Sunday, October 23, 2022

Strategies Waiting To Be Misused

In doing some research for another post, I found an old blog I wrote ages ago that touches on the same area. It was titled Should Investors Try To Hedge Tail Risk which I wrote in 2010. It makes for interesting reading because how many fewer ways there were to protect against extreme market events back then. I'm sure there were more funds than I knew about but the space has expanded dramatically both with traditional mutual funds and ETFs.

We're also seeing sophistication of strategies evolve too. While I've been clear that I am not likely to use very complex, multi-strategy funds they are still a big step up in sophistication. Here's what's going on under the hood of the Accelerate OneChoice Alternative ETF Portfolio for example.


The fact that any of these are accessible via funds, either simpler single strategy funds or a multi-strategy product is potentially a huge help to investors. That doesn't mean they are riskless, they are not. That doesn't mean there aren't drawbacks, there are. But the opportunity to use these prudently ties in with what I talked about years ago, it was going to get easier for retail sized investors to access more sophisticated strategies. I am all for it but there is a learning curve to understanding the strategies and there is also the consequence that goes with some of them doing well for a time leading to investors loading up beyond a prudent allocation and then some sort of unforeseeable blow up comes along.

It may not be the case where the strategy is flawed so much as how someone implements it that leads to blowing up or less dramatically, just lousy returns. Here's a link to an epic thread, seriously it is fantastic. If you have any interest in sophisticated portfolio construction, bookmark and then get to work as best you can. 

I've skimmed the thread, not dug into the the content shared. On there I see a lot about risk parity, return stacking and capital efficiency which are all things we've explored here for months. We've been bagging on risk parity funds all year and it continues to get worse.

 

Risk parity as I know it essentially leverages up on bonds so that the units of risk measurement from stocks equals that of bonds. There can be other assets types included and as I was told in a Twitter conversation there are other types of risk parity that are doing better than RPAR. I'm still not sure how various arbitrage strategies nest under risk parity per that convo but here's a paper saying that global macro leveraged 4 to 1 is another example of risk parity. Global macro is kind of vague but it's a multi-asset strategy based on macro factors, you could sub in top down factors like politics or interest rates or other big picture indicators for macro which might make it easier to understand. Global macro is usually long/short and has a lot of moving parts. I still have more to learn because I'm not seeing how another leveraged strategy is the same as risk parity and like I said, not sure how arbitrage is either.

I saw confidence expressed in the Twitter thread from people commenting that they understood how to properly use the leverage that goes with return stacking and capital efficiency. Maybe they do but not everyone playing around with these concepts will and there is where people can blow up or cause serious damage to their portfolio.

As we've talked about before, the WisdomTree US Efficient Core Fund (NTSX) is known as the 90/60 fund. It leverages up to to allow investors to capture a full 60/40 portfolio with only 67% of their assets leaving the other 33% to return stack. There are relatively safer ways to return stack and relatively aggressive ways to return stack. Putting the remaining 33% into a T-bill would be relatively safe and YTD would be down 20%. Putting the leftover 33% into a Bitcoin futures ETF would very aggressive and be down 40% YTD. That might sound like a far fetched example but I am telling you it is not. A behavior that repeats over and over is huge overweighting of asymmetric bets that then go the wrong way.

I don't know if return stacking and capital efficient strategies will proliferate but the more popular they become the greater the chance they are used incorrectly, leaving people not realizing how leveraged up they were. Even leveraging down as I've phrased it can go bad. A strategy like managed futures should go up when stocks go down. It usually does go up when stocks go down. I bet it will do that the vast majority of the time so return stacking with leverage to add managed futures could be a form of leveraging down but there is no certainty that managed futures must always go up when stocks go down. Something like 80% in NTSX, so a little leverage there, with 20% in managed futures, ok that might work often but in some random event they could both go down. 

If return stacking or capital efficient portfolios are something to even do at all, they should be in modest proportion.

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