the market keeps going down, you'd have left future alpha on the table. If the market rockets higher from here and you don't rebalance, you'd lag that snap back. The point is that I think this concept can be effective in being all-weatherish but there would need to be rebalancing along the way and it is not likely that rebalancing will always be optimal, maybe never but it can smooth out the ride and allow for being somewhat close to "normal," long term equity market appreciation.  

Quickly adding in from NTSX' inception to the end of 2021, so no bear market effect, the NTSX/ARBIX/BTAL combo would have outperformed VBAIX by about 100 basis points. Again, I think the VBAIX chart is wrong, if not wrong then the portfolio built for this post would have outperformed VBAIX dramatically. Assuming the 100 basis point outperformance, it did that with 33% of the portfolio in holdings designed to not track the stock market, those being ARBIX and BTAL. So overall, slight outperformance by leveraging down to a lower volatility profile by blending holdings with very different attributes and intended effects.

I chose BTAL for this exercise because it tends to go up when markets go down more as a matter of direct cause and effect, relying a lot less on how things should work IMO than commodities. ARBIX could be replaced by any number of other funds targeting different strategies toward the same type of result.

I would also note that I wouldn't put 20% into one strategic fund, I wouldn't put 13% into one strategic fund. No strategy can always "work" even if they work most of the time. Where an all-weather outcome is the objective, loading up on a couple of narrow based strategies takes the risk of being exposed to once in a lifetime surprises. I have no idea what could cause merger arbitrage to ever cut in half but I will not let the risk of some insane outcome like that cause anything more than a lag to the portfolio versus the damage caused by a 20% allocation cutting in half.