Saturday, March 23, 2024

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. 

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