A Mix Of Good & Incomplete Advice

Morningstar had an article titled 3 Ways To Simplify Your Portfolio and while some of the points made sense, others missed the target somewhat. 

The first nugget is to swap your actively managed mutual funds for index funds. This isn't automatically an act of simplification. The argument to use index funds is valid of course, including index funds makes plenty of sense but someone with a portfolio of two actively managed mutual funds probably has all the simplification he needs. Owning two actively managed mutual funds may or may not be ideal but that's not the point, the point of the article is simplification. 

The second point is to "favor broad all-market funds" over narrower products. This is a valid approach to engaging in markets and certainly would be simpler. Interestingly, this advice contradicts a different Morningstar article about four investing mistakes to avoid. That second article notes that because there was no place to hide in 2022 (we'll get to that in a moment) but it covers a lot of ground including the importance of sector diversification and the trouble posed by broad bond market exposure in 2022.

The last point of simplification is to "delegate some/all of your asset allocation to a target date or allocation fund." I would say that since target date funds became common, we've had two serious market events; the Great Financial Crisis and the current bear market. Both times, target date funds floundered. What good is their form of diversification if it doesn't help when you really need it? Target date funds have been a source of regret in both events. I've been banging this drum since before the GFC actually not realizing back then how lousy they'd actually be. 

I do want to touch on the comment from article number two, the one about mistakes, that there was no place to hide. There were places to hide, to say there wasn't is silly. There are always places to hide in these events. Picking them ahead of time may not be realistic where it comes to narrow equity exposure which is an argument for diversification. If you use narrow exposures, do you have any defense (like military contractors) exposure? If so that was probably up this year. Certain narrow pockets of the health sector were up, the Healthcare Sector SPDE (XLV) shows on Yahoo Finance as being down 3.28%, would you consider that to be hiding with the S&P 500 down 21.13%? There were pockets in the materials sector that were up, energy was up and there were others. 

Fixed income was brutal this year but floating rate did relatively well, short dated paper did well, some of the fixed income proxies we'd looked at like merger arbitrage and convertible arbitrage generally looked like horizontal lines, which is what I think people hope for from their fixed income. This year of course, duration went from the upper left of the chart to the lower right very dramatically so the shorter the duration you had on, or more correctly the less exposure you had to long duration, the better off you were even if it didn't feel like it. 

We've looked at a ton of diversifiers, plenty of which are up a lot this year and others that didn't quite work out the way investors would have hoped. Here's a chart of three diversifiers that didn't really work out the way I think the managers would hope compared to Vanguard Balanced Income (VBAIX) which is a proxy for a 60/40 portfolio.

 

RDMIX came out of the blocks with a great start to the year. It's a very complex, multi-asset, return stacked strategy. If you are a fund holder (not one of the managers who I engaged with once on Twitter) and you can explain in simple terms why the fund had such a rough final 7 months, I'd love to hear from you. My point is there are so many moving parts, there's know way for the typical fund holder to understand what is happening.

I've beaten up on risk parity pretty much all year, longer than that really. The leveraging up on fixed income kind of risk parity doesn't work in a fund wrapper. Wealthfront hasn't been able to make it work, AQR couldn't make it work as a stand alone and RPAR hasn't been working. Look at the few funds yourself, can you find any basis for believing it will offer any benefit as a diversifier or as an all weather portfolio? If rates rocket lower, then yeah, they should probably rally but with a nod to simplicity, there are simpler ways to make that bet.

FIG is the Simplify Macro Strategy ETF. It is a multi-strategy fund that attempts to be all-weather. It started trading mid-year so that -17.xx% return is not correct but its close tracking to VBAIX is correct. It has traded inline with 60/40. There is, however nothing that says FIG must keep up with 60/40 if it rockets higher from here. I have no idea if FIG would go up, at this point there's no way to know. This year may turn out to be an anomaly for FIG and maybe it will prove itself to be everything the managers hope it is but right here, right now, I don't think it has provided a basis to expect it to go up with markets or protect in down markets.

A few months ago we started to describe portfolio construction as simplicity hedged with a little bit of complexity. We each have our own idea of simplicity. RDMIX or risk parity are not simple to me, maybe they are to you. An equity fund tracking an industry or a single strategy fund like merger arb or managed futures are all simple to me. If they are not simple for you, don't use them. If multi-asset, return stacked strategy funds are simple to you and you find one(s) you like, go for it. 

Back to target date funds. Why would anyone expect them to do any better during the next negative market event? If you want to stick with them or plain vanilla 60/40, then over the long term, assuming proper asset allocation and addressing sequence of return risk when relevant, I am sure those funds can get the job done. But going that simple and just holding on means there will be other years in your future like 2022. Great if you didn't panic this time but what if you panic next time, closer to your planned retirement date? 

If that doesn't sound appealing, then take the time to learn about some of the simple-complexity strategies we've been dissecting all year. We've looked at dozens of combos of plain vanilla equity paired with diversifiers that protect on the downside without taking meaningful interest rate risk. By simple-complexity I mean single strategy funds. Managed futures isn't opaque black box but it isn't that simple either. A fund that is just managed futures would be an example of simple-complexity as would merger arb and there are plenty of others. If you do go this route though, remember to diversify your diversifiers. They may not all work in every market event. Tail risk for example did not have a great 2022.

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