AQR Uses Leverage, Should You?

What a great day. I got a good bit of outside work done this morning and it's the first day of NFL Redzone so why not dive into some portfolio theory on the blog?

Following up on yesterday's look at the Dragon and Sloth portfolios, I had a thought about what to do with Dragon's 21% weighting to long volatility and how trying to use a long VIX product creates a huge drag on the result, so huge that replicating the portfolio really isn't valid. 

We've noted more than a few times that client holding CBOE Global Market (CBOE), the exchange where VIX trades, has some of the defensive attributes that go with being long volatility. I believe the reason for that is a market crisis potentially causing more trading in VIX derivatives is good for CBOE which causes the stock to go up in quite a few different types of broad market drawdowns. I'd describe this as fairly reliable but certainly not infallible. FWIW, CBOE has a kind of low correlation to the S&P 500 at 0.34 and was only down 2% in 2022. 

Here's how we replicated Dragon;

Portfolio 2 as indicated just swaps out VIXM for CBOE and Portfolio 3 is "My Version" from yesterday but 10% to CBOE instead of VIXM.

Portfolio 3 with the highest weighting to equites (we're considering CBOE to be long volatility) doesn't have the highest CAGR but it was better than VBAIX, with a much lower standard deviation and the best Sharpe Ratio. The truer replication of Portfolio 2 was the best performer but that obviously is because CBOE outperformed the S&P 500 meaningfully over the period studied. CBOE might continue to outperform, I don't know but I think the defensive attribute we described above can persist as long as it continues to be home to the VIX complex.

Cliff Asness had a long writeup In Praise of High Volatility Alternatives. The meat of the post compares different weightings to stocks/bonds/alternatives building more and more leverage into the portfolio. Cliff focused on this exercise with a volatility target of 10%. I'm using his weightings for this exercise but the volatility targets don't quite get to 10%. That's ok, I think pull some interesting information. 

Portfolio 2 with 17% leverage has lowest CAGR. The trade off between no leverage and 51% leverage is interesting. 58 more basis points in CAGR with leverage but inferior standard deviation and Sharpe Ratio. 

The next version uses AQR Style Premia Alternative Fund (QSPIX) for the alternative. 

You might draw a different conclusion but the unleveraged version seems to be the most compelling combo. The argument is pretty strong at least. 

With AQR Diversified Arbitrage (ADAIX).

Again, unleveraged seems to be the best of the bunch but unlike the first two, the standard deviation of all of them exceeds the CAGR.

The last one we'll look at is the Catalyst Millburn Hedge Strategy (MBXIX) which a hedge fund-like mutual fund with sort of a high equity beta compared to most of these types of alts. With this one, the argument for unleveraged isn't as strong with the others. The CAGR is 108 bp lower than the version with 51% leverage but the standard deviation is 231 basis points lower. 

My tendency is to be very cautious about using leverage. I've talked countless times about leveraging down as opposed to what we're doing in this study of leveraging up. Anyone wanting to follow Cliff's lead with the leverage could use either ReturnStacked Global Stocks & US Bonds (RSSB) which gives $1 of exposure each of the two assets classes in the name of the fund for each $1 invested or the WisdomTree US Efficient Core ETF (NTSX) which leverages up such that a 67% weighting to NTSX equals 100% into a 60/40 portfolio. To buy either one though, you have to want Agg-like bond exposure. 

It would take some creativity and a high tolerance for tracking error to get to the 51% leverage in Portfolio 3, the 17% in Portfolio 2 would be pretty easy to get to or of course anyone interested in actually doing this would probably go with whatever number they found to be optimal. 

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.