Tuesday, June 11, 2024

Diversification Is Alive & Well!

Yesterday we asked if diversification was dead. It is of course not dead but bonds became a far less effective diversifier years ago, long before 2022 when interest rates started going up. The reason I say that is with rates on their way to zero, the risk to holding longer duration bonds went up. The risk was there for years, 2022 when when there was a consequence to investors who took that risk. 

Avoiding long duration bonds was a big theme to my writing (and portfolio construction) for a long time, still is, but then the thought evolved to where I started saying that long duration fixed income has a source of unreliable volatility that makes it very difficult to model it in to a portfolio with any confidence. 

Finomial drew a similar conclusion about fixed income awhile back and posted this paper where they subbed in 40% into managed futures. I would say that is a very big bet but the math in their backtest supports it. 


Obviously, their study is compelling but it is not clear to me that the intention is to suggest anyone actually put 40% into managed futures. I would argue that the 40, or whatever percentage not in equities, be spit amongst various attributes in order to diversify your diversifiers or as we talked about the other day, to add differentiated return streams. 

I try to articulate these by saying what they do, it makes it easier when anyone asks. So, client/personal holding BTAL is very reliably, in my opinion, negatively correlated to stocks. Managed futures although is negatively correlated, is more crisis alpha to me that can go up in any environment. Things like merger arbitrage are horizontal lines that tilt upwards almost all the time so they do relatively well when stocks are lagging and do relatively poorly when stocks are doing well. There are alts, like global macro, which tend to have no correlation to equities. At times they will do better and be capable of going up a lot but sometimes not. Lastly, shorter term income sectors like T-bills or floating rate that don't really take meaningful interest rate risk but now have higher yields. 

And finally because I think it is related, this ridiculously short chart, because that's all we have for now, is interesting. Those are three of the four ReturnStacked funds compared to the Vanguard S&P 500 ETF. It's only two weeks which is ridiculously short (repeated for emphasis) but these all seem to be doing different things. 


I don't really ever see myself using their funds but that doesn't mean we can't learn some things about diversification. If these still look totally different a year from now, it would be productive to try to understand these dynamics better. 

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.

4 comments:

Gregory Becker said...

I like diversification. But I'm also looking at many years of saving still. So if I'm going to add diversification and maintain a high enough cagr, I need leverage. Feel like that might be the case for other buyers of alts that use leverage. For me, I actually hope to to add 200-300 basis points to cagr while keeping overall portfolio volatility roughly the same.

One other point: I think Corey gives a great example of how to reduce sequence of return risks but selling from a standard 60/40 portfolio in down years and replacing it with a return stacked product (e.g. stocks and bonds). That's a neat trick to do in retirement that could get someone through a rough market patch without "selling" at the bottom by keeping their notional exposure.

Roger Nusbaum said...

"...replacing it with a return stacked..." as long as getting the timing wrong doesn't hurt you. Increasing exposure after a 25% decline is a good idea but would be painful if the final low for that cycle was 40% down from the the highwater mark.

Gregory Becker said...

Just clarifying for that strategy: If you're in draw-down mode pulling 3-5% yearly, you can still sell and keep the same notional exposure.

E.g. sell ~6% VBAIX, pull 4% out of IRA to live on, take other 2% and buy 1.6% RSSB and .8% VT and you kept the same exposure prior to selling (assuming I did my math correctly).

Point is, you can sell during the drawdown, take cash out to live on, and yet keep the same notional exposure negating a lot of the risk of sequence of return risk. I assume you wouldn't want to do it for more than a handful of years, but it's a great way to access leverage at the cheap rate of futures + the ETF expense ratio which together is prob a hair under 1%.

Roger Nusbaum said...

I'm tracking you now, got it.

Be Careful Being Too Academic

The Up & Down Wall Street column in Barron's looked at how Friday's PCE report validated the FOMC's decision to cut by 50 b...