60/40...60?

Meb Faber hosted a fun podcast with Rodrigo Gordillo and Corey Hoffstein that dove very deep into managed futures and return stacking. Rod and Corey are very involved with various investment products (look at RDMIX and RSBT for more) that use managed futures to offer a return stacked strategy. 

Early on there was mention of building a 60/40 portfolio and then adding another 60% on top of that in managed futures. They position it as not leveraging up necessarily because managed futures' correlation to equities and fixed income is typically negative or there tends to be no correlation. That sort of correlation attribute is desirable for helping to manage portfolio volatility or put another way, to help smooth out the ride. Stocks are the thing that go up the most, most of the time. Occasionally they go down and when they do it makes sense to have a little exposure to things that tend to go up when stocks go down. 

So what about that 60/40/60 mix (equity/fixed income/managed futures)? We can backtest this back a good number of years on Portfolio Visualizer. The first pic shows the portfolio makeup.

 

VBAIX is the Vanguard Balanced Index Fund which is a proxy for a 60/40 portfolio. Here are the results.

 

The long term stats are very similar. Going year by year it was almost a split as to which portfolio outperformed. There were three years where VBAIX outperformed by 500 basis points or more and there were three years where Portfolio 1 outperformed by 500 basis points or more. Two of the three where Portfolio 1 outperformed were 2008 and 2022 which supports the idea of managed futures offering a form of crisis alpha.  

This is all very interesting stuff. When I listen to or read about this theory there seems to be a lot of reliance on back testing or more fairly, looking back at real world results. Part of the success of both came from yields going down pretty steadily until last year. The CAGR for AGG wasn't so hot but rates going down like that is unlikely to be repeated. With yields so low for much of the time studied, the cash in managed futures funds got no yield to speak and now it does. That point came up in the podcast and they didn't think it was too big of a deal because inflation is now much higher. So maybe not an advantage in real yield but is an advantage in terms of nominal yield. Both issues potentially skewed the past results and if not repeated going forward, may make the future of this strategy less reliable.

A concern with levering up 60% into one strategy is that something that no one can see coming crushes, in the case, managed futures. There was a pretty violent whipsaw in March when shorter term treasuries had a counter trend move. That caused a lot of the funds in the space to go down close to 10%. Why couldn't something even worse happen? Actually allocating 60% to some sort of diversifier seems like poor risk management. 

Now I am adding a third portfolio as follows with the results. BTAL and MERFX are personal and client holdings.

 

Is comparing 70% in stocks to portfolios with 60% a fair comparison? Decide for yourself but I feel like this is an example of leveraging down. BTAL is long short equity in such a way that it tends to go up when stocks go down. MERFX is in there as a cash proxy, there are plenty of things to sub in as cash proxies. The standard deviation of Portfolio 3 is the same as 60/40 with a higher CAGR so I think it is comparable to 60/40.

Stocks go up the most, most of the time. 70% then becomes an overweight versus a more typical 60% so ok a little more risk in the face of a 2008 type of decline. The 10% weighting to BTAL takes nowhere near the risk of 60% into managed futures obviously. I have been a fan of managed futures since the Financial Crisis, I have faith in it but bad things happen to narrower strategies every so often for reasons that no one could get out in front of and the risk of going so heavy, even if there was no leverage, seems unnecessary. 

The influence of the podcast might be to use managed futures in some proportion, or not, and maybe to do some work on how to use leverage in a way that doesn't expose you to getting blown up in some sort of black swan, maybe instead, "leveraging down" as I've talked about it before.

For any advisors reading this, I believe it is crucial to expand the base of what you know in terms of how to construct portfolios. Stay curious and keep moving forward. I recently became aware of an advisor I know getting caught with a lot of longer term bonds that have now been crushed after last year. The exact scenario I have been describing for years, clients are forced to wait in these bonds until they mature in the 2030's with below market yields between now and then. Of course they could get bailed out if yields go back down to where they were a few years ago but that is a big if. 

Disclaimer stuff, all of this is a theoretical way to explore portfolio construction.