Diversification Palooza

Let's take a look at diversification. It's a vital component of investment success and while there are many ways to structure a diversified portfolio with no single way being best, there might be a few ways that are not so good. 

Jim Bianco Tweeted out that as/of last January, Bill Miller, the old Legg Mason guy, had 50% of his net worth in Amazon and 50% in Bitcoin. Long time listener, first time caller, am I diversified? I love that joke. Miller has gotten caught very publicly this way before with extreme positioning, one example being a bunch of financial companies that went under in the Financial Crisis. It has happened enough that he might simply accept the potential reality of this and be able to live with it. 

Would you be able to live with it? I could not. Having at least a little sense of what you can and cannot tolerate is very important investment trait.

Corey Hoffstein helped this conversation along breaking down return stacking versus portable alpha. We've been talking about return stacking for months now but haven't mentioned portable alpha. They're kind of the same thing as Corey notes. At a high level both use leverage to try to enhance returns either nominally or on a risk adjusted basis. Portable alpha though is when the investor builds the leverage themselves in their account. This can lead to negative equity in a dire circumstance. 

The easiest example of portable alpha might be buying an S&P 500 index fund on full margin. At some point on the way down, all your equity would be gone, you'd owe the brokerage firm money. Compare that to buying a 2x leveraged S&P 500 index fund, so no margin. All that can happen is that you lose what you put in, you wouldn't end up owing money to the brokerage firm; return stacking. On the way up, both would add to returns but different consequences on the way down. I don't think those are actually examples of real portable alpha/return stacking but they easily illustrate the point. 

There's a quote out there attributed to Warren Buffett about leverage that most dangerous things about investing are ladies, liquor and leverage and the first two are only there because they start with L, it's just the leverage that's the problem. A related heuristic says not to confuse alpha (outperformance) with leverage. When you employ leverage, even if your leveraging down you are taking an extra risk. Yes, something like managed futures or gold or commodities more broadly should go up when stocks go down but should does not mean they must. Any fund that is leveraged to what should happen could cause a problem in your portfolio. That doesn't mean avoid no matter what but understanding this nuance is important.

Here are some examples.

 

NTSX is the 90/60 ETF we've mentioned many times before. It leveraged up such that a 67% allocation to that fund gives the same result as putting 100% into the Vanguard Balanced Index Fund (VBAIX). That leaves 33% for return stacking opportunities...and risks. Here are the results;

 

The three are not that far apart which surprised me a little and the superior CAGR and Worst Year results for Portfolio 1 are thanks to the tremendous performance put in this year by managed futures. Putting 100% into VBAIX for the period studied delivered noticeably inferior results versus NTSX+BIL which surprised me. The CAGR was 7.89%, standard deviation 12.98 and worst year was 17.37%.

As we've explored this, I've talked about the relative safety of leveraging up with BIL. I can't think of a serious problem that could rise leveraging up that way but just because I can't think of one doesn't mean there isn't one. I've talked about "leveraging down," a term I think I created as variation on return stacking where equity exposure is levered up but that leverage is then offset with something like managed futures. Can a 20% allocation to managed futures give the same protection as 40% to fixed income allowing that extra 20% to go to equities, 80% equities/20% managed futures? Maybe or maybe the mix could be 75/25, you get the idea. The risk though would be that like this year, in some future downturn, the thing that should be protecting the portfolio (managed futures) fails to do so for whatever reason. That may not happen often but it only takes one failure to cause a serious problem. 

Pivoting a little bit, Roni Israelov from NDVR, before that he was at AQR, did a lengthy study and determined that proper diversification requires at least 200 stocks to avoid "unlucky outcomes." The idea of needing a hundred stocks or a couple of hundred is not new but he has a slightly different reasoning, the idea to Israelov is to reduce the role that luck plays in a portfolio. 

The article refers to concentrated portfolios as having 20, 30 or 40 holdings which is amusing to me as I run pretty close to 30 most of the time. In trying to figure out position sizing of thematic (narrow based) ETFs or individual stocks, how much are you willing to lose if something goes to zero with you holding on all the way down? If your tolerance is 50 basis points of your portfolio, then yeah, you probably need 200 names. From the top down, I think of narrow based ETFs as being interchangeable with individual stocks. If you were interested in the solar theme and silver mining theme, you might chose an individual stock but it would be worthwhile to spend time learning about any ETFs in the themes you care about. An ETF might be the better bet, or individual stock. If you can accept that no single wrapper is best for all exposures, take the extra time to explore more than one. 

Client portfolios have mostly individual stocks, a few narrow based ETFs and I talked recently about using broad-based exposures to dial up or dial down the net long exposure I have on. 

Finally a new ETF. The NEOS S&P 500 High Income ETF (SPXI) owns the S&P 500 and tries to enhance the yield with call option strategies that can include covered calls but also buying calls, not sure if they mean spreads or not and the prospectus doesn't mention option spreads. The other day we mentioned an ETF that does kind of the same thing but with put options, so not really the same thing, but similar in that an options overlay hopefully provides extra income to fund holders. These are very worthwhile to explore and learn about. One of these will end up being the secret sauce. Will it be SPXI? I doubt it, selling calls works against the market's ergodicity but hey, you never know. 

I have no interest or intention of using any of the funds mentioned in the post personally or in client accounts.