We Were In Iceland!

We got back late Wednesday after eight days in the country. We had a blast and the scenery was epic. While I was connected and able to get done what I needed, I've still been catching up on stuff so I am glad to be able to get back to blogging.

First up is an article by Aaron Brown for Bloomberg about "hedge fund style investing" for individuals. It looked at things like merger arbitrage, managed futures and risk parity. If you've been reading my blogs and articles for any length of time you know I am huge believer in using alternative exposures in suitable (meaning small) doses to help manage equity market volatility. 

To Brown's question of whether individuals should pursue these strategies, generally the answer is yes with the caveat of having the time and inclination to learn the advantages and drawbacks of various strategies. For example, merger arbitrage is very unlikely to ever go up or down a lot. The advantage then might be it lowers overall portfolio volatility but the disadvantage might be that it won't offer much protection if it drops 2% in a 30% drawdown for the broad equity market. Protection might be a better word to describe a fund that goes up a lot when stocks go down a lot. 

Risk parity seems to get talked about less lately, this is one that I just don't think gives any basis to expect it to "work" when packaged into a retail accessible fund. I've seen some very broad definitions of risk parity here and there so the context I mean is where the bond position is levered up.

In 2022, the Vanguard Balanced Index Fund (VBAIX) was down 18% (rounded) and the Risk Parity ETF (RPAR) was down 22.5% rounded. YTD, VBAIX is up 9.7% and RPAR is down 0.1%. I've been banging the anti-risk parity fund drum for a long time. I just don't think it works. An investor wanting to use any alts should spend the time to learn and be skeptical. I've been using alts in client portfolios since before the Financial Crisis but am still plenty skeptical. 

In a related article from the WSJ, researchers looked at whether leveraged ETFs are as dangerous as they are purported to be. Their conclusion is no. They are not saying there is no added risk and they are not denying the potential tracking error, just saying it's not as crazy as the boilerplate warnings indicate. Their research corroborated a very casual observation that I have been making for a long time which is that 2x levered broad funds track kind of closely over the long term, 2x tracks closer than 3x. They quantified the tracking error at 5.3% annually for 2x and 13.5% annually for 3x. 

The context of my comments here are that these funds are not being used to leverage up like buying on margin to have more exposure for the same dollars. More like utilizing capital efficiency in an attempt to produce a better risk adjusted return. 

For me, the 3x is a clear no. Here's a couple of different uses of a 2x levered fund going back as far as Portfoliovisualizer goes.

A 50% weighting in 2x should equal 100% S&P 500, but of course that isn't quite the case due to tracking. A 55% weighting to 2x seems to offset the lag looking backwards. The result going forward is unknowable but I continue to believe that 2x used in this manner would track pretty closely. If the 5% historical tracking error is a no go for you, then don't do it. This is all a theoretical exercise anyway. 55% in 2x has tracked very closely to 100% SPX but the standard deviation for 55/45 is noticeably higher. It's tough to see on the chart but going year by year, there has been some noteworthy dispersion which might be a contributing factor. 

Above, I quickly mentioned capital efficiency. Where 55% into a 2x fund is a theoretical exercise for me, the pursuit is whether portfolios can be made more capitally efficient and maybe move closer to the 75/50 concept; a portfolio that captures 75% of the upside with only 50% of the downside which although elusive would be a far superior long term result. 

Hopefully everyone knows that the levered funds all target a daily objective which is one contributing factor to the tracking error potential. The WisdomTree US Efficient Core Fund (NTSX) is a different type of levered fund. It is a 90/60 equity fixed income fund such that a 67% allocation equals 100% to 60/40 leaving the remaining 33% to add portable alpha (potentially levering up) or leverage down which means seeking to reduce risk and volatility or maybe just buying a 5% T-bill which would be an alpha adding strategy without incurring more volatility. NTSX uses derivatives but the tracking error versus VBAIX appears to be very slight. 

Maybe someone like Innovator could create levered long ETFs, targeting broad indexes that seek to track the underlying index over much longer time periods. Maybe they could expire like buffer funds which would not be great for taxable accounts or maybe they could simply reset. I think NTSX shows there is a way to do this.

Then all the portfolios we've built using single day ETFs in pursuit of capital efficiency might actually be implementable.   

The information, analysis and opinions expressed herein reflect our judgment and opinions as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation.