Blending Tail Risk and Asymmetry

Let's do some crazy stuff with this post....crazy.

I've been thinking about the Alpha Architect Tail Risk ETF (CAOS) that we wrote about the other day. As I mentioned, I am not sure whether it would actually go up if there was a serious, fast-ish decline. It very well could work but it hasn't been tested yet. I do believe it can function as a short term cash proxy if nothing else that might go up like a tail risk strategy when the next meaningful decline happens. I don't think the risk to holders from the option strategy would be ruinous. 

For purposes of this post we'll give it the benefit of the doubt, cash proxy most of the time and tail protection when the market drops a lot. The cash proxy, might be tail risk too reminded me of Nassim Taleb. He is some sort of advisor to Universa Investments which specializes in tail risk protection. He's written and talked about tail risk frequently. It's an interesting idea and if CAOS turns out to not be the answer, maybe something else in the future will be. 

Another concept that Taleb has written many times about is asymmetry. Starting back in 2007 or 2008 I wrote about his barbell portfolio idea that goes very high risk with 10% of the portfolio in search of asymmetric returns and then very conservative with the other 90%. The returns generated from the 10% could almost be enough for the entire portfolio. Think in terms of putting 10% into a stock that doubles, the stock would be up 100% which would be 10% for the overall portfolio, plus whatever yield the conservative 90% could bring in. 

Here's an example of the effect.

Of course it is backwards looking and cherry picked. The narrative is not "all you need to do is pick a stock that doubles." There are lessons here though for how to allocate to higher risk, higher volatility which is not so far removed from reality. Chances are if you go to the sector level in your portfolio construction, you're not expecting huge gains from the staples sector but it is reasonable to expect the best chance for adding performance to your portfolio will come from tech, discretionary or maybe a couple of others. Things like staples and utilities tend to be lower returning, higher yielding. 

So back to Taleb's ideas of tail risk and asymmetry. We'll use CAOS for tail risk and what has more asymmetric opportunity than Bitcoin? Maybe Bitcoin goes to zero or maybe it goes to a bazillion.  CAOS only has about a year of track record but that's ok, it's just a blog post. 

The numbers for Portfolios 1 and 3 add up to 105% because I am replicating 5% into a 2x bitcoin fund. There's at least one, the symbol is BITX, it is just a few months old so we can't really backtest it but it is form of capital efficiency that someone could implement if they wanted.

Portfolio 1 is full blown Taleb-concept with 95% in tail risk and 5% in 2x bitcoin. Portfolio 3 is more of a diversified portfolio. I believe uranium miners to be somewhat asymmetric. The time period is too short to be useful in any way but it is interesting. 1 and 3 dramatically outperformed with much lower standard deviation and the Sharpe and Sortino are meaningfully higher than 60/40.

Since CAOS hasn't had a real test of going up in a serious decline, if we replace it with more T-bills to get a longer backtest, the results are similar.

It only goes back to 2018 because in 2017, Bitcoin went up an amount that may not be repeatable. Portfolios 1 and 3 both concentrate the risk into narrow slices of the portfolio.

I've told the story 100 times about my first exposure to what is now called capital efficiency. When I worked at Fisher Investments 22 years ago, there were a couple of guys who were fascinated by the idea that for a stretch, 2% allocated to short Nikkei futures equaled the return of the S&P 500. I don't know if they were right but it is a great example of the barbelling that Taleb used to talk about. market like returns with very little capital at risk. 

The blending of tail risk and asymmetry also carries on an almost 20 year conversation about my very obvious and un-unique observation that the fund space would evolve to offer increasingly sophisticated strategies and tools to retail-sized investors. 

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