The Importance Of Diversifying Your Diversifiers

Bob Elliott who runs the Unlimited HFND Multi-Strategy Return Tracker ETF (HFND) wrote a blog post that could be summed up as diversifying your diversifiers but anchoring your alts bucket around managed futures will get the best result. He referred to the non-managed futures alts at "diversified alpha" but never specified what strategies to include with managed futures.

This has sort of been my positioning. Diversify your diversifiers certainly, although if Bob was saying to anchor around managed futures, my preference is managed futures being one of potentially a few alts.

Mutiny Funds put out a paper on the hows and whys of using alts for The Cockroach Portfolio that they manage and that we've looked at a few times. It is very worth reading with a couple of points really standing out to me.

The Cockroach has a 25% target allocation to equities inspired by the Permanent Portfolio (PP) but also because over longer periods than are typically studied, they have found the "greater probability of loss a and lower returns over 30 years than commonly believed." They studied 1841-2019 and I am sure they are looking at the data correctly. I've seen other studies that go back further than any reasonable definition of modern times. I don't put stock into data sets that include the 1900's. It is fun history to look at but I can't get to the point of applying lessons from the banking crisis of 1878 to investing today. Fun note, the 1878 banking crisis was mentioned in an episode of Deadwood. 

One fascinating point looked at getting great market returns later in your accumulation period versus earlier. This is in the neighborhood of sequence of return. Picture retiring in 2010 versus 2020. The S&P 500 was down 22% for the 10 years ending 1/1/2010 while the ten years ending 1/1/2020 it was up 189%. Getting that 189% between ages 50 and 60 will be far more impactful than between 25 and 35.

Mutiny makes a point that I've been writing about and have embedded into my process since 2004. Their wording, "investors should not only aim for strong compounding growth but also seek to mitigate large drawdowns and periods of low returns." 

This is what 75/50, getting 75% of the upside but only 50% of downside, is all about. Actually achieving 75/50 is no easy thing but the idea has influenced my process for 20 years and apparently Mutiny for the years they been around (less than 20 years). When you avoid the full brunt of large declines, your recovery doesn't have to be as big to get back to trend. 

Both Cockroach and PP are built around having at least one thing doing well no matter what is going on in the world. This is important. If everything goes up together then it is likely to go down together too so you might have diversified issuer risk but not market risk. As we say all the time, whereas stocks are the thing that goes up the most, most of the time in the modern era I would want more than 25% in equities for anyone needing normal stock market growth for their retirement plan to work. A 50 year old with $10 million happily living a $150,000 lifestyle might not need more than 25% in equities but that's not most people. 

Mutiny makes heavy use of managed futures (trend) and while I don't know the extent that Bob Elliott does, his post above certainly focused on it. The S&P 500 is off to a good start this year and interestingly so too are most managed futures funds.

The negative correlation between the two has been pretty reliable, I don't take for granted it is infallible, so this year is just one of those things maybe. I think fixed income continuing to trend lower in price and commodities continue to do well is helping the space. ASFYX is a client and personal holding. Looking back, 2014 is the only year (available to backtest) where equities and managed futures were up similar amounts. Every other year, 2011 forward, the returns were pretty different with the negative correlation standing up more often than not. 

Tying it back to diversifying your diversifiers, I think the way to do this is to understand the correlation and volatility attributes of various diversifiers. Obviously you also need a basis to believe the strategy will work. The short lived Simplify Tail Risk ETF (CYA) was an example of one that didn't work. 

Portfoliovisualizer has a correlation tool that is very handy in this context.

There's all sorts of information here. The range here of correlations is pretty wide along with different volatility profiles. There are expectations embedded in these numbers. Merger arbitrage has been a pretty reliable way to reduce portfolio volatility and act like how investors hope fixed income will act. It's not going to go up a lot when stocks drop a lot. There is use for MERIX' combo of attributes as long as you have the right expectations. MERIX, PPFIX, BTAL are client and personal holdings.

BTAL goes long low beta and short high beta. That has the effect of not looking like the stock market very often, the correlation has been reliably negative. It is up 6% this year though and was up for much of 2018, taking a different path to a similar result before tailing off in October of that year. If stocks are up a lot, BTAL could go down a lot is the right expectation to have.

I've been consistent about wanting to use diversifiers in small doses for the hopefully rare occasions that a specific strategy doesn't work when it is most needed. Markets can whipsaw faster than the signals that most managed futures funds use. We saw that in March, 2023. That was not calamitous but it did make for a tough year for the group. Abrupt changes in interest rates can impact other alt strategies in other ways. With most funds being free to trade, or almost free, there's no need to make a disproportionately large bet on just one alt 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.