A Great Portfolio That No One Would Want

Sitting for the Alpha Exchange Podcast, Corey Hoffstein said he's very rarely seen advisors use merger arbitrage which is part of the story of why they stack merger arb on top of bonds in the RSBA ETF.

FT Alphaville looked at recent trends in active share which measures the extent to which a mutual fund is or is not a closet indexer. They say that active share isn't terribly useful for market signals, it's more like noise but lately it has been very low (so a lot of closet indexing).

So maybe it is more noise but it does lead to an interesting conversation that ties in Corey's observation about merger arbitrage. How orthogonal are you willing to be? We talk about this a fair bit but I think it is an important idea to keep on the front burner. 

A little quiz. Which portfolio result would you rather have? I will give you a very small hint. Portfolio 1 is the only choice. Ok, I am done being snarky. The Portfolio 1 has the same longer term result at the S&P 500 but with only 58% of the volatility. 

Along the lines of the 75/50 portfolio that captures 75% of the upside with only 50% of the downside (run the numbers, they work), the result of Portfolio 1 is in the same neighborhood. Obviously if we wrote this post last December, the portfolio would have been behind the S&P 500 not equal to it but the result still would have been compelling. 

You can see just by looking that Portfolio 1 has actually taken a very different path to a similar result as the S&P 500. But orthogonality comes at a cost which is the anguish caused by the periods that deviate away from the index by the largest amount. In the partial year of 2020, Portfolio 1 was down 83 basis points while the S&P was up 18%. In 2021 it lagged the index by 12%. Portfolio 1 was way ahead in 2022, way behind in 2023 and 2024 but it was up nicely those years and this year it is way ahead. 

Portfolio 1 is comprised of two funds and it isn't an idea that I would suggest anyone hold. It has throw in the towel at the wrong time written all over it. It's a portfolio that no one would want.

But when we talk about orthogonality or being truly diversified with holdings that are negatively correlated to stocks or uncorrelated to stocks, small doses of those two funds or any of the other funds we talk about in this regard makes for more resilient outcomes. What we are trying to do is add the effect of Portfolio 1 into a diversified portfolio. 

Having a couple of holdings that look nothing like the S&P 500 should help with avoiding the full brunt of large declines. Stocks are still the thing that go up the most, most of the time which is why you don't want a portfolio of alts, hedged with a little bit of equity exposure.

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.

We'll Make A Macro Fund Out Of Your IRA Yet

Bloomberg had a quick writeup that tried to hold out hope for the traditional 60/40 portfolio of stocks and bonds with duration noting some recent signs of life. The article was a little thin I think because it read like they were hanging a hat on one good week. 

Josh Brown was quoted at Politico saying “We’re in a very different world where stock market reactions are not at all aligned with what more experienced people would think should happen. It’s baffling, and it’s actually one of the most interesting things I’ve ever seen in my time in the investment markets.”

The connection here is that things can change. This will be annoying but that doesn't mean things must change but just that they can change. The difference is a mindset of being on the lookout for change without finding things that aren't actually there. I appreciate the two handed economist nature of the comment but hopefully it makes sense. 

Being able to create a portfolio that has the attributes of what bonds used to offer is a change that obviously I think is important which is why we spend so much time on the topic and of course plenty of other advisors, product providers and many others in the ecosystem are doing similar work....I think.

Here's an interesting read from Bloomberg about a company that will allow people to design their own indexes. It's not radically new, maybe it's a little different from some other ideas but someone who can create a more useful index for themselves might be better off. I don't necessarily mean getting better nominal returns but more able to create something they can live with through rough times so they reduce the odds of making bad behavioral mistakes. 

The other day we had a little fun about turning your IRA into a global macro hedge fund. I don't actually think that is too realistic to create other than just buying a mutual fund with the word macro in the name of the fund or in the objective as stated in the prospectus but we look at countless ways to build portfolios that are macro light....very light. 

I wanted to circle back in that regard to Saba Capital Income & Opportunities Fund (BRW) which we looked at a few weeks ago and might be macro-ish. You can look for yourself but the construction of it is interesting if nothing else. I had a hard time finding correlation info for BRW related to Saba taking over for Voya in managing the fund but looking casually, it appears that at times BRW does correlate to equities and times it doesn't, kind of doing its own thing. If I am seeing that correctly then maybe it really macro-ish. And if it is macro-ish then the look throughs are simpler to understand than the typical macro mutual fund. 

BRW has a "yield" in the low double digits but much of that can be ROC. According to Claude.ai, 70% of BRW's April distribution was ROC. Here's data compared with AOR which is a proxy for a 60/40 portfolio from iShares.

Price only, BRW could not escape 2022, it did not provide crisis alpha. From 2023 on, it's been mostly able to keep up with the distributions which for a closed end fund is pretty good. BRW owns Bitcoin so it is possible that the growth in Bitcoin is what has allowed the market price to be stable against such a huge payout, sort of like a barbell approach to portfolio construction which we talk about here every so often. 

Some people think maintaining the distribution with ROC is a negative and while I certainly understand the argument but for someone with some sort of strategy of taking income, tax free income seems like a positive. Keep in mind that this ROC distributions lowers cost basis which would drift into the realm of higher capital gains tax but that rate should be lower than the tax rate on dividends. 

More than building a full macro strategy, we're probably more adding a little macro in with BRW if you'll grant me that BRW is a macro strategy. SPMO is plain vanilla equities, BLNDX is 50% equities so we're getting close to a normal allocation equities. CBOE is equity exposure too but also has one foot in the first responder defensive camp along with BTAL. Gold and managed futures are diversifiers, the portfolio gets yield from SHRIX and BRW while SHRIX along with ARBIX are low volatility holdings.

The return numbers for all are price only for anyone interested in taking the income out. The overall yield is close to 4% with a good chunk of that coming from BRW and SHRIX. With dividends reinvested, Version 1 compounds at 12.75%, Version 2 at 14.11%. PRPFX at 7.21% and AOR at 4.01%. 

Versions 1 and 2 had some crisis alpha in 2022 with returns of -4.01% and -5.31% respectively versus a drop of 17.38% for AOR, all of those price only. The reason to use AOR instead of VBAIX is VBAIX gets distorted every now and then from larger capital gains distributions. 

Back to the top and the Bloomberg article about 60/40, in kind of a reverse Karl Popper, there are countless ways to build a competitive portfolio that avoids duration. Part of the success of all of these studies we do comes from intentionally avoiding duration. Even if you believe the various things we regularly include in these offer no value, the takeaway can be to just avoid duration and the now unpredictable volatility that goes with it.

Because I couldn't work it in elsewhere, BLNDX, BTAL and CBOE are client/personal holdings. 

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.

A Fund That Shorts ETF Inefficiencies

After yesterday's post about long short equity, a reader Tweeted to me about a new (to me) fund, the Militia Long/Short Equity ETF (ORR) which listed earlier this year. Part of my reply was that as a kid growing up in Boston in the 70's, I might need to buy a few shares just for the symbol. 

There's not a lot of color on ORR's website but it is high turnover and the approach is fundamentally driven.

It came out right before things got squirrely so the first few months serve a useful test. That it has outperformed right out of the blocks is obviously better than the alternative but maybe more interesting is the differentiation captured in the two boxes I added. Using the jargon from yesterday's post, maybe ORR should be considered a variable biased fund. 

Depending on how much turnover there is, looking at the holdings may not be that helpful but I did see something very interesting. Part of the short book appears to be shorting volatility drag that often goes with leveraged ETFs and shorting the erosion that goes with crazy high yielding derivative income funds. We talked about this recently with a filing from Defiance that will short 2x long MSTR ETFs and short 2x short MSTR ETFs.

ORR is short a couple of those ETFs but to be clear, the above just borrows part of their idea, the actual fund has a lot more going on under the hood. The symbols I chose, allow for a long backtest as follows.

The results are of course interesting but don't account for the cost to borrow the shares. TNA appears to cost about 100 basis points per Fintel, SDIV is 60-70 basis points and XYLD usually ranges from 1.2%-1.4%. Those are annual costs. Where the backtest is total return, the expense of paying the dividends should be accounted for. 

I wanted to check in on the ReturnStacked Bonds & Merger Arbitrage ETF (RSBA). It started trading late last year. The idea is that each dollar invested gives $1 of exposure to US Treasuries of varying maturities and $1 of exposure to merger arbitrage. The fund's website shows AUM just under $19 million.

We talk about merger arbitrage as a proxy for how investors hope fixed income will trade. It usually have little to no volatility and tends to move upward very gradually. I've owned the Merger Fund (MERIX) for clients since the financial crisis. The fund is having a relatively good year in 2025, up 4.39% per Yahoo Finance. 

Portfolios 2 and 3 use ETFs from F/m to dial in the maturities that RSBA shows on its site. UST in Portfolio 4 is a 2x version of the iShares 7-10 Year Treasury ETF (IEF) but I would note that factoring in distributions, UST's total return lags IEF by 11 basis points.

When we look at results for any of the ReturnStacked funds, they often don't look so great. For someone who wants Treasuries with duration (I do not) as well as merger arbitrage (I do want that one), there appears to be better ways to build that combo. I will say that while the characteristics of merger arb are similar from manager to manager, the exact results can differ from manager to manager.

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.

Put It All In.....Long Short?

NEPC posted a short paper about how to choose the right alternatives to diversify a 60/40 portfolio. The introduction covers the same ground we have been covering here forever.

Investors can count on a broad array of strategies to incorporate diversification into their portfolios. These approaches—often overlooked in an upmarket—help diversify away from equity risk which is the most prevalent risk in investment portfolios. They also help stabilize the portfolio over the long term and improve risk-adjusted returns. Gains originating from diversifying strategies can serve as a source of liquidity during/post a market downturn, serve as dry powder to reinvest following periods of stress, reduce volatility drag, and/or increase the terminal value of the portfolio. At NEPC, we think it is critical to establish clear goals and expectations when building a diversifying allocation. If investors are unclear on the goals of the allocation, they are more likely to abandon the strategy. In our view, a diversifying allocation is meant to complete portfolio construction, not compete with the return-seeking portion of the total portfolio. While many investors utilize a mix of strategies to create a diversifying allocation, we believe that the optimal approach should have two main characteristics: provide complementary attributes in various market environments and include strategies with a low correlation to each other and a portfolio consisting of stocks, bonds, and private investments. As a result, in this paper, we focus on global macro and trend following, fund-of-hedge-funds, multi-strategy, and event-driven approaches. We believe that when these five low-correlated approaches are combined and customized to meet the individual investment goals of our clients, they can efficiently achieve the required level of diversification while earning returns over a full market cycle.

The conclusions weren't new for what we've studied here other than sending me down a bit of a rabbit hole for long short equity. We've talked about there being different types of strategies within long short, well it turns out there are proper names for these types. Some of them below;

• Market Neutral- Vanguard Market Neutral (VMNIX) as an example
• Long Biased- AQR Long Short (QLEIX)
• Variable Biased- Invenomic (BIVIX)
• Event Driven- could include merger arbitrage
• Quantitative/Statistical- I would include client/personal holding BTAL in this group

That got me to thinking that these could be the building blocks for a portfolio. Where some people have talked about putting it all in trend/managed futures, what would it look like to put it all in various forms of long short? Long biased could be a substitute for plain vanilla equity, market neutral and merger arb could be substitutes for plain vanilla fixed income and the use of BTAL is pretty similar to how we discuss it in other posts. For the record, putting it all in trend/managed futures is a terrible idea.

Portfolio 4 is VBAIX and Portfolio 5 is price inflation.

Portfolio 1 does not keep up with portfolios that have close to a normal allocation to equities but that portfolio was less volatile, did have an adequate real return and had much smaller drawdowns except in the 2020 Pandemic Crash. Another important observation is that Portfolio 1 is truly differentiated from 60/40. In the 11 full and partial years studied, it was plus or minus more than five percentage points from VBAIX five times. Sometimes that was a good thing and sometimes it wasn't. And it case it's not obvious, Portfolio 1 would be very expensive. 

Combining equity momentum and managed futures in Portfolio 3 is a step closer to putting it all into trend which is something we've looked at several times before and the backtests usually look pretty good. Portfolio 3 was plus or minus five percentage points from VBAIX six times and again, sometimes that was a good thing but sometimes it wasn't.

That was a pretty rough showing for the four managed futures funds. The choice was sort of limited for the number of funds that were around back then but it was a rough stretch for the strategy, pretty much just tracking inflation. 

Seeing a strong backtest is one thing but living through a year where you own Portfolio 1 and it was down 6% like in 2020 while VBAIX was up 16% that year would be very difficult to endure. 

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.

Is Your IRA A Global Macro Hedge Fund?

Some very quick hits from this weekend's Barron's. 

A couple of good ones from Morgan Samet and then James Anderson from Lingotto. Samet said "you have to repeatedly think orthogonally." I love that word and we occasionally talk about orthogonality here. It is very important trait for portfolio construction. One example that we review constantly here is avoiding bonds with duration. That part of the market has gone from very high risk when yields were very low to a serious pain point with large declines and unreliably volatility. 

The various funds that are down 30-50% from their 2021 highs can never make their way back to those prices and if from here, yields move up from the 4-5% to maybe 5.5-6.5% range, those same funds might be very hard pressed to get back to today's prices. Many advisors and pundits never got off of bonds with duration and recommend it still but the risk reward tradeoff makes no sense to me.

Then Anderson, referring to a different colleague said "he was even more frustrated than I am that public-market investors haven’t adopted the view that outperformance is reliant on extreme winners." We talk about this point a few different ways including the barbell theory of concentrating risk into a narrow slice of the portfolio. 

Getting that right is not easy of course but in a normal bull market, you're probably not going to have a laundry detergent company double in a year. 

In the StreetWise column, Russ Brownback from Blackrock said "I’m like, guys, the range on the S&P 500 over the next 10 years is probably 5,000 on the downside and 10,000 on the upside. So you’re gonna be kicking yourself if you’re getting too cute about a hundred points now.” 

We talk about the natural inertia that lifts the market from the lower left to the upper right of the chart. That inertia is pretty dependable over the long term but we don't know the path. Using the number from the quote, there is no question that the S&P 500 will hit 10,000 at some point but we cannot know how long it will take or whether the path to 10,000 will be by way of 4000 first. We've also used the word ergodicity to describe this effect.

Lastly, an article for retirees about how they can navigate their portfolios through choppy markets. An advisor said "this is not the time to treat your portfolio like it’s a global macro hedge fund.” When would be the time to treat your portfolio like it's a global macro hedge fund? Ok, I am being snarky but there is some contrast with this comment and the idea of orthogonality discussed above. 

We talk a lot about using alts which I believe is one form of orthogonality but it is a stretch to think of our discussion (and my implementation) as being anything remotely similar to global macro anything. I'd be happy with just being resilient through market events like the one we are going through now. 

The comments on this last article we're discussing were very critical of the article for being way too basic, offering nothing new. What was the first article you read that said "have a years worth of expenses in cash in case the market drops?" Even if you now come at that a little differently, at one point you didn't know about that, you read that advice for the first time and then you knew. Some number of readers of that article learned today to set some cash aside for expenses in case the market drops a lot. 

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.

Friday Night Volatility

From a satirical account.

I don't know if he's making fun of T-bills and chill or Trinity and chill or something else but after a rough week, trying to find something to just hide in will appeal to some people.

Quoting myself from a long time ago, if gold is your best performer then chances are things aren't going well in the rest of the market. 

In the middle of 2022 you could have found plenty of people who would have said buying managed futures and taking the rest of the year off is looking pretty good. I've been saying for ages not to go too heavy into managed futures in case they don't "work" in some random market event and right on cue from Meb Faber;

The worst 12 month return in the index' history? C'mon, man. As great as I think managed futures is for diversification, 20% was never the right answer. Not while it was going well and not now either. Five-10% (I am nowhere near 10%) is plenty. 

I wanted to check in on the GraniteShares YieldBOOST SPY ETF (YSPY). The fund sells puts on the Direxion 3x SPY ETF (SPXL).

It looks nothing like SPXL but I don't think that really is the right expectation. It is not a proxy for SPXL, you could just buy that fund if you want, YSPY sells SPXL's volatility which will usually be a little different. The 6% decline is a little misleading because it excludes dividends. For now, the three dividends are characterized as ordinary income so not terribly tax efficient. The reason I say for now is that some of the crazy high yielders will recharacterize the distributions later. I have no idea if YSPY will do that or not but any holder should keep an eye on that. 

Factoring in the distributions, the total return has been far from catastrophic.

YSPY came out right before a crazy stretch for markets so it's like a small test for a yield barbell. I don't see myself doing this but it could work for the right circumstance. I don't think YSPY can keep up with the dividend so there would need to be frequent rebalancing. A side note is that apparently the Yahoo chart for YSPY doesn't go back to its inception? Yahoo can be quirky that way. 

And a quick follow up to Morning Coffee With Claude. I got it wrong about how Claude does or does not remember previous queries. 

No, I don't learn or retain information from our conversation. Each time we chat, I start fresh without memory of previous interactions. I also don't use our conversation to update my training or improve my responses for future users.

This means I can't build on things we've discussed in past conversations or remember your preferences over time. However, within our current conversation, I can refer back to what we've talked about earlier in this same chat session.

I either mixed the point up with something else or just flat out was incorrect.

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.

Morning Coffee With Claude

Spending a little more time trying to figure out AI.

I asked Claude AI for the bearish case against owning Netflix (NFLX). Here's part of the answer.

Market Saturation and Slowing Growth Netflix faces increasing difficulty adding new subscribers in mature markets like North America and Europe. The company has largely exhausted the pool of potential subscribers willing to pay for streaming services in these regions, leading to slower user growth and higher customer acquisition costs.

Intense Competition The streaming landscape has become crowded with well-funded competitors including Disney+, HBO Max, Apple TV+, Amazon Prime Video, and others. This competition fragments viewership, drives up content costs, and makes it harder for Netflix to maintain pricing power. Many competitors can afford to operate streaming services at a loss since they're subsidized by other profitable business lines.

There were also concerns about debt and people getting rid of the service during recessions. What is the bull case in favor of owning Netflix?

Global Streaming Market Leadership Netflix remains the dominant global streaming platform with over 260 million subscribers worldwide. The company has significant first-mover advantages, brand recognition, and operational scale that create competitive moats. Its global reach provides diversification and access to emerging markets where streaming adoption is still growing rapidly.

Content Creation Excellence Netflix has built a sophisticated content production machine that consistently creates popular original programming across multiple genres and languages. Shows like "Stranger Things," "Wednesday," and "Squid Game" demonstrate the company's ability to create global hits that drive subscriber engagement and retention. This original content library becomes increasingly valuable over time.

The total output for the bullish case was longer but not more compelling. As it is with humans, so it goes with AI that the bearish case always sounds more intelligent?

Then I asked it to compare and contrast the iShares Exponential Technologies ETF (XT) with the Technology Sector SPDR (XLK). It said "pondering" for a few seconds before giving an answer.

The final point it made in response to this query was

Performance Considerations

Both funds can benefit from technology sector growth, but their performance drivers differ significantly. XT's performance depends heavily on the adoption and success of exponential technologies, while XLK's performance is more tied to the overall health of established tech giants and their earnings growth.

The choice between them depends on whether you prefer focused exposure to emerging tech themes with global diversification (XT) or concentrated exposure to proven US tech leaders (XLK).

There is legit differentiation between XT and XLK in terms of composition and performance.

Claude did note the difference in volatility between the two, concluding that XT is more volatile. Looking at the chart, it is not obvious to me that XT is more volatile as opposed to lagging badly. Both Portfoliovisualizer and Testfol.io have XLK being more volatile, so I asked about that as a follow up. 

You're absolutely right, and I apologize for the error in my analysis. The data shows XLK is indeed more volatile than XT, which is counterintuitive given the typical assumptions about thematic vs. sector ETFs.

Why XLK is More Volatile Than XT

The higher volatility in XLK likely stems from several factors:

Concentration Risk: XLK is heavily concentrated in a small number of mega-cap stocks. Apple and Microsoft alone often represent over 40% of the fund, with the top 10 holdings typically comprising 60-70% of assets. When these giants move significantly, they create outsized impact on the entire fund's performance.

Market Cap Weighting Effect: XLK's market-cap weighting means that when the largest tech stocks experience dramatic swings - as they frequently do during earnings seasons or market rotations - the fund amplifies these movements. The 2022 tech selloff and subsequent recovery periods would have hit XLK particularly hard due to this concentration.

There was a little more but the above gives you the general idea. For this sort of use, AI isn't necessarily an answer machine, it is a tool to help figure things out. It makes mistakes which doesn't have to be the worst thing in the world as long as you realize it can get things wrong. While I doubt someone else will ask Claude to compare XT and XLK, it won't get the volatility question wrong the next time if someone does ask that same question. 

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.

Capital Efficiency Or Inefficiency?

Treasuries with duration have been rolling over for a couple of weeks perhaps digesting the pending legislation currently being hammered out in congress and then over the last couple of days, the credit rating downgrade is also entered the mix. As rates have moved higher with the ten year close to 4.60% and the 30 year above 5%, stocks might also be rolling over again. Admittedly, it's just a couple of days so who knows yet if stocks are rolling over or not.

At a similar point after the tariffs were announced, I suggested taking the opportunity to stress test or revisit and revaluate any portfolio strategies or techniques that interest you. These events are great learning opportunities so I want to revisit capital efficiency the way we've looked at it before which is to leverage down as we've described it before. 

The starting point for this post is the Miller Value Partners Leverage ETF (MVPL) which depending on a technical analysis process will either own plain vanilla S&P 500 via an ETF or have 2x exposure. Where equities trend up most of the time, MVPL should be expected to have 2x exposure most of the time. The variable would be how well its signals do going from 2x to 1x and then back again.

The weightings to equities and managed futures should all be the same while the unleveraged portfolio has just 20% in ARBIX which we're using as a fixed income substitute. The fifth one below is just VBAIX.

The period available to study was terrible for managed futures which might be why the results are meh. There's nothing catastrophic with any of the results. The RSST version is a little bit of an outlier to the downside but all of them lag VBAIX. For 2025, the MVPL version is the best performer and the RSST version is the worst. 

If we take out the MVPL and RSST portfolios, we can go back quite a bit further and the results do a little better, thanks in large part to 2022.

Circling back to the result for this year, managed futures has struggled of course and while a 20% allocation is nice and tidy for a blog post, it would be better in real life to diversify your diversifiers. And while ARBIX is a fine substitute for fixed income with no duration, same thing, diversify your diversifiers. Twenty percent in just two alts that way is a bad idea. 

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.

My New Friend, Claude

A reader left a link to a short post from Felix Salmon provocatively titled How AI could end the ETF boom. Ok, you've got my attention but, is this actually something new? A few years ago Schwab starting offering thematic baskets of stocks and if you search on Google you can find several similar products from other companies. 

It's safe to say that at least some of these products use some form of technology to assemble and then maintain these baskets. As AI evolves, some may already be using AI and maybe others soon will. Salmon's post seems more like a report on an evolutionary step not a revolutionary step. 

I played around a little bit with Claude AI from Anthropic. This link may have the output, it is the link I see but I don't know if it will show the results of my inquiry. First I asked it to suggest an all-weather portfolio that included managed futures. It pretty much spat out Ray Dalio's all-weather with a 15% allocation to managed futures. 

Then I asked it what it thought about including global macro and if it thought it was a good idea, how much should go to global macro. It suggested the following.

Claude AI suggested QAI for global macro and I used EBSIX in my version. The rest of my version uses names we regularly use for blogging purposes. BKLN allows us to avoid interest rate risk for this backtest. 

As we often see, a decent portfolio strategy this time from AI that can be improved upon. 

Then I asked it to Build a basket of global publicly traded stock exchange companies which may not be the first thing people would think to ask but is a niche I have been very interested in for probably 20 years. Again, I don't know if that link will work. Claude spat out a list of publicly traded exchange stocks from the around the world but it also included one or two private companies. It left out the New Zealand Stock Exchange. 

"What about NZX Limited? Did you leave any others out besides NZX?" It told me I was right and found a few others in addition to NZX. This was as specific as it got with construction;

Portfolio Allocation Strategy

• Core holdings (40-50%): ICE, LSEG, Deutsche Börse, HKEX
• Growth component (25-30%): Nasdaq, SGX, B3, NSE
• Value positions (20-25%): CME, Euronext, ASX, TMX
• Consider equal-weighting to avoid overconcentration in largest players

Most of these are in Testfol.io.

There are some interesting numbers in the Claude basket related to volatility and Sharpe Ratio. Both exchange portfolios held up much better in 2022.

I'm not saying AI's role is nothing. It will evolve to add some amount of value, maybe a lot of value but I think it is too early to know. I have mentioned before that Matthew Tuttle includes AI queries in his daily email so I am guessing he believes it is farther along than I do and he may be right. Whatever the current state of AI in the portfolio construction process, I would encourage advisors to engage with AI at least a little. 

That sentiment is similar to Bitcoin and the cryptos. I think an advisor should have something to say about Bitcoin when a client asks and I think an advisor should have something to say about AI when a client asks. 

Portfolio managers have been using computer based screening forever so AI doesn't seem that different conceptually, all the better if AI screening is a big improvement over more common screening methods. 

Circling back, I took a couple of names out of the Portfolio 1 backtest to have it go back further and got results that were a little more interesting. 

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.

Quadrant Practicality

A quote attributed to David Swensen that I hadn't seen before.

“As a general rule of thumb, the more complexity in a Wall Street creation, the faster and further investors should run.”

If you read a lot of posts here, you might have read something from me along the lines of allocating a lot to simplicity with just a little bit to complexity. Swensen was the long time manager of the Yale Endowment and anything you might find about how the endowment was allocated under Swensen probably won't look very simple but he was a big advocate of simplicity for individual investors. 

Here's how Portfoliovisualizer builds a simple Swensen portfolio.

And plugging into Testfol.io which goes back further and comparing it to VBAIX.

Swensen did better over the course of the backtest with a little more volatility and bigger drawdowns. From 2000 to 2019, Swensen outperformed 14 times. From 2020 on, VBAIX outperformed four times. I think the difference can be attributed to more duration which hasn't been doing quite as well as it used to and having less domestic equity. 

The portfolio certainly is simple enough but where bonds with duration are concerned, the world got a little more complex in recent years. An investor agreeing with that comment about duration could go a couple of different ways, either go simpler like with T-bills or add a little complexity, tools to manage portfolio volatility in the manner that bonds used to. 

There's no wrong choice but I prefer adding a little complexity with the various tools we talk about all the time here. These include alts that trade in the manner that I think people hope bonds will as well alts that more reliably offset equity declines which we've categorized as first responders and second responders. 

I've detailed the manner in which I work these into a portfolio and maybe you think it is simple or maybe not, it is all relative. One idea that I think marries simplicity and complexity is when we take the permanent portfolio which is equal weighted 25% into stocks, long bonds, gold and cash, and try to update it to adjust to the reality that long bonds are not the reliable diversifier they once were. 

Research Affiliates (RA) threw its hat in this ring with a long writeup about managed futures. They talked about "four pillars" as being "economic growth (equities), income defensiveness (bonds), absolute return (alpha) and trend following (tail risk)." 

Portfolio 1 is an attempt to be true to the RA paper using AGG for bonds. Portfolio 2 uses a bond proxy with client/personal holding Merger Fund.

Portfolios 1 and 2 have been almost identical looking back. Looking forward, Portfolio 2 avoids duration risk. VBAIX has 60% in equities and PRPFX has the 25% equity sleeve but also owns commodity equities and gold so Portfolios 1 and 2 are not likely to keep up with the other two. 

I would imagine that Portfolios 1 and 2 would be more all weather-ish with smaller drawdowns as has been the case in the backtest. They do have a positive real return and having half the volatility of 60/40 would be appropriate for some people like maybe those with a very low risk tolerance or someone far enough ahead of where they need to be that they could be partially in game over mode. 

This quadrant style can be a valid way to go but I don't think it is ideal. We've looked at countless ways to get closer to a "normal" equity allocation but still having noticeably less volatility. This can allow for more growth opportunity over the longer term. 

I would pick on RA's use of the term tail risk in conjunction with managed futures. Tail risk is typically more of a first responder sort of defensive. Managed futures has been a first responder in some events but not all events. And to repeat from many previous posts, in real life, I would not put anywhere near 25% into those alts. Loading up like that exposes the portfolio to unnecessary risks. Diversify your diversifiers.

The takeaway is the potential simplicity of quadrant-inspired portfolio construction. I'm not a fan of literally having four 25% buckets but having four or five tranches in more practical weightings makes a lot of sense. 

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.

Easier Aging

Following up on our conversation about private assets soon being available in 401k plans, Jason Zweig weighed in and he is not a fan. The most interesting part to me was about an interval fund from Redwood Investment Management, located in Scottsdale. Interval funds are easily bought, usually expensive and have limited liquidity for getting out. We've looked at these before, really hitting on the extent to which interval funds (don't) mark to market. 

Jason reported that Redwood owns shares of its interval fund in its mutual funds. A couple of the mutual funds have interesting names and strategies, one of them appears to apply trend following to high yield, but the results are not interesting. There is a systematic macro fund whose year by year results seem show a lot of equity beta. I would prefer any sort of macro fund to be more of a does its own thing alternative without much obvious correlation to equities. 

The question of double dipping the fees is quickly addressed (the mutual funds are not doing that). 

There was no version of the word complexity in the article but I think Jason was trying to sort out the idea of complexity in a portfolio. I would imagine he'd be less inclined than me to include a little complexity into a mostly simple portfolio. The issues with interval funds make them complex complexity. A mutual fund that offers managed futures or some sort of arbitrage are complex but the access and liquidity are not. Maybe selling a mutual fund is a good idea or maybe it's a bad idea but it can be done without hassle. If someone wants to allocate some of their allocation to complexity into an interval fund, go ahead but as is often the case, there are probably cheaper, simpler ways to add the same effect into a diversified portfolio. 

The FT had a depressing article titled America's Sickness Economy.

The US is spending more money to get inferior outcomes. The short version from me is that our diets are terrible, we do not exercise and we are terrible at treating the chronic maladies caused by our terrible diets and lack of exercise. It has been getting worse, not better, for many years in terms of lifestyle and our political system has been making it worse. I've never been a fan of any politicians but the entire system has become far more dysfunctional than it was in previous decades. 

This has been an area of interest and a topic of conversation here since the start of the original blog site back in 2004. I hope I've come to know and understand more than I did but either way, 20 years have gone by and as opposed to making any progress, things are much worse. Twenty years is a decent chunk of someone's life. Anyone who has been waiting for them to fix it has squandered those twenty years as opposed to trying to prevent/solve their own problem. 

We learn as children that we need to exercise and we learn as children that we should not eat too much sugar. So there's nothing new but still we do not exercise and we do eat too much sugar (and processed food). The list of problems that can be solved and conditions reversed by getting serious about diet and exercise is endless. And even if you don't want to dig in on how that all works, on some level, everyone knows to cut back on sugar and get some exercise. 

Every aspect of aging is easier when you're healthy, fit, have good body composition, can bend down and pick up heavy things, don't have to spend a lot of time at the doctor's office and not taking a bunch prescriptions. 

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.

Timing Vs Risk Assessment

Before Justin Walters and Paul Hickey founded Bespoke Investment Group, they worked at Birinyi & Associates. This was around 2005 or 2006, something like that. They did a weekly survey of bloggers, bullish and bearish, I recall this starting very close to the start of the bear market associated with the Financial Crisis. Every week for more than a year I was bearish. Bearish, bearish, bearish, week after week and I believe I was deemed as being the most accurate of the group. 

Then at some point I flipped to bullish, probably very close to when this article posted at Seeking Alpha on 12/28/2008 titled 2009: Expecting a Massive Rally. When I did switch to bullish for this survey, Paul and Justin mentioned in the email that went out asking for survey participants to respond. I don't recall how much longer the survey went on but I am pretty sure I stayed bullish for the duration until the survey ended. 

This is similar to how I have viewed and blogged about the middle of the yield curve and further out going back close to 20 years. Locking in for ten years at 4.50%-5% (this was 2006 and early 2007) made no sense to me. It seemed like not enough compensation for the potential volatility and then yields went lower for many more years. Then of course yields bottomed and started to go higher causing pretty big price declines in long dated bonds and many bond funds. I certainly missed capital gains by avoiding that part of the bond market but I am not looking to bonds for capital gains. For me, bonds are about mitigating the volatility from the equity portion of the portfolio, the portion where I do want capital gains to come from. Cool for anyone who is looking for gains from bonds, that's just not what I am looking for. I am looking for yield, yield equivalents and predictability. 

Neither of these seem like market timing in the manner in which the phrase is commonly used. Please leave a comment if you disagree with that contention. 

The prompt for all of this came from the following thread.

Elsewhere in the thread, Corey mentions LDI, liability driven investing where durations/maturities are matched to income (liability) needs. LDI is typically associated with pensions and maybe also endowments. I'm sure Corey is using the term in the correct context so then it is up to the end user what they want to do. Trying to time interest rates is definitely very difficult to do with any consistency. The yield on the ten year Treasury is 4.41% as I type this. Someone says they're going to go in in at 4.75% or sell at 4.20%, that is a short term strategy that is a form of trying to time interest rates. 

What we argue for here is assessing risk. I've made comments here and there about maybe 7% being an attractive point where risk for longer term bonds would be fairly compensated. Maybe it would 6.5% if we ever got there or maybe 7.25%? I'm not expecting anything like that, more like if it ever happened, I would be interested. 

If/when the Fed starts cutting, how low will they go? I don't know but I'm pretty sure it won't be zero. I'm pretty sure it won't be 1% either. I'm less certain about 2% but that seems like a stretch unless there is another calamity that extends beyond capital markets. When Fed Funds were at zero, there was yield without duration available in the threes and even into the fours. If Fed Funds goes down as low as 2%, there will be yield without duration in the fours and fives, probably higher but you need to spread your exposures around. 

In that context, I draw a much different conclusion about needing to match LDI in retail sized advisory client accounts by locking in ten years at 4.41% for treasuries or 5.4% for A rated corporates (per Fidelity). 

Ben Hunt had a doozy of a thread that led him to conclude that we are in for a stagflationary outcome. As we mentioned the other day, Torsten Slot said that in the face of stagflation, we should expect interest rates to go up and stocks to go down. 

We've been talking a good bit about quadrant-inspired portfolios over the last few months and if Hunt and Slok turn out to be correct about stagflation, the concept will probably get a lot more attention.

I built out the following variation on a quadrant portfolio to compare to VBAIX which is a proxy for a 60/40 portfolio and inflation. I didn't know this was available but I typed in the work inflation and there is was.

A portfolio with 40% equities is not very likely to keep up with one that is 60% equities but that isn't the point. The quadrant inspired portfolio above will hopefully be more resilient in times of strife. In 2008, it was down 13% versus 21% for VBAIX and in 2022 it was down 4% versus 16% for VBAIX. For what it's worth, the Permanent Portfolio Fund (PRPFX) was down just under 9% in 2008 and in 2022 it was down 5%.

The long term CAGR for the 40/20/20/20 versus PRPFX being almost identical is interesting but 40/20/20/20 had considerably less volatility. The real return of the backtest is pretty good and would become important if we do go through a lost decade or stagflationary event. 

In the real world, I would diversify the diversifiers and I would split the 40% to equities to include foreign stocks. 

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.

Fear Of Commitment

Price Action Lab had a blog post that amusingly referred to managed futures as being a long term commitment. That led to an older post that tried to figure out the optimal allocation to managed futures. 

Basically, they said to get the highest return you should have zero in managed futures and if you want the best Sharpe Ratio (risk adjusted return) you should have 75% in managed futures. The 75% number was put out there in jest....I think. The more serious point was the human behavior of wishing you owned less when equities were ripping higher and wishing you had more when equities were falling, except this year? 

First as a reminder, I would never have anywhere close to 25% in managed futures but the point of the chart I built is to show that there may not be a single optimal allocation to managed futures that will work in all seasons. With all four of the above being backtested, the returns were driven by equity allocations, 65% in equities will hopefully outperform 60% in equities and so on. I couldn't get the 25/75 blend to the highest Sharpe Ratio so I am not sure how Price Action Lab got there. 

As someone who thinks managed futures is a great diversifier that is pretty reliable (not infallible), I view it as potentially a source of crisis alpha with a low to negative correlation to equities. In that light, 20% or 25% makes no sense to me. We talked at length in 2022 and into 2023 when managed futures was booming and people were coming out of the woodwork to suggest huge weightings to managed futures which I said was a bad idea back then and is a bad idea right now in terms of constructing a portfolio. If you are trying to trade a bottom, I have no idea what someone should do. 

There are some funds that blend managed futures in with other things. There are different funds that do this with different effect that may or may not be additive depending on how you view things. BLNDX is one that I think blends it in with an additive (positive) effect and there are other funds I believe don't blend managed futures in with a positive effect.

Most client accounts have a stand alone managed futures fund and the weight is low single digits. Most client accounts also own BLNDX in a similar weighting. I think of BLNDX' outcome as benefitting from managed futures more than being a proxy for managed futures but anyone else might think of it differently.

I am confident that in the next crisis managed futures will work but a little bit can go a long way. Spreading across several holdings that can offer crisis alpha instead of concentrating on just one makes for much better diversification and offers much more resilience as this year has clearly shown us. 

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.

Private Equity In Your 401k? Just Say No

We have a couple of different articles about private assets being available or otherwise worked into 401k plans. 

First is 401k provider Empower starting to rollout private equity, credit and real estate into plans they offer, ranging from 5-20% allocations. This quote made my eyes bug out. "Wall Street firms have been pushing to get private investments into the hands of individual investors, and they see the $12.4 trillion market for 401(k)-type retirement plans as crucial to this growth."

I'm always going to read something like that to mean we need more suckers. To call the current goings on with private equity and private credit a bubble as relates to giving individuals access probably isn't correct, I don't think the space is big enough at this point. The entire private credit and private space is probably large enough to be a problem akin to a bubble but I'm not sure there's enough homogeneity to tie it all together into a systemic event like mortgages through the banking system.

The first time I was on CNBC it was to talk about solar stocks. I was asked if the group was a bubble. I said no because it was too small to be a bubble. The whole group could disappear without making a dent in the stock market. The better word was mania. I think private equity and debt is closer to a mania on that scale. 

But, if you like private credit then you'll love leveraging up 4-1 to buy it in your 401k through a company called Basic Capital. Here's the gift link from Bloomberg. The very short version of this is that 15% goes into an equity index fund and 485% goes into private credit. The yield from the private credit should more than cover the interest expense, there is interest, and the fees and the yield that is left over, when levered up and combined with the modest exposure to equities should give a low double digit return. 

I really am simplifying that. 

This is of course interesting stuff. It might be insane but it can be interesting and at a high level is a building block for risk parity. 

The four portfolios put 15% in the S&P 500 and 485% in the fund named in the portfolio. I played around with some other funds too. The drawdowns can be brutal and although the backtest doesn't show it well, just about all of the different portfolios did endure some really big declines. 

The program doesn't have margin calls though. It is treated more like a mortgage (read the article). 

Equal weighting the four (subject to rounding) and then comparing to VBAIX.

There's a little less volatility and quite a bit more growth but there was no crisis alpha in 2022. The drawdown that year wasn't catastrophic compared to VBAIX but was a little worse. If this levered 401k platform really does invest in private credit then the risk of statement shock would be less because of how private assets (don't) mark to market. Cliff Asness calls this volatility laundering. 

There wouldn't be a problem unless....

It would be difficult to get used to not getting at least daily marks on something like this. I am not saying people should check their 401ks every day but any day that someone does check, the information should be current. 

Usually when we look at these sorts of complex products I will say that whatever you're trying to do, there's probably a simpler and cheaper way to do it. The closest I can think of to replicate this in a simple fashion would be 15% in an S&P 500 fund at 85% in the Simplify Short Term Treasury Futures Strategy ETF (TUA) which leverages up the two year treasury 5x. When I plug that combo into Testfol.io, it only compounds at 1.70%, far less than the blend we looked at and VBAIX but with more volatility than both. The intended use for TUA is for capital efficiency not for leveraging up like this.

Some of the AQR funds do different things with leverage but the to the best of my knowledge those funds are more balanced like maybe 400% long and 300% short. 

The strategy that Basic Capital is offering is legitimately interesting but I don't believe there is mechanism where the strategy could exist in a fund at least for now. I am going to naturally be biased against using something so complicated, illiquid and expensive. I can't get to a point of thinking the potential reward is worth the risks.

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.