The last couple of months we've been having a ton of fun looking at what are hopefully very sophisticated portfolios that involve terms like capital efficiency, return stacking and leveraging down (that term is a Random Roger original). We've also looked at with how these portfolios are constructed, what the possible drawbacks might be and how to achieve similar results with much simpler portfolios that might avoid some of the drawbacks of the more sophisticated approaches.
The general ideas being explored by a small number of market participants at this point are useful and I think we're going to see a lot more investment products and conversations about these concepts and strategies. Despite having fun with this, I've tried to be consistent in pointing out possible drawbacks and knowing how to be appropriately skeptical. A few things then to go over today.
Michael Gayed who manages the ATAC US Rotation ETF (RORO) had a video ad on Twitter explaining RORO's year to date performance. The symbol RORO is an acronym for risk on/risk off. Michael's done work that shows that when lumber outperforms gold, you should be in risk on mode and when gold outperforms lumber you should be risk off. The track record appears to work. Under the hood of RORO, risk off means owning bonds. Bonds of course have gotten pasted this year so looking at the chart for 2022 you can't see when it went risk off.
Also RORO uses 1.3x leverage when it's in risk on and long equities. I don't know whether Michael would consider RORO to be part of the capital efficiency/return stacking niche or not but it seems like it could be a cousin if nothing else. In the video ad, Michael says RORO is meant to protect against equity downdrafts not downdrafts in bonds. I think this is an example of something I've been writing about as a drawback to to these types of sophisticated strategies and no doubt in my mind, RORO is sophisticated. The fund relies on how things should work, maybe over reliant on how things should work? When stocks go down, bonds should go up. They almost always do go up but this time they didn't.
A lot of the capitally efficient/return stacked strategies rely on how things should work. Relying on certain cross asset dynamics that usually work always working is a bad bet. It ignores risks that you can't account for. I've been very wary of low interest rates for years. We've looked at this countless times. I had no idea when rates would rise or what would cause it to happen but the risk of buying bonds with yields at all time lows was one to avoid. I don't know when the sequence of market events for RORO caused it to go into risk off but right now it is in risk off mode per the fund's home page, with positions in a 10-20 year ETF and a zero coupon bond ETF.
This takes us to risk parity or RP. RP seeks parity in risk taken across multiple asset classes, often just stocks and bonds but seems to be on a path to branch out. How much exposure to bonds would you need to equal the risk or volatility to equities? Getting to that parity usually involves leveraging up the bond sleeve to get to the same risk/volatility profile of equities.
I've said many times, I don't think it works in fund wrappers. As some sort of institutional offering, it may very well work but this space is littered with funds that have either closed or have had very underwhelming results.
Risk parity should work. Intellectually, I want it to work, but it doesn't, not in fund form, not for my money. The silliness of should and want in that last sentence aside, we've looked at risk parity quite a few times over the course of 18 years of blogging, it just doesn't work in funds accessible by retail sized accounts in brokerage accounts.
An article at Risk Parity Chronicles looked at ten ideas to possibly improve risk parity and I wanted to look at a couple of them. Number 2 was to move from market cap weighting to minimum volatility equity exposure. In theory, if you lowered your equity volatility wouldn't you have to increase your fixed income exposure? That aside, I am not a fan of min volatility funds. They're valid, but it's just a factor and no factor can always work as hoped for. That is a critical point of understanding. During the Pandemic Crash of 2020, the two largest funds went down almost as much as the S&P 500 index and came off the low much slower than the index.
In the Christmas Crash of 2018 they went down about the same as the index but they did a better job bouncing off that bottom. For the first six months of 2022, the worst of the bear market so far, when the SPX was down 20.5%, USMV was down 13.3% and SPLV was down 8%. The extent to which they "work" or don't work seems to be event-dependent. I would rather manage the downside with products that are more cause and effect protection like inverse funds which have fewer moving parts, relying on fewer things working as they "should."
Number 3 from Risk Parity Chronicles was to lengthen duration of the bond exposure.
Longer maturities and durations increase volatility. Layer on top of that the possibility that bond volatility is now going to be higher than it's been. It has been higher lately and it is my opinion that this step up in volatility will persist but that it won't be reliable volatility and thus less effective in portfolio construction. Short maturities have good yields for the time being and a 2 year note yielding 3% will not be anywhere near as volatile as a 30 year bond paying a little more than 3%. If I am not being clear, I would not rely on intermediate or longer bonds to reduce volatility or risk for the time being.
Number 5 is to increase leverage. This too is a no from me, dawg. Misusing leverage is the easiest thing in the world to do. As the space evolves and proliferates (I am convinced this will happen), we are going to hear a lot of stories of risk parity/return stacked/capitally efficient portfolios that blew up for using leverage in a way that back tests beautifully but then encounters some sort of never seen before real world event. Leverage should be used very sparingly or not at all and I would further suggest only use it to leverage down if you have the time to learn about that.
8 is about REITs and I think the author is having the epiphany about REITs. They don't have the diversification benefits that proponents of them would hope for. Like just about everything else, at times they outperform as they did before the financial crisis and times that the lag which it has most of the time since.
If you believe REITs are a proxy for something else, cool, want the yield, that's cool too but it seems that the only time it tracks differently from equities is to go down when equities are still going up.
There are several items about different exposures to also build in like managed futures, merger arb, tail risk and others. Learning about these and implementing some of them in small doses? All for it. Much like REITs and MLPs in 2006, you see recommendations to put 15-20% in these "new" asset classes now. Just as 20% into MLPs was a bad I idea 16 years ago (I wrote about it back then all the time), that much into managed futures now is also a very bad idea. Managed futures went years and years with disappointing returns. It is having a heyday now and is clearly helping navigate the current bear market but at some point, investors will learn the hard way they had too much in managed futures, even worse for anyone who levers up to put 20% in managed futures.
The posts I've written lately where I put 20% into tail risk or something else using portfoliovisualizer, that is just for economy of words but I pretty much always disclaim that I would never put 20% into one alt strategy. I'll put together a post with a portfolio with more realistic 5% weightings to several alts to put a finer point on something that is closer to reality for my approach.
A lot of the content I see, like from Risk Parity Chronicles seem to be a search for the ideal portfolio, I can relate, with some sort of expectation that it could be kind of set and forget. I'm not a fan of that sort of passivity in investing. Use passive products as the core if you prefer but occasionally changes need to be made.
The naysayers of this idea say you can't outperform so you shouldn't try. That's the wrong framing. Over an entire investing career, there will be times you do outperform and yes plenty where you don't but the framing here from me at least is about avoiding certain risks that I think are obvious as well as trying to smooth out the ride as much as possible. That might not always work but sometimes it will, or at least it has anyway.
I also think it is becoming increasingly important to not be overly reliant on how things used to work, repeated for emphasis. Also repeated from past posts for emphasis is that I prefer to use diversifiers that are more directly cause and effect or otherwise simpler in their construction.
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