A Great Result That Would Be Very Difficult To Live With

We've got a lot to pack in today starting with a two hour podcast with Jason Buck who created the Cockroach Portfolio and Jim O'Shaughnessy. I hopped around a bit and took in maybe 45 minutes. There was a lot of deep stuff, Jason is a complex guy. There are just two points that I wanted to explore here.

The first one is the difficulty in holding diversified portfolios. Jason cited the cliche we say here that if everything is going up together, you aren't diversified because they will all go down together. In other interviews Jason has said that being diversified means there's always at least one holding that will make you want to puke. 

We'll dig in a little on the Cockroach Portfolio in a moment but he talked about trying to talk people out of investing in his fund because of the behavioral challenges that go with sitting in one holding, even if it has a small weighting, that is down most of the time (your diversifier). 

Jason has talked frequently about Nassim Taleb and Universa (a hedge fund that specializes in tail risk strategies) but I didn't realize the influence that Universa had on Jason. He said the Cockroach came about from reading Taleb and then trying to reverse engineer the concepts that Taleb wrote about. 

Here's how the Cockroach is allocated;

Below is the most recent version of the Cockroach that we tried to reverse engineer;

And here is how it has done through yesterday;

I threw in the Permanent Portfolio Fund (PRPFX) because quadrant style investing is also a source of influence on the Cockroach and I included the Trinity ETF (TRTY) because I think there is some conceptual overlap. We can't really backtest further than with BTCFX for Bitcoin because if we use GBTC we would get some results that I don't believe could be repeated but for the almost five years, the Cockroach has done very well. It kept up with PRPFX and outperformed VBAIX with a lot less volatility than both of them. 

While that is good of course there are a few holdings that do dreadfully bad occasionally. There might be a better mousetrap than TAIL but that one is a tough hold. Managed futures funds are frequently difficult to hold. Bitcoin is currently in a 40% drawdown. I think people give gold the benefit of the doubt but 12% is a lot when it's on a downswing. All of that and our version of the Cockroach works.

Here's a more extreme example of holding something that goes down a lot from time to time from an article that tries to deconstruct Mulvaney, the CTA shop that made news for making a fortune on cocoa a couple of years ago. 

80% of their trades lose money? The long term result is fantastic but the drawdowns can be brutal. The strategy is that trades are small and allowed to grow unconstrained until they get stopped out, constantly increasing stop levels for a trade that works. Risk is managed with stop orders not position sizing or risk weighting per the link above. A reader turned me on to the article when I asked if anyone knew about any funds more volatile than MFTNX that we looked at yesterday. 

Pivoting to leverage that I think I can weave into today's discussion, Jeremy Schwartz from Wisdomtree sat for a much shorter podcast with Ben Carlson. Wisdomtree has quite a few capital efficient (leveraged) ETFs and they appear to do exactly what they say they will do. Part of the argument in favor of these funds is that the leverage is not being used to magnify one position, instead the leverage is used to add diversification without having to take away from the stocks and bonds allocations.

The idea makes sense but that doesn't necessarily remove the risk that the disparate assets in the fund both go down. If sized appropriately, that isn't necessarily catastrophic but while VBAIX was down 16.87% in 2022, NTSX, which leverages up such that a 67% weight to it equals a 100% weight to VBAIX, was down 25%. The math checks out in terms of the fund working correctly but sized incorrectly, 25% is a big decline. Additionally, with the stocks/bonds combination funds, you have to want the bond exposure they offer. NTSX has AGG-like bond exposure, RSSB has a treasury ladder of sorts that takes on plenty of duration. 

Stocks and bonds can go down together. In terms of being willing to look different, these funds are about not looking different. The ReturnStacked guys talk about their funds helping to avoid tracking error. The bond market is a great place to want tracking error, to want to look different. The benefit of looking different with respect to bonds for individuals is less volatility and the benefit of looking different with respect to bonds for portfolio managers is better risk adjusted performance.

Here's a little more about effective use of leverage from RCM.

We've looked at leverage a little differently. More real world, we've looked at how a small exposure to negative convexity can allow for a little more exposure to equities. Not a lot more, a little more. If equities start to decline, the fund with negative convexity will grow to hedge more of the portfolio. A little more theoretically, we've done some things will small exposure to SSO which is 2X S&P 500 and much smaller exposure to TECL which is 3X technology. Putting 5% into TECL only to see it blow up would be a bad outcome of course but no catastrophic.

Investors are leery of leverage which is a good starting point but as the pro-leverage crowd will tell you, serious problems comes from misusing leverage. I would tread very carefully with any of this and I would avoid a fund that leverages equities and duration. I don't know if there are more bond market declines coming but I do think there is more bond market volatility coming.

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.