Here's a quote I saw attributed to Barry Ritholtz: “The Best Portfolio is probably the one which sacrifices a bit of performance, but helps you sleep at night.”
This concept has always intrigued me, going back to my days before I was an RIA, working back then as an equity trader in the 90's. At some point I stumbled into what Jack Meyer, then CEO of the Harvard Management Company, was trying to achieve by investing in timber land. He invested directly in acreage, not an exchanged traded proxy like Plum Creek Timber used to be before it merged with Weyerhaeuser. I held Plum Creek for clients for a time but as a stock, versus a direct investment, it only partially captured the effect.
Side bar: People today ascribe some of the benefits of timber land to farm land. Farmland Partners (FPI) is a REIT that has a strange chart. Sometimes it is more volatile than the S&P 500, sometimes less. Sometimes it outperforms the S&P 500 and sometimes it doesn't. Sometimes it correlates to the S&P 500 and sometimes it doesn't. Over the last five years, it missed out on the stock market rally until late 2020 when it went parabolic, then drifted lower for much 2021. YTD it is up 15% but down 11% since May 4th, almost in lockstep with the S&P 500. The idea of diversifying into farm land to help capture the effect Barry is talking about is intellectually appealing but not sure it can be done with an exchange traded product. I spent a lot of time on this space 15 years ago or so and drew the same conclusions.
Barry's quote reminded me of another influence on how I try to manage client portfolio volatility and why I use alts (yes, that conversation continues). A long time ago I wrote about a portfolio concept derived by John Serrapere called 75/50. The basic idea was to construct a portfolio that captured 75% of the upside of the stock market but only 50% of the downside. We dove in on the math at my old URL (sad story, no longer exists) and the math checks out. Here's another blog post I wrote three years ago about it at The Maven.
John used to be a customer of the Schwab equity desk when I worked there in the mid-90's so I knew him somewhat. It was fun that he popped up on my radar in this context all those years later. I haven't seen anything new from him in many many years and his LinkenIn page says he hasn't posted in a while.
Marrying Barry's quote and John's portfolio concept is a good intersection of what I think I try to do with alts. I'm working on this quarter's client letter and have written the part already about bonds not "working" during this bear market.
"If everything you own is going up together in a bull market, what is likely to happen in a bear market?" I don't remember where I picked that one up, I'll just assume I did not coin that phrase but it is a crucial concept. If something has a high correlation to the stock market, it should be expected to go down when the stock market goes down. When do you think the most behavioral mistakes are made, when the market is going up or going down? Certainly in terms of panicking, that happens more frequently when the stock market is going down.
When the market is going down, you're certainly glad for anything you own that is going up, it softens the blow. Of course, when the market is going down it is human nature to think you don't have enough exposure to the thing that is going up, whether it's going up almost by accident like certain defense contractors this year or going up because it "should" go up in a down market like managed futures.
InvestmentNews threw its hat in the ring on the Morningstar article about alts that we've mentioned a couple of times this week. Here's an interesting quote from Tom Holsworth of AHP Financial who said “I’ve had lots of experience and therefore I don’t use them, because I’ve never seen anybody that could successfully pull it off.” I think he is talking about timing when to add liquid alts and that he believes it cannot be done.
Cannot be done? Agreeing with that part of his statement underlies my entire strategy or thesis, it underlies Barry's quote and John's 75/50 portfolio. I've long relied on the 200 day moving average as a catalyst for defensive action. I have broadened that a little to include also taking defensive action when the S&P 500 Index gets too far above it's 200 DMA and re-equitizing a little when the S&P 500 gets too far below its 200 DMA. An easy descriptor for my faith in the 200 DMA, conceding there are flaws, is that when the S&P 500 is below its 200 DMA, it indicates there is a problem with demand for stocks. That problem might be serious or it might not but is a problem of some sort.
It is of course a form of timing but I make incremental changes, as opposed to selling out completely, to mitigate the consequence of being wrong. It in no way implies a guess that a top is in or a bottom, just that, as influenced from John Hussman, risks to markets are elevated by some amount when there is a problem with demand for equities.
I slightly re-equitized a few Fridays ago when the S&P 500 was down about 24% from its high, coincident to the index being 20% below its 200 DMA. Buying when the broad market has dropped 1/4 of its value is not a bad idea even if you buy more down 35% from the high or 45%. The idea is not timing, it's buying after a large decline regardless of what comes next.
But what about managing the alt side, the diversifier side which I believe should be much smaller than an allocation to equities. This chart shows the PIMCO Trends Managed Futures Fund (PQTIX) compared to Guggenheim Managed Futures (RYMFX) and the S&P 500 going back five years ending December 31, 2021.
Neither fund really captured the bull market in stocks in those five years. Can you sit on something like this, even rebalancing in to buy more every so often realizing it is very unlikely to keep up with a bull market. Being comfortable that diversification means you have some holding that look like PQTIX and RYMFX when the stock market is raging higher. When stocks are going up, it will feel like you have too much in diversifiers like these.
The benefit comes in a year like 2022, both managed futures funds are up 17% versus down 20% for the S&P 500. We played around with some numbers earlier in the week on the impact that a 20% allocation to a couple of different diversifiers. I'm not going to be a fan of 20% into a single diversifier with a large portion of someone's serious money. I used to say never to put as much as 20% into diversifiers and while I am not close to 20% in client or personal accounts, I can see that needing to evolve if the bond market doesn't find some sort of stasis soon.
If you "diversify your diversifiers" then you start down the road of the Cockroach Portfolio that we looked at the other day or the various attempts by some mutual funds to create a variation of an "all-weather" portfolio.
If you're considering and increase to an allocation of diversifiers you need to do the work to make sure they don't rely on the same things. Any alts you would consider, do they take interest rate risk? If they all do then you're kind of loading up on just one diversifier...kind of. That could work against what you're doing versus one diversifier taking interest rate risk, doing poorly by itself while any other diversifiers you use go on to "work" just fine.
If this sounds like more than you want to do or more than you think you're able to do, then don't do it. This all can scale up as far as you want to take but remember that a portfolio of diversifiers hedged with a little bit equity exposure is not where you want to end up unless you're in game-over mode.
That was fun!
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