Digging In To Tracking Error

I stumbled into some content about model ETF portfolios including one interesting portfolio that was comprised of ETFs that I'd mostly never heard of. It was impressive that the portfolio was not just a collection of the largest Vanguard, iShares or Schwab ETFs. I'm not going to try to dissect the portfolio for a couple of reasons. There's no need to create the impression of bagging on the portfolio, they are trying something innovative. Also the track records of the funds is very short, and it is tactical enough that it could have a different look every couple of weeks so I'd have no way of know how it positioned previously. 

With something like this, once you dig in and understand the process, you probably need to be all in an not second guess it. From there it will either work as hoped for or not. Part of the analysis needs to be what sort of tracking error might there be and why. 

One of the funds in the model is the Goose Hollow Tactical Allocation ETF (GHTA). It owns equity and fixed income ETFs and has wide latitude to vary its exposures to each. Equities can range from 10%-80% and fixed income can range from 20%-90% all with the objective to "provide total return." 

That description tells me that there could be meaningful deviation from whatever it benchmarks to. I may have missed but I did not see any mention of what it benchmarks to but a mix and stocks of bonds sound sort of like Vanguard Balanced Index (VBAIX) which is a proxy for a 60/40 portfolio. If GHTA's tactical process can add value around a 60/40 portfolio, that would be interesting and if you want it to add value versus something that is plain vanilla, it would have to have tracking error. 

The above goes back to GHTA's inception. Right out of the starting block for GHTA, VBAIX fell off a small cliff and GHTA managed to avoid that decline. In those first three months or so, GHTA outperformed by about 8.5% which accounts for about half of it's total outperformance since inception. 

For the last year, GHTA is only up about half as much as VBAIX.

It missed on some of VBAIX' rally in late May last year into June. It looks like it tracked closely for the last six months of 2023, then turned down to start 2024 and then traded flattish since mid-January like maybe it lightened up on equities? Yahoo Finance has GHTA down 0.7% this year versus a gain of 4.7% for VBAIX.

Tracking error is not necessarily a negative. Again, if you are trying to add value beyond a benchmark type of holding, you have to have tracking error. It is important then to understand what an adverse tracking error might look like and what might cause it. With GHTA, lightening up on equities at the wrong time seems like one potential cause for the fund to lag or maybe getting something wrong with fixed income duration. You can draw your own conclusion about GHTA but more generically a fund like this probably is more of a "explore" position in a core and explore type of portfolio. In 2022, an 80/20 VBAIX/GHTA blend outperformed 100% VBAIX by 378 basis points while it lagged 100% VBAIX by 70 basis points in 2023.

Circling back to model ETF portfolio mentioned at the top of this post, the asset allocation was as follows.

• US Equity 56%
• Trend Following/Tactical 38%
• Emerging Market Equity 5%
• Cash 1%

I don't know often that changes but that there is not a permanent allocation to fixed income is of course intriguing to me. The constituents I chose to mimic the above asset allocation are all very generic other than maybe EBSIX which is a pretty good managed futures fund that is not in my ownership universe.

This asset allocation looked pretty much exactly like VBAIX right up until VBAIX broke in 2022 when it declined by 18 basis point versus 16.87% for VBAIX. In the other 11 years (full and partial) it outperformed VBAIX in 6 years and lagged in 5. Anyone paying for this, in normal years it is a flip of the coin whether you'd outperform or not but either way, not much tracking error until you needed it. 

That is pretty much what I try to do. Stay somewhat close and then hopefully a lot of tracking error for going down less in years like 2022. With an adequate savings rate, riding something like VBAIX up and down for every basis point will get the job done over the long term provided panic selling can be avoided. Successfully going down less in yeas like 2022 reduces the odds of panic selling which hopefully leads to a better long term result. 

The appearance of not adding much value most of the time requires patience on the part of the investor. Markets go up most of the time, investors don't need protection against everything going right. 

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. 

Incorporating Return Stacking?

Return Stacked ETFs wrote a short paper in support of their ETF suite about how to incorporate return stacking into a portfolio. For anyone new, return stacking, also known as capital efficient, involves leverage to build a diversified portfolio. Return Stacked currently has three funds. RSBT is 100% bonds and 100% managed futures. RSST is 100% equities and 100% managed futures. RSSB is 100% global stocks and 100% US bonds. There are funds from other providers that do a similar strategy with various other asset classes and percentages. 

Looking at RSSB. The idea is not that you would put 100% of a portfolio into that fund. A 50% weighting would equal (there's some nuance here to learn about but this is close enough for today's post) putting 50% into stocks and 50% in bonds but with RSSB only 50% of the dollars would be exposed to risk assets.  The remaining 50% could just sit in cash earning interest.

Hopefully that gives some context but that isn't how Return Stacked positions their funds.  They offer various solutions of course but the one I've seen most often is as follows. Assume a portfolio is simple 60/40 all in a fund like Vanguard Balanced Index (VBAIX). Sell 10% of the VBAIX position, put 5% (half the VBAIX proceeds) into RSSB. That 95% invested equals 100% in VBAIX with 5% left over for something. That something could be cash to manage sequence of return risk. That something could be one or more alternative strategy funds in search of a better risk adjusted result. That something could be an attempt to add alpha with a holding that would hopefully outperform like an individual stock or thematic ETF, even Bitcoin. 

I'm most interested in that second one, improving risk adjusted results. The first idea for sequence of return risk, yes, the numbers will pretty much work out as far as replicating 100% with 95% invested as described. Trying to add alpha (as described, you'll see that referred to occasionally as 'portable alpha') comes down to picking the right stock or narrow ETF or getting the timing right for a crypto. 

The idea then is to see if we can get their concept to work. Does adding 5%, or some other percentage, on top of a 60/40 portfolio improve the result in any way whether that is better performance, smaller drawdowns, less volatility or some combo of those three? The way I backtested it, Portfolio 1 in each instance is 100% VBAIX. Portfolio 2 in each instance is an unlevered mix of mostly VBAIX with a smaller allocation to one alternative. Portfolio 3 mimics return stacking with 100% VBAIX and then a small allocation to one alternative stacked on top of the 100% so obviously it leveraged. 

You can play around with this on Portfoliovisualizer yourself but I started with 5% weightings to the alternatives and the differences were almost nothing. Even 10% didn't offer much of a difference but at 15%, there were some differences. Get ready for a lot of images. 

The return stacked version using BTAL gives up 19 basis points of growth versus plain vanilla VBAIX with a standard deviation that is noticeably lower. In 2022, the return stacked version outperformed plain vanilla 281 basis points but was still down 14.06%. 

The return stacked version with managed futures outperformed by a noticeable amount but it was much closer with standard deviation. In this one, the return stacked portfolio was down 12.49% versus down 16.87 for plain vanilla in 2022.

In the third one, we're using AQRIX as the alternative. There was plenty of outperformance, the standard deviation was quite a bit higher and in 2022, this return stacked portfolio lagged VBAIX by 184 basis points.

And the last individual alt with the Merger Fund. Very little difference in return or standard deviation. In 2022, plain vanilla and return stacked were only separated by 11 basis points.

I tried to select alts with different attributes. BTAL is IMO very reliably negatively correlated, managed futures less so because it has a better chance to go up when markets are going up, AQRIX does its own thing and is capable of helping in a decline and MERIX is a reliable absolute return type of strategy. 

A little more realistically for me, this last one divides the 15% to alts equally among the four.

Again, there is a little outperformance, the standard deviation is a shade lower and in 2022, the return stacked version outperformed plain vanilla by 131 basis points. 

Would any of this be worth it to you? There's no wrong answer. Is it worth it to you? One to frame an answer could be to ask whether the complexity is worth the incremental benefits. 

We've constructed many theoretical portfolios with competitive returns as all that we've looked at today but with much lower volatility and a much better result in 2022. The big difference between those and today's attempt to replicate the Return Stacked portfolio is the decision to avoid bonds as captured in VBAIX or other portfolios using the typical aggregate bond exposure. 

In writing about the Return Stacked funds before, I typically include that to use these funds, you have to be ok with bond exposure they are using which approximates the aggregate index. 

If you've ever studied top down portfolio construction you've probably read that getting asset allocation decisions correct accounts for about 70% of the return achieved. Our experience in past blog posts doing similar exercises, excluding bonds, supports this tenet of top down theory. Case in point.

Portfolio 2 allows us to increase the weighting in equities from 60 to 65%, get a higher CAGR but a lower standard deviation with a decline in 2022 of 9.89% versus plain vanilla 60/40 at 16.87 and our attempt to mimic return stacking which fell 15.56% in 2022. Again, avoiding bonds was the more important decision. In a way, upping the stock exposure to 65% is a form of leverage but we are using the alts to "leverage down" as I've described it. The alts are more effective as diversifying equity volatility as we've seen countless times.

I would encourage anyone to do this sort of exploration in portfolio construction. I think the Return Stacked guys are definitely on to something here, I just think that for now, there is better way to incorporate what they are talking about into a diversified portfolio. 

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. 

Opening Day!

And the Sweet Sixteen!

What a great day for sports fans. The Padres game started when the stock market closed and finished in time to start watching the NCAA Basketball Tourney games. A few points today from some interesting articles and other observations. 

Larry Fink, the CEO of client holding Blackrock (BLK) thinks Boomers should help the younger generations figure out retirement. He had other thoughts too that you can read here. I am big on older people setting examples or outright helping younger people. I became most aware of this when we first moved to Walker. I've written about this plenty but my earliest involvement with the fire department exposed me to "older" people still able to get it done physically. My Neighbor with a Backhoe was a great example but there were others. This was in my 30's and I perceived 60's and older has being old. I learned that those ages might be old but they do not have to be. These were great lessons for me.

This sort of example setting can pertain to finances too. This is not about being wealthy so much as having your house in order, setting examples related to saving money effectively, avoiding debt, having an emergency fund and being at least close to being on track for retirement. If millennials and Gen-Z are as lost on this stuff as we are led to believe then I think we can help. We have to be smart enough though to convey help in a way that is not received as intrusive. Starting by setting examples that get noticed is a good way to go. 

Barron's interviewed Cliff Asness from AQR. I don't think the interviewer asked very good questions, it felt like a wasted opportunity but there was one point that I would convey. Many of AQR mutual funds, and other vehicles too I believe, struggled for quite a few years but then turned it around in this decade, give or take a few months. AQR is obviously a very smart shop but they struggled and that happens. There is a school of thought that says buying an active manager when they are struggling is the best time to buy because inevitably they will come roaring back. The psychology of actually doing this is extremely difficult but the bounce back at AQR is good example to support theory.

Mark Hulbert, writing for Barron's found a study that seeks to explain the night effect of the S&P 500. We've looked at this quite a few times, basically, most of the gains for the index occur overnight. The market closes at some level today, opens higher the next morning with that gap up accounting for most of the gain for the day. It's a real thing, it just didn't work for the now closed fund that targeted the effect. That fund had symbol NSPY. The study cited by Hulbert isolated news related to earnings as well as 8-k disclosures which tend to happen outside of market hours. 

This got me to thinking about a new fund we mentioned recently, the Roundhill S&P 500 0DTE Covered Call Strategy ETF (XDTE). It seems like it lags the ProShares S&P 500 High Income ETF (ISPY) every day. I have been test driving ISPY in one of my accounts and it also sells 0dte calls. 

When I first mentioned XDTE I compared it to ISPY noting that ISPY sells calls at 2pm the day before they expire and XDTE sells them right at the open on the day they will expire. The chart is useful, it compares XDTE to ISPY, the S&P 500 itself and I threw in JEPY which sells 0dte puts on the S&P 500. On 3/25, XDTE went ex-dividend for $0.20 but none of the others did so you could add 40 basis points to XDTE's result and see it is still behind the others. 

The other post where I mentioned XDTE was March 8, its second day of trading. I guessed that any difference in performance between XDTE and ISPY would be from the night effect. XDTE can capture it, ISPY cannot. Maybe that accounts for the difference over the last three weeks, or maybe not. The methodology allows XDTE to capture the night effect but maybe as was the case when NSPY was trading, the night effect isn't working. I will continue to follow this one.

And finally a quote from Bill Brewster that resonates and that I will try to work into my quarterly letter to clients. 

I'm not a pessimist, I do expect the market to go up most of the time as it always has. But, as Mark Yusko has said, risk happens fast. The S&P 500 will get to 10,000 at some point but maybe there will be multiple bear markets between here and there or maybe a couple crashes or whatever. To me, it makes sense to spend time understanding the prevailing risks and threats and stay emotionally prepared for any air pockets that come along. The perma bulls like Tom Lee and the guy from Carson Financial add no value. No one needs to prepare for everything going right. 

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. 

Avoiding Overly Sophisticated Portfolios

Let's continue the conversation about all-weather generically and then the Cockroach Portfolio.

First a comparison of the Permanent Portfolio Mutual Fund (PRPFX) versus a 60/40 portfolio comprised of two Vanguard mutual funds. We can test this all the way back to 1993.

PRPFX has a lower standard deviation and it's market correlation is 0.67. You can see over the 30+ years it has lagged by 114 basis points annually. This period is noteworthy.

During the five years of the internet bubble, PRPFX lagged 60/40 by 12%-17% per year which would have been very difficult to endure. Going from 2003, forward which strips out the internet bubble and recovery, PRPFX still lagged by 60 basis points annually and surprisingly, had a higher standard deviation. PRPFX outperformed 60/40 in 2008 by almost 12 percentage points and in 2022 by 11 1/2 percentage points. For the last ten years, 60/40 has blown away PRPFX and the standard deviation numbers for PRPFX in that time were only so so.

In February we built a do it yourself version of the Cockroach Portfolio which is a "derivation of the permanent portfolio" as follows. The funds chosen, allow us to backtest for ten years.

And the results versus the same 60/40.

Back in February, we also backtested it without Bitcoin, and the growth was only 33 basis points annualized. 

Putting 20% in VIXM pretty much doomed that version of the portfolio. The actual Cockroach's allocation to volatility is dramatically more sophisticated than what I did. 

I think 20% into volatility, 20% into managed futures and then 16% into gold is way too much into assets that you don't expect to look like the stock market. Stocks are the thing that go up the most, most of the time. Protection against some of the equity market's volatility makes sense to me but if you neutralize it entirely, you won't get much growth along the lines of DIY Cockroach without Bitcoin. 

Either the Cockroach can't be easily recreated with retail accessible funds (seems more likely) or it is too conservative to grow (seems less likely). That doesn't mean we can't take a bit of its process to inject into our portfolios. Arguably, I've done this with small allocations to volatility strategies. I'd been using managed futures, which Cockroach is big on, since long before I ever heard of the Cockroach.

Circling back to the idea from the start of my blogging days that funds will get more and more sophisticated, democratizing access to strategies that were previously unavailable, I think we can use a couple of newer volatility funds that might introduce better results into today's discussion.

The backtest is ridiculously short but we're working on portfolio theory. Here you can see the makeup of the Cockroach as we mimicked it in February and Cockroach Light which has a much less in volatility funds and 60/40 is Portfolio 3.

We've talked a lot about CAOS and a couple of times about MAXI. CAOS pairs BOX spreads as a cash proxy with a put option overlay. I think they have the cash proxy part of the fund very dialed in but I am not convinced the fund will offer too much tail risk protection, I am curious to see if it ever will. I mentioned MAXI the other day. It owns Bitcoin and it sells option combos on broad and narrow index ETFs. The options strategy should not get in the way of whatever bitcoin does as opposed to the Roundhill Bitcoin Covered Call ETF (YBTC) where the options are bitcoin options which will peg the price of bitcoin and limit gains if/when bitcoin moves up quickly. 

Where we talk about long volatility strategies and short volatility strategies, MAXI appears to be a long/short volatility fund. Owning Bitcoin could be thought of as long volatility and selling options combos is short volatility. MAXI is bitcoin via futures and income from the options strategy. If bitcoin turns out to be a complete scam then MAXI should be expected to go to zero. A percent or two into something that goes to zero is not going to blow up a financial plan even if it would be very disappointing.

That DIY Cockroach, our attempt to mimic the real thing, did so poorly even with 4% bitcoin is surprising. The huge weight to VIXM is probably what did the portfolio in. Cockroach Light outperformed 60/40 by a noticeable amount as a matter of luck probably thanks to bitcoin and the standard deviation is much lower probably due the very large weightings in RYMFX and client holding BKLN. 

In dissecting Cockroach Light, I am not worried about a broad based, equity index fund malfunctioning or somehow breaking. The threat is that occasionally, it will go down a lot. Bank loan funds are mostly lower risk but the space did blow up in 2008. I found two mutual funds that were around back then, EVBLX and LFRAX, that were down 30% and 21% respectively that year. I would not put 30% into bank loans IRL but I've had a small allocation for many years. T-bills instead would be less volatile with a lower yield. Managed futures can be a very challenging hold as we've talked about countless times. The group struggled for many years in the 2010's and we saw a nasty whipsaw a year ago. That whipsaw did not truly break the strategy but was a good humbling for anyone who actually put 20% or more into managed futures off of 2022 hype. BOX spreads used in CAOS are a legitimate cash proxy so as I mentioned that fund's biggest threat IMO is turning out to be an ineffective hedge with a very modest bleed from puts expiring worthless over and over. And finally MAXI which I mentioned relies on bitcoin turning out to be a real thing. 

The category weightings work but I think doing anything along these lines would require more holdings for fixed income and dividing the managed futures sleeve into several different strategies.  

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. 

Random Roger All-Weather 1

In Saturday's post we touched on all-weather portfolios and assumed a lot of overlap with the Permanent Portfolio (PP). All-weather is a term typically associated with Ray Dalio and PP is typically associated with Harry Browne. Both seek out diversification that hopefully results in a robust result regardless of prevailing market events.

All-weather and PP are in Portfoliovisualizer's dropdown choices for portfolios to study. Looking at a reasonably long time frame, All-weather and PP get left noticeably behind 60/40 but not dramatically so IMO. The standard deviation of both is quite a bit less than 60/40. For 10 years, 60/40 compounded at 7.81% versus 5.20% for Dalio and 5.29% for PP. 

The arrows highlight years that would be been challenging to hold. Also you can see that both did fantastically well in 2008 but in 2022 Dalio did worse and PP was down a little less because they are both heavy in bonds which got pasted. If you compare both to 60/40 starting in 2009, stripping out the great year of 2008, 60/40 compounded at 9.54, All-weather at 6.08% and PP at 5.96%. The results, in nominal terms can work, I am not being critical, but going this route will create periods of misery. In 2013, both of them missed out on a very good year and then they've each taken turns completely missing out in other years. If my thesis about bonds' unreliably volatility and less diversification benefits from bonds turns out to be correct, then Dalio All-weather and PP might struggle more often in the future.

Just because bond-heavy might not offer as much protection in the future doesn't mean the high level objective of robust results regardless of prevailing market events or a portfolio in the direction of 75/50  can't be achieved. I think it can.

Apparently Charlie Munger thought that diversification could be had with just three stocks. A common type of portfolio in the Boglehead realm is built on three mutual funds; domestic equity, foreign equity and bonds. With that inspiration, here is a three fund portfolio that back tests with all-weatherish attributes. 

EBSIX is managed futures and client holding MERIX is pretty much a horizontal line that tilts upward no matter what is going on. And the result versus the same variation 60/40 used above.

Keep in mind that in the period available to study, managed futures did poorly. In the ten full years in the study, EBSIX was down in four of them and up less than 5% in two other years. The period isn't that long but a lot happened with the Pandemic Crash where our attempt at all-weather did much better and the worst year was only -0.88% versus -17.06. The CAGR is competitive and the standard deviation is much lower. Included in the results for 60/40 is significant outperformance in 2023. 

VOO is plain vanilla equities. I'm not worried about a malfunction there as opposed to the occasional very large decline. Merger arbitrage could have some sort of problem I suppose but the under the symbol MERFX, which goes back to 1990, the worst year for the fund was 2002 when it dropped 5.67% but during that year it did go down 14% before recovering most of that decline before the year ended. Looking at the Societe Generale website, I can't find a period where equities and managed futures were both down a lot. Managed futures dropped mid teens a few times but not when equities were down a lot. There's a handy slide-tool that starts in 2000 that you can look at. That can only be taken as a proxy but it's better than nothing. 

In 2002, the year that both equities and merger arbitrage did poorly, the SG Trend Indicator was up 28%. Trend and equities would have just about canceled each other out, Trend was up a little more than the S&P 500 was down so factoring in MERFX' decline, maybe the whole mix was down about 5% which looks like would have been the worst year but click through and play around with it and let me know if you see it differently.

I have to say that when I had the idea for this post, I didn't expect to find something that would backtest that well. The idea was to bundle plain vanilla equity, something that would trade with very little volatility like how I think people want their bonds to trade and managed futures. The managed futures sleeve was about capturing something that is mostly negatively correlated to equities but that can still go up. 

In the real world, I would be more comfortable splitting the 40% MERIX sleeve into multiple, unrelated strategies that trade the same way as MERIX. They're out there and we've discussed them plenty here. I also would not consider 30% in managed futures. While I have unyielding faith that the strategy does work over the long term it is pretty clear to me that there are times where the holding does make you want to puke as Jason Buck said. Puking on a 5% weighting is nothing like puking on a 30% weighting. 

I was going to point this post toward "we probably don't want all-weather even if we think we do." Portfolios I manage absolutely have all-weatherish attributes but maybe we do want all-weather. If you think you do, ok but I would encourage using more than three or four funds. I think you could get away with one broad based equity fund for that sleeve keeping in mind that at some point, small cap and foreign will again outperform for an extended time. Obviously I believe in splitting up the negative correlation sleeve and the low volatility sleeve into multiple exposures that take different risks. 

I labeled the portfolio with the number 1, I'll try to work on others and we can compare them in future posts.

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. 

Ergodicity Podcast Notes

Jason Buck who runs the Cockroach Portfolio at Mutiny Funds sat with Rod Gordillo and Adam Butler from the Rational/Resolve Adaptive Asset Allocation Fund (RDMIX) and the Return Stack ETFs for a podcast type of show. It was billed as being about ergodicity and while they touched on it, the conversation spent far more time on other topics. These guys have interesting things to say without being so far ahead me that I can't understand or argue the other side of what they are talking about. It was 90 minutes but well worth the time. This post is just some notes of what they said and maybe a little color from me. 

Line item risk. This is one they talk about a lot, more so Rod and Adam. The context is usually alternatives when they are struggling but I would broaden it out to more traditional holdings like individual stocks or broad based ETFs. How long have small caps been lagging? Continuing to see that in your portfolio and it being a source of frustration is a reasonable reaction, just don't succumb to that emotion and sell out of simple frustration.

If you have individual stocks then you always will have line item issues. There will always be a couple of stocks that are doing relatively poorly. If nothing else, one stock in a diversified portfolio is going to be the worst performer. Recently we looked at a stock that although has been a great long term hold, has had very long stretches where it lagged behind. Giving up in frustration too frequently is likely to end up in chasing heat which will probably end badly.   

A thought from me is that there is emotional freedom in realizing and accepting that some holdings will do poorly. Where alternatives are concerned, Jason referred to them sometimes as holdings that make you want to puke. That's probably a good way to think about it unless you have a three fund portfolio. 

Ergodicity. Their discussion here didn't resonate with me at all. The simplistic investing application is that the stock market is going to move to the upper right at some rate over the long term, really the intermediate term. The more active you are in terms of trading, the more you fight against that ergodicity working for you. A little more technical is that like a Monte Carlo simulation, there is essentially an infinite number of possible market outcomes in our respective lifetimes. The vast majority of which result in the market moving to the upper right. 

Holding bonds. If I understood correctly, the Cockroach Portfolio holds bonds. The take from Jason is that bonds are part of any diversification strategy, or he thinks they should be. Ehhh, ok, I guess. He's technically correct but I've been banging the drum for many many years about the elevated risk in bonds which has now transitioned into maybe a little less risk because prices fell so much toward having increased volatility (see the MOVE Index) that I have been describing as unreliable volatility. We've looked at countless ways to get the effect of what people hope bonds will do without taking on bonds' unreliable volatility.

Derivations of the Permanent Portfolio. Jason made this point. He said we're all running derivations of the Permanent Portfolio (PP). The Cockroach certainly is. I think we've made the same point here a couple of times but it was interesting to hear him say it. The origins of his very sophisticated portfolio has very simple roots. The PP allocates equal 25% portions to equities, long bonds, cash and gold. The idea here is that no matter what is going on in the world, at least one of them will be doing well. There is a mutual fund with the same name that has symbol PRPFX which is pretty true to PP even if not exactly so.

Tail risk strategies. The idea of tail risk is very appealing but implementing it hard to do. In theory, tail risk sits on cash and a little bit in put options. When markets go down, the puts go up and offsets some of the decline in the rest of the portfolio. Part of the difficulty is that puts that are bought will expire worthless if market doesn't drop before expiration resulting in a slow bleed. The Cambria Tail Risk ETF (TAIL) has bled in this fashion over the years. 2022 was problematic for TAIL because it was long treasury duration for it's cash holding which overwhelmed the put options causing the fund to drop 13% despite the nasty bear market that year.

Jason told an anecdote that in 2022, one of the tail risk managers he uses for the Cockroach was up 35% while another was down 25%. Recently the Simplify Tail Risk ETF (CYA) closed for essentially being a failed fund. I believe the way the fund used debit call spreads on the VIX as opposed to buying index puts caused the failure but I haven't seen anything from Simplify to corroborate that theory. 

They made a point that we've made here which is that tail risk might work better for crashes and managed futures might work better for bear markets which tend to be slower than crashes. A contrarian thought from them, "tail risk is now as cheap as it has ever been" because if how low the VIX is. I wonder what sort of signal that might be sending. For now, the Alpha Architect Tail Risk ETF (CAOS) might be the best shot for adding tail risk via a fund. We've looked at it several times and so far, I'm not convinced it will go up when stocks drop. It is a combination of Box Spreads and an actively managed put option overlay. I am pretty sure they've figured out avoiding the erosion effect that has troubled TAIL but based on how it has traded, I haven't seen it "work" as hedge. Maybe the next event will be different.

Social risk. Both RDMIX and Cockroach, being derivations of the Permanent Portfolio are also then some variation of all-weather. Neither one will look like the market very often. When the market is going down, that is a good thing, for the last 15 months or so that is a very challenging thing. Rod told a story (more of an investing parable maybe) where he was at a dinner party and one person was heavy into long equity and doing great, someone else in real estate doing great and so on. Meanwhile, Rod is sitting in RDMIX which was down 46 basis points in 2023 and is up 4.46% so far this year. Of course RDMIX did relatively well in 2022 down 3.06% but he said the circumstance was difficult. He had nothing to brag about. 

I'm going to write a full blog post on this point but thinking you'd be happy with down a little in 2022 and up a little in 2023 is different than living through that result. All weather is not 75/50, 75% of the upside with only 50% of the downside, it typically smaller swings than that. Down 2% in 2022 would have been great but what about up 5% last year and then flattish so far this year? I'm not bagging on that sort of result, I am saying it is emotionally challenging to actually endure. My blog post will be about all-weatherish, building all weather ideas into a portfolio not having the entire thing be all-weather.

No dignity in buying mutual funds. That was a great one-liner from Jason. He noted that everyone wants ETFs but there are limits on what can be done in ETFs. We've made that point many times. Most things can be done in ETFs of course and when the comparison is truly apples to apples, the ETF is going to be better but the reality, and beyond the scope of this post, is that not everything works well in an ETF wrapper. From the start of my blogging I have been saying that it is not logical for ETFs to be the single best exposure for every segment of the market and that is still the case. Mutual funds may be dying a very slow death per the FT but they're not dead yet and if a mutual fund is the best way for you to add a specific exposure then use the mutual fund. 

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. 

A Leveraged Covered Call Fund?

Of course, the stock market is off to a very good start this year. I write all the time about managed futures as a diversifier and being able to live with the reality that managed futures will probably struggle when stocks are going up. The space languished for most of the 2010's. This year is kind of an anomaly so far. Stocks are up and so are a lot of the managed futures funds. 

The black line is the S&P 500 and the rest are a sampling of managed futures mutual funds and ETFs. The fund I use is smack in the middle of the pack. The group did fantastically well in 2022 of course when equities and bonds cratered. In 2023, many in the group were down modestly, due in my opinion to a vicious whipsaw in the treasury market last March that they didn't recover from. 

I talk all the time about small positions into diversifiers like this one in case something goes wrong. That whipsaw was a perfect example. One interesting note is that the pink line fund that has done the best this year by a wide margin was the worst performer last year by a wide margin. 

The Miller Value Partners Leveraged ETF (MVPL) might turn out to be a wild one. At a very high level, the fund will use very short term signals to rotate from being 100% SPDR S&P 500 (SPY) or 100% in the ProShares Ultra S&P 500 (SSO). So it will either be 100% or 200% in equities. The Miller in question is Bill Miller's firm but it looks like his son is the lead manager.

Miller the elder made his bones at Legg Mason a while ago with a very long streak of beating the S&P 500. The tide sort of went out on him when the internet bubble popped and then again in the financial crisis. He's also been in the news for betting heavy on Bitcoin and making a fortune. The negative take on him would be that he is a bull market genius, the positive take on him would be that he is a gifted risk taker able to emotionally wait out periods of huge declines. 

There is nothing defensive about the fund. 100% long isn't defensive. The stock market goes up most of the time so I am guessing the return will be positive most of the time but that doesn't necessarily mean the fund will meet whatever objective they actually have in mind. I would also guess that in a down trending market the fund might have to lag. If at any point it is long SSO as the market goes down then it would lag and it seems plausible that it will at times be wrong footed in either SSO or SPY.

There are at least two risks here beyond equity exposure. One is whether the signal they are relying on will work the way they hope and there is the tracking risk of the 2x fund. We've looked at SSO's tracking quite a few times before. Most of the time it has been sort of close but there can be no certainty about how it will track in the future and "sort of close" is obviously very subjective.

The fund just came out on Feb 28th. It's initial impression certainly could be worse. 

Yesterday, I poked a little fun about stacking investment fads. Well here's another one in a filing from Direxion with a hat tip to Eric Balchunas.

Eric reports that these will be 1.5X the JP Morgan covered call funds which are actively managed. We'll just look at the first one which will be 1.5X the JP Morgan Equity Premium Income Fund (JEPI). JEPI is fairly new, had great performance in 2022 and lagged the S&P 500 by varying amounts in every other year it has existed. 

Although JEPI's history is too short to draw a solid conclusion, since it's inception in 2020 it has kind of been a 75/50 fund meaning it has captured about 75% of the S&P 500's upside with only 50% of the downside. The numbers aren't exact but is in the neighborhood. For anyone new, 75/50 will outperform over the long term with less volatility. Most of JEPI's success though is attributable to 2022 when it outperformed the S&P 500 by 1466 basis points. 

The above backtests 1.5X JEPI back to JEPI's inception. The proposed 1.5X JEPI backtests very well. It had a higher CAGR than the S&P 500 with slightly less volatility. It did outperform the SPX by a lot in 2022 of course but it also outperformed in 2021 and for the seven months in 2020 it only lagged the S&P by 104 basis points. 

If 1.5X JEPI ever lists then I think there is a capital efficiency angle to the fund that we could explore. I put the following together. The 90% in JEPI would really bein 60% in 1.5X JEPI which works out to 90% covered call, 10% managed futures and 25% in T-bills. 

Obviously the concerns I mentioned above are still relevant but the result would have had very low volatility, 75% of the upside and a lot of cash set aside for sequence of return risk. It is another example of leveraging down as I like to describe it, using a capital efficient fund to build a full portfolio in a smaller portion of the portfolio and instead of adding on top, leveraging up, we can build in a large cash buffer. 

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. 

Investment Fad Stacking?

Do you like Bitcoin? Do you like trend following? Well Global X has a new fund that combines both. The Global X Bitcoin Trend Strategy ETF (BTRN) owns Bitcoin but will change the exposure ranging from 0%, 25%, 50%, 75% or 100% based on a secret sauce combination of exponential moving averages of varying lengths. Anything not allocated to Bitcoin will be in a Global X T-bill ETF. 

The index methodology sheet says "based on the average of the four exponential moving average calculations" and talks about a scoring system to determine the current bitcoin weight. Page 3 of the prospectus includes "...at each scheduled rebalance date..." 

My first reaction to this is that Bitcoin might move much faster than any sort of blended moving average signal and that is I what think they are doing, blending the four m/a signals together. As Mark Yusko has said, risk happens fast. That is true in both directions and very relevant to Bitcoin. It can move 10% in a day or two "just to stay in shape." 

If you have an interest in speculating on Bitcoin, or you're a true believer it might make more sense to avoid funds that get in the way of capturing the full effect. A futures based fund might have a small tracking error which is not what I mean. The Roundhill Bitcoin Covered Call Strategy ETF (YBTC) is very new, but right out of the starting blocks does not look like Bitcoin. Where BTRN is trying to "minimize downside risk" there's a good chance it won't look like Bitcoin either.

One fund that might not get in the way of capturing Bitcoin's effect is the Simplify Bitcoin Strategy PLUS Income ETF (MAXI). MAXI owns Bitcoin and sells options combos on equity indexes to layer an income stream on top of the Bitcoin exposure. I've mentioned MAXI before. I said it sort of tracked Bitcoin other than a very large payout at the end of 2023. 

BITO is the ProShares Bitcoin Strategy ETF. MAXI pays $0.15 every month except in December when gains are accounted for. It paid $4.18 for 2023 which might be a big tax bite depending on the end user but add that back in and MAXI is arguably a Bitcoin proxy with yield. I've bagged plenty on Simplify before but this fund doesn't seem like a failed product.

It is almost a long/short volatility fund. It buys volatility via Bitcoin and sells volatility with the options overlay. To be clear, it is not selling options on Bitcoin so the options strategy should not impede access to the full effect of Bitcoin. The risk here, beyond the obvious of Bitcoin dropping 70 or 80% again is that selling equity volatility can go badly in a bear market. Yes, it is spread off but some of the spreads are very wide. 

Someone wanting the full Bitcoin effect might not want BTRN or YBTC but what about the attributes they do provide. I have to believe that BTRN will deliver some of Bitcoin's volatility. At times it can make sense to increase or decrease portfolio volatility. Doing so with one trade allows for changing the volatility profile without a lot of portfolio turnover, just one simple trade. 

The above surprises me. Will Bitcoin evolve to have a closer correlation to equities? If it was as high as 0.75 before it can get there again. If BTRN turns out to be half as volatile as plain vanilla Bitcoin, it will still be much more volatile than equities, so a possible way to add volatility with one trade without the line item risk of full boat Bitcoin if BTRN works as advertised. 

Similarly with YBTC which is the green line in the first chart. It hasn't captured Bitcoin's volatility but it is more volatile than the S&P 500 and it is harnessing Bitcoin's volatility to generate a high yield. A small slice of the portfolio that adds a little volatility and a little yield into a portfolio isn't a terrible idea. If a 2% weight into one of these things goes to zero, tisk tisk it was a bad trade but clearly not ruinous. 

I use the word proxy all the time as in some fund is a proxy for equity exposure or the covered call funds we look at are not proxies for the S&P 500 and so on. That word has been a crucial part of my process for portfolio construction for my entire career. MAXI might be a proxy for Bitcoin, I don't think BTRN or YBTC will be proxies for Bitcoin but they can be proxies for other things is the point. This highlights the benefits of being curious enough to explore new funds even if the odds of actually using them is very low. 

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.

Spitznagel's Prediction? Doom

Amy Arnott from Morningstar wrote Top 10 Things To Know About Building A Diversified Portfolio. There are some good ideas here, some of which we've covered before like no way of knowing what segment of the market will be the best performer, this pertains to individual holdings too, that REITs aren't great diversifiers but there is absolutely a place for the attributes of higher yield and lower beta and she also touched on alternatives. 

She said when it comes to diversification, not all liquid alternatives are the same. Maybe I am selling Morningstar short but I am pleasantly surprised that they acknowledge that alternatives can play a role in a portfolio. I agree with their point here but I think it could have been expressed a little more plainly. If you are going to use alternatives, it is crucial to understand the strategies well enough to know what they will and won't do. Merger arbitrage is not likely to go up when stocks drop a lot, it is likely to be flattish. Over time, if the fund is executing well, it should go up slightly most of the time with very little volatility. You'd have to look elsewhere for alternatives that provide a good chance of going up a lot when stocks drop. And of course, the thing that goes up a lot in down markets will probably go down in up markets so you don't want to be too heavy in that type of alt because stocks go up most of the time. 

Business Insider had a quick writeup on Mark Spitznagel's call for the "worst crash since 1929." When rates were low, a flood of debt was issued and now that rates are up it has created a debt bubble that will pop at some point, by his reckoning, after an even bigger run up for equities into a state of euphoria and then whoooooooosh. 

So he is basically laying out a serious risk factor and hyping it up some by referring to 1929. Most of us have been through two episodes of the stock market cutting in half and several other 20-30% drops. There will be future such events and maybe Spitznagel will turn out to be exactly right but what happens after that? The market stops going down, begins to work higher and eventually makes a new high. I've been saying that forever, it has always worked out that way and if you don't agree with me that it always will work out that way then you might want to sell right now at the high and never buy stocks again.

As opposed to trying to guess when the next market event will happen, I would rather maintain exposures to holdings that should go up when stocks go down, holdings that should trade like horizontal lines no matter what is going on and have enough cash set aside to meet clients' expected income needs. Knowing, your income needs are secure while the market is crashing, there will be future crashes, is very empowering. 

On Wednesday I sat in on a presentation about the NEOS S&P 500 High Income ETF (SPYI). It's another covered call fund whose strategy is to buy all the underlying stocks and sell index options against the basket of stocks. They are capturing favorable 60/40 tax treatment on the options and a lot of dividends from the stocks are qualified. They said this methodology gets the after tax yield up into the mid-eights versus a six handle yield from competing strategies. I am relaying what they said, you can talk to them for more details. The fund is actively managed which allows them to stagger the strike prices of the calls they sell and to not cover the entire portfolio both of which they say allows for better upcapture than something like Global X S&P 500 Covered Call ETF (XYLD).

Well not always but still. 

In trying to study these, it is clear to me they are not going to look like the S&P 500 on a price basis and even in the SPYI powerpoint, it didn't really look like the S&P 500 on a total return basis. Since SPYI's inception though, the S&P 500 is up a lot which doesn't allow for down market or flat market assessments which would be relevant. 

The following comparison is interesting.

JEPY sells 0dte put options. In an email from Defiance when they started to list this strategy they said these put selling funds should look like covered call funds. So far it is certainly meeting that expectation which again means not capturing the return of market cap weighted equities. There is some price appreciation on a total return basis (need to reinvest most or all of the dividends) and the standard deviation has been much lower so far. I'd like to see a bear market test to feel more confident in that observation though. 

Can the attributes of the options funds (derivative income funds) be combined with other things to create a result that is competitive with a plain vanilla 60/40 portfolio but avoids bond market volatility? 

Obviously the answer is yes. We could play around with quite a few different ideas but for now, the one above, blending SPYI with Standpoint Multiasset (BLNDX/REMIX) which is a client and personal holding give a result like I described above. Again, it is not a proxy for the S&P 500 but it seems like a reasonable proxy in the very short period available to test for 60/40. It gives up some growth which would compound to a big difference if the numbers stayed consistent (big if) but with significantly less volatility than 60/40. 

I think the attributes here are desirable but IRL it would need to be built with more holdings than just two in case something goes wrong for a year or two which could happen with any sort of alternative strategy. 

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. 

They're Coming After Covered Call Funds

Bloomberg had a fun article looking at whether the boom in hedge fund trades and ETFs that short volatility one way or another might cause some sort of negative stock market event. There have been volatility events before. The 1987 crash was partly attributed to selling portfolio insurance and there was the so called Volmageddon of 2018. The former was about selling index futures and the latter was about shorting the VIX. 

Events don't repeat but the can rhyme. 2018 was not 1987 and if there is another event where volatility ends up being a major determent then it will be different than the other two but with some overlap. The behavioral overlap might be complacency. The strategic overlap might be a sophisticated tactic of selling a derivative of the market. 

One interesting number about "derivative income" ETFs from the article was that in 2019, before the very popular JEPI ETF listed, they has $7 billion in AUM and a the end of 2023 the space had grown to $75 billion. The growth begs the question as to whether all that additional options selling is compressing volatility. A squeeze like that could compress volatility which could contribute to a sort of complacency that isn't bullish for markets. 

The article seemed to go back and forth about the role these ETFs might play here and what the fallout might be to fund holders. The $75 billion number is not something I would worry about. Using terminology I've used a few other times over the years, if anything, "derivative income" funds are a mania, not a bubble. Manias can end badly for the space in question but bubbles are all encompassing like the internet bubble and the real estate bubble. 

The risk of selling covered calls is nothing like shorting the VIX and don't have anywhere near the leverage that index futures do. Covered call funds are marketed as lower volatility but with market upside and income. The market upside doesn't seem to work out so well with funds that sell monthly calls which is most of them. In 2022, the bigger ones did go down less than the S&P 500 which was down 18%. That year JEPI was down 3.5%, PBP was down 11.8% and XYLD was down 12%. In 2023, they were up less than half what the S&P 500 gained. 

2022 was more of a slower bear market and the promise of going down less worked out. If there is a volatility-caused crash, crashes are much faster and snap back much faster, then covered call funds may not soften the blow. The underlying basket of stocks will go down the same as plain vanilla market cap weighted but then because of how the monthly calls are sold, they may not capture the snap back.

The above is the Pandemic Crash of 2020. The covered call funds may have gone down a little less, but not much less and they did not capture the snap back. You can see where calls were sold at the start of April, PBP and XYLD traded sideways.

The crash at the end of 2018, above, was the same story.

The third chart is the same three ETF with the VIX added to capture the VIX spike that came to be known as Volmageddon that took out a couple of short-VIX ETNs. It is tough to see but the covered call funds didn't help much in the decline, they didn't make the decline worse though. None of these events were worse for the covered call funds. The snap backs were worse in two of the three instances. In the Volmageddon, the snap back wasn't immediate, stocks took another leg down and so it took a bit longer for the covered call funds to start to trail off again from VOO. 

Bear markets and crashes come along every so often. That will not change going forward. I don't believe selling calls poses additional risk beyond whatever downside risk goes with market cap weighting. If the S&P goes down 30%, sure covered call funds could do a little worse, or better, but they are not going go down 50 or 60% in a down 30% world. If the S&P cuts in half again, these will too but again, that would be inline with market cap weighting. I also would not expect them to be down only 10% in a down 50% world either. Great if it happens, JEPI did outperform by a ton in 2022, but I would not expect it. 

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. 

Are Retirement Savers Doomed?

Kerry Hannon from Yahoo interviewed Teresa Ghilarducci who is a professor at The New School and is often cited in the media as an expert on retirement. We've mentioned Ghilarducci a handful of times over the years. I think she has interesting ideas even if I disagree with most of them. She appears to be a big believer in having the government play a very big role in solving the problem.

There clearly is a problem, that much is certain. We are grossly undersaved and there's not a lot of visibility for how it will work out. Layer on top of that the threat of some sort of reduction in Social Security payouts starting sometime in the mid-2030s. 

She has a lot of ideas about what should be done which are again very government-heavy. I think everyone could get on board with one of her ideas which is that the taxation on Social Security should be cut. She doesn't believe that people should have to work beyond a certain age, different story if they want to, but we shouldn't have to. 

Ghilarducci is very critical on the shift 40-ish years ago that took the onus off companies and defined benefit plans and transferred the responsibility onto the worker with defined contribution plans. There is a reasonable criticism here that employees haven't been given the tools, via workplace education, to be up to the task of managing their 401ks and then knowing how to decumulate effectively. If it is true that the problem is worse now than it was 50 or 60 years ago when more people were pension eligible, yes it is up to us to solve our own problems, but if collectively we are not solving our problem then the criticism is reasonable. There can be both serious shortcomings and fantastic success stories with 401ks. 

Of course, if you read the article, read the comments too. Always read the comments. Most of the comments filtered into two camps, one was the government should stay out of it and people who did all the right things and retired in their mid-50s.

The government is going to get involved at some point. That's not my endorsing the idea, I'm saying it is going to happen. There were comments about means testing Social Security which I first mentioned ages ago at the first iteration of my blog. And I think means testing will come down to an income/net worth level that isn't very high. If you think that is unfair, you're right, but I wouldn't bet against that outcome.

I've read a couple of things over the years that say a cut to Social Security won't be what most people think it will be. There won't be some random date where everyone gets a 23% reduction. If you're getting SS now, you're not go to have it cut. Anyone taking before the drop dead date won't have it cut. It might not even effect people born in the 1970's. The people who will be subject to a cut will have a long runway to figure it out and adapt. Again, I am passing on conclusions from others that I've read so hopefully, if cuts have to come, that turns out to be correct. I would not apply this thought to means testing. If they go that route then I think that would be aggressive and unfriendly for people who've done the right things.

The idea that the government will screw it up if they intervene resonates somewhat but my primary reason for not wanting the government coming in a big-footing us is that I think people who wait around for the government to "fix it" may never see it happen. The idea of waiting for anyone, government or otherwise, to solve my problem without my giving the full effort goes against everything I believe in. I don't want the stress, aggravation or sense of lost time by sitting around hoping someone else gets it right. That seems like a miserable way to live. 

There are so many things that seem to be broken or are at risk of an unfavorable (for people who did the right things) outcome which is why I've talked so much about having a Plan B or Plan C and developing a third income stream beyond SS and portfolio income. 

One final point about working longer. One commenter said something about working until 70. I was not sure if he was saying he has to or wants to. Someone replied saying he'll never be able to do it. That might be overly negative but anyone who is 60 and thinking "yeah, I gotta keep working until 70" is hopefully putting some effort to stay healthy and at least moderately fit. I've used the phrase "life becomes much easier when you...." and one of the references is staying fit. Working until you're 70 out of need becomes much easier when you're fit too. It may not work out but I would not feel regret if I tried and it didn't work out. We can control the input, not necessarily the output. Putting in the work increases the odds of favorable outcomes even if that work can't ensure favorable outcomes. 

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.

Volatility Funds Continue To Thrive

If you've been reading this site for any bit of time you probably know my intrigue with volatility as an asset class or strategy and the various types of funds that try to harness volatility. The space is being hit with a lot of new products and I am having a ton of fun looking at these new funds. We've got several more to look at today and I'll talk (again) about how I've incorporated volatility into client accounts.

A few weeks ago the ProShares S&P 500 High Income ETF (ISPY) launched. I am test driving a few shares in one of my accounts. ISPY is a covered call fund that sells calls that expire tomorrow. As explained to me, every day between 2pm and 2:30 it sells call options that expire the next day. Its first monthly dividend was $0.48 and the second one was $0.31. I manually reinvested the first dividend. Because of the lower second dividend I won't reinvest that until the third dividend pays.

The lag for ISPY isn't quite as big as the chart shows when you factor in the dividend but the upside is still being capped because of the call writing. I believe the strategy will allow for more upcapture of the index than something like Global X S&P 500 Covered Call ETF (XYLD) which sells monthly calls. ISPY will probably offer long term growth but at this point I doubt it will really look like a much higher yielding version of the S&P 500.

I mention ISPY because a new fund does something very similar. The Roundhill S&P 500 0DTE Covered Call Strategy ETF (XDTE) also sells one day options but does it a little differently. Instead of selling at 2pm the day before expiration is sells first thing in the morning options that expire that day. It has no covered calls overnight. If you believe in the night effect, XDTE will capture it while ISPY will not. The night effect came from a study that showed the vast majority of the gains in the S&P 500 come overnight, the market opening higher than it closed the day before. There was an ETF that targeted this effect and of course Murphy's Law, the night effect didn't work very well during the fund's life and the fund closed. I'd expect the "yield" of XDTE to be less than some of the others but I do believe in the night effect and maybe it will have better upcapture than the others.

The newly listed Defiance S&P 500 Income Target ETF (SPYT) offers yet a different take on 0dte options. It will sell not covered calls every day but call credit spreads targeting a 20% "yield." Specifically, it owns S&P 500 ETFs and every day will sell a call and buy a call with a higher strike, that is the credit. I tend to be curious about all funds but not this one. Buying calls reduces the "income" available to distribute and doesn't really protect against a whole lot for just one day. The underlying index isn't too likely to go up 10% in a day. The underlying index isn't too likely to go up 5% in a day. How frequently does the S&P 500 go up 3% in a day? The long call in the spread is trying to protect against price appreciation being capped by a big rally. That might make sense for a month or longer but I can't figure the value on a daily basis. 

A few weeks ago we talked about Bitcoin covered call funds and Roundhill has one of those too with symbol YBTC. It is very new but we can get a little sense of it compared to iShares Bitcoin ETF (IBIT).

YBTC looks like it is synthetically long Bitcoin by going long a call and short a put and then it sells call options that are shorter dated. It has already paid out two monthly dividends totaling about 6% of the $50/share that the fund started at back in mid-January. So on a total return basis it is up close to 20%, far, far behind the 64% that IBIT is up. YBTC is certainly harnessing volatility but even adding the yield back in, it isn't a proxy for Bitcoin on the way up. On the way down, the calls wouldn't make it worse but if Bitcoin again goes down 70 or 80%, this fund shouldn't be expected to do much better. 

Kind of related, there is a YieldMax covered call, single stock ETF for Microstrategy. The symbol for the common is MSTR and the YieldMax fund is MSTY.

Again the covered call fund doesn't really track the underlying. It hasn't paid out a distribution yet, MSTY's price has just been capped from keeping up with the common because of the covered calls. If you are unfamiliar with MSTR, the CEO has become one of the loudest Bitcoin touts, turning the company's stock into a Bitcoin hedge fund. It made news this week that it was again selling convertible securities to buy more Bitcoin. It has done this several times before. I don't know if they did this when Bitcoin was down a lot, Barron's said they did it before at $50,000.

I am not in any way suggesting doing anything with Microstrategy. I don't really understand how it is ok for a CEO of a publicly traded company to turn that company into a Bitcoin proxy. How is there not a governance issue? He has leveraged up the company to buy more and more Bitcoin. He could be a tout without leveraging the company in this way.

Hopefully, throughout this post anytime the word yield was used, I put it in quotes. As we've looked at quite a few times, many of these funds don't keep up with the yield and on a price basis they go down. Spending the entire yield, spending even most of the yield is probably a road to zero at some point, not for the funds, they will reverse split as the YieldMax Tesly ETF (TSLY) recently did but for an investor's position.

I've mentioned that I am also test driving the Defiance NASDAQ 100 Enhanced Options Income ETF (QQQY) which sells 0dte puts. I bought 100 shares on the first or second day in Mid September for a total of $2017.00. I've manually reinvested each dividend such that I now have 132 shares with a value of $2180.64. In the almost six months the price of the fund has gone from just over $20 to closing at $16.52 on Thursday. Based on price alone, the fund is down 18% in six months. If I was taking out the dividend and spending it, the position in my account would be down 18%. The total return though is 8% which annualizes out to 16% +/-. In that same six months, the underlying QQQ is up 20% so QQQY, is not up even half of what plain vanilla QQQ is. 

These options funds are proxies for different things. With QQQY/QQQ, the options fund does have a much lower standard deviation per Portfoliovisualizer, at 9.85% versus 16.59%. Is that worth anything to you? Should it be worth anything to us? Maybe. Where I did not expect QQQY to be an equity proxy, I am happy with it so far but would like to see how it does in a downturn that is more meaningful than what we've had since the fund came out. 

Back to Bitcoin volatility. I think there is a way to sell Bitcoin volatility in a manner that any such fund doesn't get destroyed. A Bitcoin volatility fund could spread off the risk, use very short term options that are far out of the money. I've disclosed using Princeton Premier Income Fund (PPFIX) for clients. It is a volatility fund, it sells weekly puts that are very far out of the money. I've used the analogy of picking up pennies a mile and half in front of a steamroller as opposed to picking up nickels and dimes right in front of a steamroller. For a while I used a long volatility fund has a hedge, it tracked medium term VIX futures and its negative correlation to the equity market was pretty reliable. 

I will continue to study this. The work and willingness to experiment with very small dollars in my account helps me to work through the things I write about which is how I filter the few things that actually make it into the portfolio. 

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.