Don't Rely Solely On Backtesting

The only place talking about the strategy known as carry has been the ReturnStacked guys. That might be a slight exaggeration and I did find someone else talking about it, a short paper by Campbell & Company. The explanations of what carry tend to be complicated but I think I can distill it to be simpler even if it is too simplistic. 

There is the version where carry is the return just by holding an asset like the dividend from stock or the interest from the bond. There is the carry trade where you borrow or sell short a low yielding currency and buy a high yielding currency and make the difference between the interest paid on the borrowed currency and the interest earned on the currency that was bought. The other version, often call futures yield, involves going long futures contracts that are in backwardation and short futures contracts that are in contango. 

For example, the ReturnStacked Stocks & Futures Yield ETF (RSSY) is long UK Gilts (UK bonds) for September. That contract closed Friday at £99.85. The December contract closed at £99.37. Rolling forward could be done profitably, that is backwardation. RSSY is short DAX futures (the German stock market). On Friday, DAX futures for Sept closed at €18,694 while December closed at €18,868. It would cost money to roll forward, that is contango. 

From manager to manager I don't believe there's any differentiation in what carry is long and short but I do believe there is differentiation in how positions are weighted. If RSSY is long UK Gilts, there wouldn't be other managers who are short. Maybe other managers have larger or smaller positions but not on the other side. Typically sizing is risk weighted and I am saying the process for risk weighting might be different across different managers. 

Carry is like a cousin of managed futures. I'm trying to learn more but as best as I can tell, although carry is uncorrelated to a lot of things, it appears to be less reliable of a diversifier for equity exposure than managed futures is. Since there are no single strategy carry funds it is difficult to get a great feel how it performs in various market conditions. If you know that my comment about being less reliable than managed futures is incorrect, please leave a comment. 

Speaking of ReturnStacked, I tried to play around with a combo of the Permanent Portfolio using leverage and managed futures. This was probably inspired by yesterday's mention of the Cockroach Portfolio. What I had in mind is 60/40/40, equities/fixed income and managed futures and then a big sleeve to gold too. Using the WisdomTree Efficient Gold Plus Equity (GDE) would be a way to build this, along with the ReturnStacked Bonds & Managed Futures (RSBT). GDE offers 90% gold and 90% equities so if you put 60% into GDE you'd have 54% each into equities and gold and 40% each into bonds and managed futures by using RSBT. 

The funds are so new that it can't be backtested very far but we can back test it with the following and compare it to the Permanent Portfolio Mutual Fund (PRPFX) and the Vanguard Balanced Index Fund (VBAIX) which is proxy for a 60/40 portfolio.

Using these funds allows us to backtest the idea for ten years instead of one year due to how new RSBT is. The result is very interesting.

I just used 25% in gold, not 54%. Adding all of that leverage and the standard deviation was actually slightly lower than PRPFX and VBAIX and the return was noticeably higher. That this can be done with GDE, a S&P 500 Index fund and RSBT is positive in terms of democratizing access. 

The way these correlate, this is not assured destruction but obviously there would be pain in some sort of event where two of them went down a lot. Yes, I am skeptical about ever doing this but there is something to it and I am interested in studying it. 

Barron's had a profile on the Frost Credit Fund, the institutional symbol is FCFIX. It's a five star fund and has been around for a while. Here's the latest sector allocation compared to a year earlier.

The article makes a comparison to the Janus Henderson AAA CLO ETF (JAAA) which is a client holding. 

I think this is a good example to look forward, not to make a prediction  but understand portfolio holdings a little  better. Why did JAAA outperform in 2022 and why has it lagged FCFIX by a little bit since? CLOs are so called spread products, a spread, a higher yield, over treasuries. That helped CLOs outperform when rates were going up. The article refers to FCFIX making the decision to reduce CLO exposure because the managers believe gains can be made from regular bonds as rates go down. That's been happening and FCFIX has managed it well, outperforming JAAA. JAAA is still an excellent hold in my opinion, trouncing AGG on pace to return 7% for the year. That's the pace, there's no guarantee. 

If FCFIX is correct about gains from plainer vanilla bonds then it will continue to outperform JAAA and if they get that wrong (assuming no changes in positioning) then it makes sense to expect JAAA would outperform. 

Who knows if the managers will get that right. The FOMC pretty much said they are going to start lowering rates but that doesn't mean the middle of the curve and further out must drop in yield. If it doesn't, FCFIX wouldn't be hurt but its expected outperformance might not pan out. 

Let's play around with FCFIX in two versions of a similar portfolio with funds we don't do a lot with here.

We've mentioned BIVIX once or twice and QLEIX three or four times. We use AQMIX for blogging purposes all the time and I don't think we've looked at SPMO before.

BIVIX was the clear winner with less volatility and strong outperformance including a positive result in 2022. But there's a wrinkle with BIVIX that we've talked about before.

BIVIX outperformed by a little, earlier in the back test but 2021 and 2022 were monster years, the fund rose 61% and 49% respectively. Those two years skew the entire back test and there's no way to expect a fund to repeat such an outlier of outperformance. There's also the reasonable question of wondering whether something that could outperform by that much could also lag by that much. 

All the backtesting we do here is fun and there is utility to it but it is important to understand the why behind the results sometimes. Any backtest you might do with BIVIX fits into that category.

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.