Don't Fear The Complex, Don't Abuse It Either

Morningstar had an article titled Why Investment Complexity Is Not Your Friend. With the priority we place on relative simplicity here, this of course was of interest to me.  The intro talked about the proliferation of new funds that are not plain vanilla, the types of funds we explore here frequently. Morningstar noted that with the new funds, the "range of options (can) be overwhelming, but it often leads to worse investor outcomes."

Agree with me or disagree but there is utility in these funds which Morningstar does not seem to believe but it is very easy to use them incorrectly leading to bad outcomes, on this point I agree with them. There are a couple of niches that seem to have gotten more attention on Twitter and blogs including here; managed futures and capital efficient funds that use leverage to build exposure to more than one asset class with the expectation that the blending of those asset classes will lower volatility.

The common argument against these funds goes down the road that no one needs them and even because some people will misuse them they shouldn't be available to investors. 

I don't know whether these funds rise to the level of fad of not but things that are faddish often do end badly. Yes, the funds that are using leverage, I certainly can't say they are misusing leverage, might lead to bad outcomes for investors. The idea of blending two or more assets that usually have negative correlations together, even with leverage is not on its face terribly risk but neither is it infallible. You don't need to spend time isolating what specifically could go wrong, just knowing that something, anything, could go wrong is enough.

A modest allocation to a fund like we're talking about that blows up it little more than a lesson learned with no financial damage done. Repeating from past blog posts, just like 20% into REITs, MLPs or gold was a bad idea when pundits were suggesting that leading up to the Financial Crisis, 20% into managed futures or risk parity or some of the others are a bad idea now. 

Like a lot of things there is a balance to be struck here. First, plenty of investors simply do not believe in using these types of strategic tools. That's valid. Don't use them if you don't believe in them. To Morngingstar's point, they are not simple, they are opposite of simple. The Morningstar article doubted investors' ability to understand these funds. Certainly, not every fund strategy will be clear to you or to me or to anyone else. Anyone considering these funds needs to invest time into understanding the strategy underlying any fund catching their eye. 

While I agree that using just one fund with a 20% weighting to hedge or otherwise protect the portfolio is a nice clean idea that is appealing on some level, I think it is a bad idea. In some random event both your core, like equities, and hedge could both go down at the same time. Managed futures usually centers around a 10 month trend. A few weeks ago most of the space got caught wrong footed when yields on short term treasuries dropped dramatically. There is no reason why managed futures couldn't get wrong footed again at the same time that equities are going down. This could be the case with any of the hedge/protection funds we talk about. Once you figure out how much you want to own, less than 20% for me, I would suggest owning several different strategies in smaller slices rather than one strategy in a big chunk. 

To the title of the Morningstar article, complexity can be your friend when used/sized correctly. We talk all the time about plain vanilla being the thing that goes up the most, most of the time. It doesn't get much simpler than plain vanilla equities. A little bit of complexity as a your hedge, when used correctly can go a long way to managing volatility and as we saw in 2022, can be more effective than fixed income for this purpose. Simplicity hedged with a little complexity.

Big Risk In Multi-Asset Funds?

Credit Suisse is being absorbed into UBS ostensibly to prevent it from being completely vaporized. The debt is now worthless, I saw PIMCO and Invesco are/were large holders. But what about the exchange traded notes, ETNs? CS has a few out there and apparently they'll be ok. ETNs look a lot like ETFs except they are actually unsecured notes of the issuer. 

When you buy an ETN you are adding the layer of potential complexity that a bankruptcy could wipe out the ETNs. To quote Mark Yusko, risk happens fast. That I could be out in front of a bankruptcy is not a bet I would want to make in the context of owning an ETN for whatever exposure and also knowing the bank well enough to know it was going to fail. CS stock has been in a verrrrrrrry long trend downward, it has been in trouble for a long time. Why couldn't something like it failing have happened a couple of years ago or a couple of years from now? 

Understanding the risk associated with ETNs is pretty simple and it takes almost no due diligence to grasp that they can be wiped out in the face of a bankruptcy. There are risks associated with other strategies that come in fund form, really all funds have some sort of risk ranging from the very simple possibility that an index fund goes down a lot in value not because the fund breaks but because the index it tracks goes down a lot. Some random actively managed fund that goes up 80% in an up 10% world could easily go down that much in a down 10% world, we saw a variation of that with Cathie Woods' funds. 

Merger arb funds which we write about all the time can be vulnerable to some sort of weird macro situation that could cause deals to fail, for just a bit it looked like the Credit Suisse debacle might be a problem for convertible bonds and maybe by extension convertible arbitrage. Last week I mentioned that most managed futures funds got whipsawed by the extreme volatility in the front end of the treasury curve. Certain VIX products have blown up by 5 or 6 sigma events. Any strategy fund could have something bad happen for a reason you might be able to piece together or some reason that no one could reasonably piece together. 

We've been seeing a small wave of multi-asset funds that use leverage coming to market lately. They don't hide that they are using leverage but they are positioned with the terms capital efficiency and return stacking. It's not that leverage on its face must be bad but at the heart of many capital market calamities has been the misuse of leverage. 

The WisdomTree Efficient Core ETF (NTSX) was early to the capital efficient space. It is 90% equities and 60 bonds. The way the math works, a 67% allocation to NTSX (Portfolio 2 with 33% in the T-bill ETF) equals 100% in Vanguard Balanced Index Fund (VBAIX) which is a proxy for 60/40 and Portfolio 3. Portfolio 1 is 100% in NTSX which in 2022 was down 25.84% versus down 16.85% for Portfolio 2 and 16.87% for Portfolio 3. That's not a deathblow misuse of leverage but is illustrative. 

There's one fund our there with 90% in equities and 90% in gold and another with 100% in bonds and 100% in managed futures. Too much exposure to the 90/90 when both stocks and gold go down would be a problem. Too much in 100/100 would be a problem when both bonds and managed futures both go down. Sizing the 90/90, how much do you want in gold? A 5% weighting to that fund would be get you 4.5% in gold. You'd also be picking up 4.5% toward the total you want in equities. A 10% allocation to the 100/100 would get you 10% in managed futures if you wanted that much (I don't) and 10% toward your bond allocation. For purposes of the example, there is the presumption that you'd even want equity exposure the way 90/90 accesses it and that you'd want the bond exposure the way the 100/100 accesses it but in the real world you may not.  

Capital efficiency has also made its way into multi-asset funds, meaning 5 or 6 asset classes. That sort of leverage relies on correlations that are typically low or negative always being low or negative. Have you have heard the phrase that in crises all correlations go to one? That is a simplification of course but something to be aware of in a fund that kitchen sinks 6 different assets together with leverage. 

I have no interest or intention of using any of the funds mentioned personally or for clients.

The Food Pyramid Is Killing Us

Barron's had a fantastic (not being sarcastic) article about potential health care cost inflation coming for retirees. It laid out the threat and dug in with some numbers. 

Apparently, health insurance companies are asking for regulatory approval to increase premiums by 10-20%. One expert said to prepare for 10-14% increases for a couple of years and then expect 5% after that. "Currently, retirees with modified adjusted income below $97,000 pay $1,979 a year in Part B premiums. Healthview projects that the premium will rise 6.3% in 2024 and 6.2% in 2025, 8% in 2026, 7.8% in 2027, and around 6% annually through 2031." Part G Medicare, the one I believe to be the most robust supplemental plan currently costs an average of $1517/yr with projections of 10+% increases over the next few years. 

There was mention of the potential pain for people who retire before they can start Medicare for having to find health insurance either through Healthcare.gov or some other way. There was one anecdote from an advisor about a couple in this situation, 63 and 61 years old respectively who "pay $42,000 a year for a high-deductible policy they wanted so they could keep funding a health savings account. Their out-of-pocket spending can run another $3,000 for the year." 

I put that one in quotes for how absurd it is. First, it does seem like health insurance companies are pricing HSA eligible policies out of making any sense which is unfortunate. The above couple is paying $45,000 all in to be able to sock away $8750 into an HSA. There was no mention of some sort of extreme situation that might require that type of premium or any sort of extreme income that puts them in the highest tax bracket. They could probably find a premium for half the $42,000 that would probably mean no HSA contribution and come out far ahead. Even $21,000 seems crazy high but getting close to $2000/mo for health insurance in your early 60's is about where the market is. 

We've spent a lot of time on how to potentially sidestep or minimize the impact of health care costs and ways to greatly reduce the extent to which we need to rely on or interact with the healthcare system which to my way of thinking is permanently broken. I'm not a believer in socialized medicine but we're at a point where we are getting torched financially but we have the long waiting periods that people associate with socialized medicine. 

If you do some research you will find that all sorts of changes to our health and how we "manage" chronic maladies started to change, coincident to the US adopting the food pyramid calling for more "healthy grains" a little over 40 years ago. Obesity rates started to go up and have been going up ever since. Obesity rates are sky high now and the odds of health problems go up dramatically for those who are overweight. 

I talked about this at fire training yesterday. I said it seems as though the food pyramid was created to sell us unhealthy, high margin junk food that makes us sick or worse so that we can then pay for medication to manage our sickness for the rest of our lives. I acknowledged it as crazy talk but it is what I think and the response from the group was some general nodding and an acceptance of the plausibility of that idea. Right or wrong, I am convinced it is true supported by the increase in obesity rates, increase in Type 2 Diabetes and all the rest. Have you seen the commercial for Cologuard that claims the incidence of colon cancer is on the rise for those under 50? Assuming that is true, it is the diet suggested to us by the food pyramid that is to blame. 

Here I will not surprisingly say to eat less carbohydrates. It is the carb content underlying the food pyramid that is killing us as well as the seed oils that go into processed food. To the extent you can eat meat, cheese, eggs and fish at the exclusion of carby and processed foods, the healthier you will be. Don't take my word for it. Do the research but no one will be hurt by eating less sugar and less processed food. 

Get far enough into researching this and you will see that the right habits will greatly slow down the aging process. The right habits also includes staying physically fit. Weightlifting the most effective way to do this because done correctly it is a cardio work out and it builds muscle mass. We naturally start to lose muscle mass as young as 30 (Google it). Building muscle mass back up or as I have called it before, staying ahead of deflation is crucial. It speaks to body composition. Lifting weights will keep you muscular and a proper diet will keep your body fat percentage where it should be, about 15% for men, 20% for women.

Walk the walk time even if I sound like a jerk; I've been lifting weights since the 70's but just figured out diet six years ago when the doctor told me I was pre-diabetic. I started in that day on low carb, literally the next meal. I resolved the pre-diabetes and lost 20 pounds in just a couple of weeks on my way to a 30 pound drop to 190 and I have been there ever since. My abs came back which probably puts my body fat around 12%. I'll be 57 next month and I could probably pass for a fit 40. Something I think I've said here before, if you're doing the work that results on looking younger on the outside, you're probably also younger on the inside.

I describe all of this as simple even if it's not easy. Lift weights and cut carbs. That's it. Since I've been doing this and writing about it, I've had a lot of people from various constituencies ask me about it and have seen both successes and people who can't stick with it. Ultimately it is up to us of course. I talk about preventing or solving our own problems and how we take care of ourselves is a very tangible example. 

We've talked about the financial impact too. I've been on a lot of medical calls with the fire department and occasionally the patient will take no prescriptions. We had one a year or two or go, he was 81, did have stents put in 20 years earlier but somehow took no prescriptions. He went out of his way to say he lifted weights. My father made it to 88 with no prescriptions before 55 years of smoking cigars caught up to him. He was sick for six months before passing away. How much money did the 81 year old patient and my father save not taking meds? We would save more due to the way health care costs have been going up.

I've also been on medical calls for people in their 40's and 50's with long lists of meds they take. The more you take care of yourself the better the odds of spending nothing on health costs other than insurance. My annual physical last year cost less than $200 which is all I spent money on...other than insurance. Another example of how broken the system is, I pay $6000/yr for essentially catastrophic coverage so I can get a $200 or $300 discount on my physical. 

Again, do the research and you will find that getting in shape and cutting carbs can reverse chronic maladies that many people take medication for like hypertension and Type 2 Diabetes. No absolutes but it is possible and there is no downside to eating less sugar and less processed food. Here's a link about reversing T2D by fasting. There's another study, although I am not finding the link right now where people reversed T2D in just 72 hours by fasting for that long. Of course they then need to change what they eat to maintain that. This doesn't get talked about more because there's no money in skipping a meal.    

I will always bang this drum. The quality of life aspect of feeling better, able to do what you enjoy for longer without spending a lot of time waiting in the doctor's lobby hopefully resonates with everyone. The financial aspect of being able to get that $300,000 and rising number from the annual Fidelity retirement health care cost study down should resonate with everyone who cares enough about personal finances to read a blog like this one.

Crisis Alpha Vs Panic Alpha

Last year the term crisis alpha got talked about frequently. Markets had a crisis and things like managed futures did very well having the term crisis alpha ascribed to them, rightfully so. The segment did so well that a few new funds came to the market and a lot of financial bloggers started to talk about 15, 20 even greater percentage allocations to managed futures. I'm a huge believer in the strategy. I had one fund for clients during the financial crisis, then bought one fund in early 2020 and finally added a second fund in the fall of last year. My total exposure is probably a little under 5%.

Here's how a few of the funds did today;

 

They did very poorly on Friday too. The issue seems to be they got caught wrong footed by the massive rally in shorter dated treasuries. One of the funds I use did quite a bit better each day while the other did far worse, down 4.7% Friday and down more than 7% today.

2022 was a crisis type of year. What has gone on in the last couple of days has been a panic. Where tail risk funds didn't do so hot in 2022, they are up dramatically in the last two days. Tail risk funds own puts and treasuries. Markets have been dropping (good for puts) and yields have crashed lower in shocking fashion (good for bond prices) which is why tail risk has done well. Funds that track the VIX Index are also up dramatically because the VIX itself has gone up in a manner that one might expect during a market panic. VIX related funds did well for the first 2/3rd +/- of 2022 before trailing off some later in the year.

Tail risk and VIX could be thought of as panic alpha which is a term I might be able to take credit for, at least I haven't seen it before. There are no absolutes of course, if shorter term treasuries had somehow been flat in this panic then managed futures funds wouldn't have gone down so much but the idea that treasuries will go down in yield during a panic is something the repeats from cycle to cycle...of course though, there are no absolutes on that. 

In terms of trying to protect a portfolio or manage the volatility of a portfolio, are you trying to protect against crises, panics (crashes) or both? There's no wrong answer there. The point is one that we have made here many times which is nothing can be expect to "work" every single time. Managed futures probably is better in longer crises than crashes but it might not work for every crisis. Tail risk might be better for crashes than crises but there certainly could be some random panic where it doesn't "work" like if there was some sort of huge rally in yields coincident to crash. 

I have a couple of each, crash protection and crisis protection, the former is helping now, the latter is not. A catch phrase that applies is diversify your diversifiers. Putting 20% into one diversifier is certainly tidy for doing backtesting but what if we're on day two of something crazy for managed futures that lasts for a while longer? There is some allocation weighting where a drag on returns becomes a problem for returns. That inflection point might be debatable but a 20% allocation is well past the point of being a problem. 

If I had to pick between hedging against a crisis versus a panic, I would say it is more important to hedge against a crisis, a longer event, than a panic. The panic of early 2020 is a good example. The S&P 500 had recovered about 75% of the Covid decline in less than three months. If you're an investor, as opposed to a trader, your time horizon should probably be thought of in terms of years, not months. The longer term events are in my opinion more serious.

Repeating for emphasis, there can be no certainty that things that should go up when equities go up, will do so. There is no guarantee that things that should trade like horizontal lines that tilt upward no matter what will always do so. When you diversify your diversifiers you lower the odds of being hurt during the one event where your favorite diversifier does badly. 

Sorry to say it so bluntly but 20% in managed futures makes no sense. 20% in a VIX fund makes no sense. 20% in a long/short fund makes no sense. 20% in merger arbitrage makes no sense. 20% in short volatility makes no sense. Those are all alt strategies I have exposure to in client accounts. I think they all work well the vast majority of the time but 20% in any single one makes no sense for the unnecessary risk that such a large weighting would expose you to. 

I have no interest or intention of using any of the funds mentioned personally or for clients.