Chopping Off The Tail

Ryan Kirlin had a fantastic one-liner to describe the use of liquid alternatives.

I think it's a different way of saying what we say here about constructing a portfolio with a lot of simplicity and hedging with a little complexity. Alts like merger arbitrage or catastrophe bonds are not "return getters." In a portfolio that goes narrower than broad index funds, even some of the equity holdings will not really be return getters. 

Most clients own Johnson & Johnson (JNJ). I've owned it for clients for just over 20 years. 

I would not call JNJ a return getter. It tracked sort of close for most of the chart but the boxed areas show it going down quite a bit less than the index during declines. I should also note it was down much less than the index in the 2020 Pandemic Crash. That's generally the expectation/hope for what the stock will do. This year is sort of an outlier, testfo.io has JNJ up 25% this year versus 10% for the index. That sort of outperformance in an up market hasn't happened too many times and not what I would expect going forward.

We've talked about tech, as a narrower holding, being a source of return, or in Ryan's parlance, a return getter. Far more often than not, tech tends to outperform in up markets with the tradeoff being it will go down more in down markets. 

Something like client/personal holding BTAL or an inverse fund, maybe one of the tail risk funds depending on the environment are tools to "chop off" or at least mitigate some of the left tail. Left tail is a fancy term for extreme and typically negative events like the 2020 Pandemic Crash. We've also talked many times about client/personal holding CBOE in this context which has tended to trade as a proxy for the VIX Index during the last few left tail market events. 

Circling back to Kirlin, that Tweet is part of a thread where he linked to a paper that his firm published in 2016 about why it is not a fan of merger arbitrage. And here is Bloomberg's favorable coverage about why merger arb has gotten more attention from institutional shops lately. Long time readers might recall that I have owned the Merger Fund (MERFX/MERIX) for clients for a very long time. I am a believer in it as a very low beta diversifier. This century, it has only had one down year that was more than 100 basis points. 

Earlier in its existence though, it had a few large drawdowns. I would attribute larger drawdowns from 25-35 years ago to much higher interest rates. Financing something at 8% is a much larger headwind than financing something at 4%. There are also complexities related to spreads on deals with higher interest rates that can also make the strategy more volatile. The entire time I've been in the position, interest rates have been very low. Four-5% rates don't seem to be a problem but this might be a prompt to exit if rates take another meaningful leg higher. 

Speaking of low interest rates, for some odd reason I got a news alert about an article I wrote for TheStreet.com during the 2013 Taper Tantrum about avoiding bond funds with duration. It's pretty much the same conversation we've been having on this latest iteration of the blog for the last four years or so. The original blog where I wrote was called Random Roger's Big Picture (I hadn't heard of Barry Ritholtz yet). This anecdote about intermediate and longer rates not being high enough compensation at 3-5% all those years ago, longer actually, is a very big picture, long term theme and portfolios built with a lot of simplicity hedged with a little complexity is a very big picture, long term investing concept.

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