Insanity And Stability All In One Blog Post

Yesterday, I said I wanted to give the insanity spilling out over the weekend time to "breathe" and then things got more insane. Peter Attia of all people is apparently all over the Epstein files. Kevin Warsh is in there quite a bit, Eddy Elfenbein theorized that his nomination will be rescinded. Now I need time to breathe, I cannot wrap my head around any of this. Even Casey Wasserman is in there. Who? He's in charge of the LA Olympic Organizing Committee and he has apologized for exchanging emails with Ghislane Maxwell. 

Moving on with a quote from Russell Napier, "chasing yield is dangerous most times, but exceptionally dangerous below 2%." While I agree with the sentiment, the sample size is pretty small with the years leading into late 2021 being the only one I can recall lasting any real amount of time. A little more broadly, chasing yield regardless of the nominal levels can be dangerous. 

In wildland firefighting there is a list of what are called watch out situations. For example, fighting a fire in the dark, in a place where you've never been is something to watch out for increased risk. That doesn't mean, you don't do it, it means you do so carefully, there are way to mitigate that risk. 

Similarly, the risks of accessing yields above the prevailing risk free rate can be mitigated. One is to diversify exposures to avoid loading up on the same risk. If you own a catastrophe bond fund and a high yield fund, the risks are diversified. Of course, there could be a terrible hurricane during a credit crisis, the risks are totally unrelated. Another way to mitigate risk is to avoid risks you don't understand. No one will understand everything well enough to invest (me with autocallables), just avoid the ones you don't understand. A third one I'll add is to think long and hard before buying a derivative income fund that "yields" 80%. 

We've built much of our thesis on how to replace traditional fixed income by using liquid alternatives in a manner that spreads the risk out so that if something blows up in some sort of unpredictable manner, the portfolio impact would be very small. If you have 10% of your stability sleeve (stability, not fixed income as a nod to TPA) in merger arbitrage that might be 4% of the overall portfolio. If merger arb cuts in half, that would be awful but the impact on the portfolio would be minimal. Compare that to 40% in AGG when it drops 13% as it did in 2022. On a price basis, AGG is down 15% from its 2021 high. The only way it makes that back is if interest rates plummet. 

Barron's had warning article about alternatives that I think excludes a huge part of the use case. The context seems to focus on trying to add alpha with things like private equity. That is a much more difficult effect to try to pull off versus a lot of plain vanilla equity for growth and using alts that seek stability and in the case of the ones we look at here, succeed at delivering stability. 

AQR is out with its capital market return assumptions as follows.

The numbers are after inflation so if inflation is running at 2.8%, they'd expect 60/40 to return 6.2% (2.8 plus 3.4) in nominal terms. The 3.4% number is lower than what they say is normally a 5.0% real return for 60/40. Playing around with different time frames on testfol.io I get higher numbers than that, more like in the high sixes. Looking at the asset classes, the expectation for US equities is lower than the historical norm but the fixed income expectations seem pretty good for those income market sectors. A 2% real return for treasuries is considered good. Or at least it use to be.

That rule of thumb is built largely on the 40 year decline in yields which is now over. Buying a ten year note and holding it for a 2.4% real return is fine, not so with treasury ETFs, but that could prove out to be a very volatile ride. Is a 2.4% real return adequate compensation for the potential volatility? For me, the answer is no. With a little more engagement, management and diversification I think the real return can be nudged up and the potential volatility reduced significantly. This is the difference between 40% in bonds versus 40% in stability. 

All of the talking points we've hit on in this post are why I continually try to find new ways to improve the stability sleeve which brings us to a fund coming this week, the VistaShares BitBonds 5 Year Enhanced Weekly Option Income ETF which will have symbol BTYB. The fund will have 80% in five year treasury notes and 20% in a synthetic covered call (short put, long call, short call) position in Bitcoin with the objective of trying to get twice the yield of the five year note. 

The idea is to blend a smaller slice to higher "yielding," higher volatility with very plain vanilla exposure. I don't know, maybe an 80/20 split addresses the bleed that goes with Bitcoin derivative income funds.

I believe YBTC is the first Bitcoin covered call fund. The 80/20 mix still has plenty of downside volatility relative to fixed income products. The 90/10 mix is a little more interesting but it's more of a yield enhancement (I realize that is the name of the fund) as opposed to doubling the yield. This doesn't make a great first impression but I'll probably follow it. The path to figuring this space out has been rough. Where I believe client/personal holding PPFIX has figured it out, there will be other funds/strategies that also figure it out.

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