In our post the other day I mentioned being nowhere close to 20% in alternatives for clients or personally but conceded that the need to allocate more to that broad space might make sense if it takes the bond market a while to figure things out or if the longer end of the bond market continues to trade more like equities due to increased interest rate volatility.
Certainly there are plenty of places in traditional fixed income to hide out while the most volatile parts of the asset class continues to work through whatever it is working through. I recently added very short term t-bills and a CD for many clients getting in the neighborhood of 2.5% without taking much interest rate risk. I have a little credit risk through BulletShares but those too are short dated to avoid interest rate risk.I also maintain exposure to short dated TIPS and some floating rate stuff.
The Merger Fund (MERFX) continues to serve accounts as what I believe is a fixed income proxy. Client accounts also own hedges, call them alts if you'd like, that will hopefully help avoid the full brunt of large equity market declines, so far so good as we've talked about in several recent posts.
So starting from whatever your stock/bond mix is, let's go very generically with 60/40, with respect to the 40, how much do you want in more traditional fixed income, how much in fixed income proxies and how much in alts that hedge? Should all of the proxy and hedge sleeve be taken from fixed income or should some come from equities? There's no wrong answer and you may not want any of it, just equities and traditional fixed income. Equities and traditional fixed income with nothing else can absolutely get the job done provided the savings rate is adequate, the asset allocation is suitable and succumbing to emotion is avoided. Just because equities and traditional fixed income can get the job done, doesn't mean it is optimal, I don't think it is. I think it is important to manage portfolio volatility to reduce the odds of panicking and reduce the odds that client income needs are disrupted.
Above, I said there's no wrong answer. For me, the right answer involves continuing to seek out new (to me) tools, try to understand them in terms of what they do and how they might fit and then rule them in or rule them out. I've said a hundred times it is fascinating work and I believe I owe it to my clients to learn more and understand more. If I study and/or test drive 10 things and one makes into the portfolio like the Standpoint Multi Asset (BLENDX/REMIX) then I think that is a productive use of time. I've never thought about a ratio like that, 10 to 1 or whatever, I don't know what the actual number would be.
Where the quest involves some sort of all-weather portfolio (excluding risk parity which is a big component of Bridgewater's All-Weather Portfolio) I think some allocation to equities should be the largest allocation because they deliver the best returns over the longest period of time. There should be some amount of traditional fixed income (even though I will continue to avoid extended durations), some amount in fixed income proxies (substitutes), alternatives/hedges that offer the potential for uncorrelated returns whether that's a straight inverse fund, gold, managed futures or some other alternative strategy. Let's carve out cash as either optionality or a tool to mitigate sequence of return risk. And if you want to throw in a tiny slice to the asymmetric potential of Bitcoin, go for it.
Lately we've devoted a lot of time to managed futures because it is working again after all the years! That is of course 180 degrees the wrong way to think about. Managed futures has a low to negative correlation to equities. If managed futures ripped higher with equities over the last ten years then that would signal to me it wasn't working or something had changed. I have full faith in managed futures but that doesn't mean on the next go around it won't have some sort of problem. A strategy can work most of the time even if not all the time and you don't want to get caught with too much of anything that one time, or two times, that it doesn't work for some unpredictable reason(s). This is why I've been talking for so many years about small allocations to these things.
So, can we find something else that delivers an uncorrelated result to managed futures but delivers the same protective effect? The answer is a solid maybe, please note I am still trying to learn here. The chart compares Guggenheim Managed Futures (RYMFX) to the ProShares VIX Mid-Term Futures ETF (VIXM).
To the naked eye, they appear to have taken very different paths to a similar destination of protecting against this year's stock market decline. The correlation tool at ETFReplay supports the observation.
They don't have RYMFX in their database.
I probably don't want to initiate a position in one of these that is as large as 5 or 6% in case something goes wrong but two of them, relying on different things, each around 3% is more like what I have in mind. The work from here is to try to find out why managed futures and VIXM have such a low/negative correlation to each other. There are at least two commodity volatility indexes, like VIX but for individual commodities. OVX is a volatility index for oil and GVZ is a volatility index for gold and they look quite a bit different than VIX. At times they do similar things, at times the exact opposite and at other times you'll see one lead the other which I think accounts for the low correlation between managed futures and VIX and by extension VIXM but doesn't explain it. Here's some info that notes managed futures does well when volatility is high or in the process of moving up (I think we're seeing that on the chart) but doesn't explain.
This paper from the CME might explain it pretty well and do so in a consistent manner with some of what is higher up in this post. The paper says that managed futures is long volatility, it's also short volatility too. VIX is volatility so if you buy a VIX ETP (not any that go short VIX) you are buying equity volatility, managed futures goes long volatility of different assets (commodities, currencies and sometimes financial instruments). When volatility increases, VIX goes up in times of crises, delivering crisis alpha that we talked about a few days ago. Crises can also impact other markets of course with different effects, the volatility of commodities, currencies and so on can also go up and where the strategy goes long volatility it also benefits from crises, offering crisis alpha as we appear to be seeing this year.
Here's how VIXM and RYMFX did during the 2018 Christmas Crash;
And here's the Covid crash in 2020.
Both those events were very fast crashes. VIX is far more capable of reacting immediately than managed futures. RYMFX did fine, up a little, and while that's better than a huge decline, that's nowhere near the protection from VIXM. Those crashes happened in a matter of days, fast, versus managed futures which captures 10 month trends better suited to normal bear markets which tend to start much slower as is the case with the current one.
VIXM wasn't around for the Financial Crisis but RYMFX was. Like I said, that event was much slower and RYMFX mostly did a very good job, maybe starting to price in a recovery in equities a little early.
Going through this process in this post leaves me feeling like I have a better understanding of how these two exposures offer portfolio hedging with crisis alpha and how they differ, even if there is more work to do.
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