Diversification Isn't Always Pretty

This post could just as easily titled "so you think you want to be diversified eh?" Well here's one glimpse of what diversification looks like.

LOTIX is a managed futures fund that is not in my ownership universe. I use it for blogging purposes because it has been around a long time which allows for decent backtesting. I use a different fund in my practice.

As a microcosm, the last month shows that managed futures is, IMO, reliably negatively correlated to equities. November has been a great month for equities and a bad month for managed futures (MF). The hit to MF this month is most likely due to the huge reversal in longer term treasuries and maybe to a lesser extent, the recent decline in the US dollar.

The other day I cited an interview with Jason Buck from Mutiny Capital who said something to the effect that if you're properly diversified then some holding will have you "puking." If you listen to some of the pundits calling for 25% or more in MF, maybe you would be puking. The 25% in managed futures crowd is repeating the same behavior from 15+ years ago when there were calls for 20-25% in things like MLPs, REITs and gold. The tide really went out on the first two when the market crashed in the financial crisis and gold went up until filling the role of tending to be negatively correlated to equities.

Here's what diversification isn't.

It has obviously been a fantastic month for longer dated bonds, one of the best month's this century but the two lines track each other very closely. I believe that this sort of result over the last month speaks to what my concerns have been. I have no idea what interest rates/bond prices are going to do but my concerns have been that bonds are just as volatile as equities and that they do no reliably diversify equity exposure in the same manner they did in the 40 year period ending late 2021.

Anyone looking to trade bonds for capital gains, cool, not my trade though. So the upside is capped because bonds aren't going sub 1% again but even they do, they are still capped, at the very least the diversification benefits of bonds are now unreliable so their volatility doesn't necessarily help with equity volatility or spare a portfolio from the full brunt of the next large equity decline. They might help, they might not, no way to know and so I think the ideas we explore here offer more reliable diversification. I do hold plenty of short term fixed income that doesn't take on equity volatility or interest rate risk.

We've probably written a hundred posts looking at diversifiers with different attributes, some that should be negatively correlated to equities, like managed futures and others that should pretty much look like a horizontal line that tilts upward slightly. If you play around on Portfoliovisualizer (it's free), or go through the archives on this site, you'll see that smallish allocations to reliably, negatively correlated alternatives can go a long way to dampening or otherwise diversifying equity volatility. 

The horizontal line, tilting upwards type of alts (usually absolute return and market neutral) behave the way I think people want bonds to behave. My preference is to have exposure to both kinds, negatively correlated and horizontal lines, this is how I've been doing it for ages and I feel like it does adequately reduce volatility and help avoid the full brunt of big stock market declines. 

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.