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.

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