What About The First 10% Down?

Today I moved clients to be a touch more defensive by buying a little of an inverse fund. The risk of this event going from stocks being down a little to being down a lot has increased based on the private credit deterioration that appears to be under way and the disruption in the oil market being caused by the war in Iran which could cause economic problems here. The US doesn't get oil from the middle east anymore so supply won't be disrupted here but price has already been disrupted. Additionally, this morning's job report showed a job loss of about 90,000 people which was far below consensus yet price inflation is still running a little hot.

We should hope that the trade today proves out to have been unnecessary and that the market rips higher from here but this is insurance in case it does go down a lot. If stocks drop, the inverse exposure will grow to protect more of the portfolio (convexity) and if stocks go right back up, the inverse exposure will shrink to be less of a drag (negative convexity).

The above passage is most of what I communicated internally to the advisors who outsource portfolio management to me. To my clients reading this, you'll get an email tonight covering a lot of the same ground.

For a little more color, the point isn't to try to predict anything. Risks have increased so I am reducing the portfolio's equity beta without selling. Twenty years ago, there were far fewer ways to buy protection. The way that product sophistication has evolved, I think it is better to buy protection than sell beta. What if today was the bottom? If so, the stocks exposure I didn't sell has the opportunity to go up with the market while the slice I added today would shrink in relation to the rest of the portfolio. 

Slight pivot, Simplify has a short paper up in support of its new capital efficient ETF CTAP which is 100% equities and 100% managed futures similar to RSST. The argument for using CTAP is similar to what the ReturnStacked guys say to support their funds. The big idea is that you can maintain a 60/40 portfolio and then add managed futures exposure to help reduce tracking error.

The idea of reducing tracking error doesn't really click with me in the context they mean it. We've talked about this before. Clients don't seem to care about fixed income performance unless bonds are tanking. I had a new thought that I might have some sort of bias here. Long time readers might recall that I've pretty much never had any exposure to duration, very very little. I didn't word it this way back then but the compensation for duration hasn't been adequate in ages. I have some understanding of the distress caused by bonds tanking from when I started subadvising for the other advisors I mentioned. Absolute carnage. 

This was an easy thing to observe. How is 3% adequate for ten years let along two years let alone 58 basis points? If you were reading my stuff back then you read this from me in real time. The new thought is that since I've never relied on duration in any kind of meaningful way, clients had a small position in TOTL for a while, I don't miss it in constructing portfolios, I don't need to find a way to make room for AGG-like exposure. 

Here's a podcast from RCM that goes into great detail about managed futures in this context and related topics. One point made very plainly is that we should not expect much from managed futures during the first 10% down. Think about last April, managed futures got pummeled. It was a crash that ended quickly. A managed futures program would need to be heavily weighted to hourly signals to have had a shot at doing well during that bad week. 

Thursday of this past week, pretty much everything went down except inverse and oil. Gold down. Managed futures down. Defense contractors down. Even CBOE which is often a proxy for VIX when the market drops was down. Oh, and bonds were down. 

At this point, if you're a frequent reader you already know whether you agree with me or disagree with me about duration now being useless as a reliable diversifier but if you agree that duration has become less reliable then leveraging up to own equities, duration and managed futures has a high chance of doing much worse during the first 10% down than some sort unlevered combo of those three.

This is last April. Is it much worse? That might be in the eye of the beholder but the leverage in Portfolio 1 is certainly noticeably worse. Part of the pitch for the new generation of capital efficient strategies is that they are not levering up one asset, equities on top of equities. They are levering up with what should be uncorrelated assets. Uncorrelated except for the first 10% down.

I place great importance on figuring out what to avoid (or underweight). If you can do that every so often then you are inviting tracking error and I don't think that's a bad thing. Quite the opposite. 

It makes sense to continue to study capital efficiency, it's fascinating and the space is evolving which hopefully means better products or better ways to build it yourself. The concept we've gravitated for now is leveraging down where including strategies that have a reliably negative correlation to equities or no correlation can allow for slightly nudging up exposure to equities (the thing that goes up the most, most of the time). Another application of the concept is what we've been talking about this week with the two long short funds that sort of lever up but in different ways. HFEQ targets 2x volatility. A 20% weight to that fund would be 40% of your equity exposure in terms of volatility (maybe returns, it depends) leaving 20% to collect some low volatility yield so something similarly boring (boring is good in this context).

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.