Should You Prepare For A Lost Decade?

We spend a lot of time here trying to study and learn about how to make portfolios more robust to various types of risks including market risk (bear markets) and event risk (usually resulting in fast declines). One market risk might be a so called lost decade. A report from Gorman, Keel and Randazzo went into depth on lost decades. 

I added the green rectangle because that doesn't look very lost to me, but the red rectangle would seem to fit the bill. If you were around for the lost decade of the 2000's you know first hand that even in a lost decade, there will be pockets of the market that will do at least ok, if not better than ok. 

In the 2000's, dialing up foreign exposure was pretty important for example. Someone who builds a portfolio that includes individual stocks would reasonably have at least a couple that would do just fine if we have another lost decade. There are now more ways to build a portfolio that includes all weather types of funds or tools that would allow investors to build their own all weather portfolio to succeed in a lost decade. 

Ares tried to make an argument for (private) infrastructure to play a role in a lost decade (my interpretation) because they say it tends to go down less, has fundamental tailwinds behind it and doesn't necessarily rely on a favorable economic cycle. It's not that infrastructure is reliably countercyclical but money can still be spent on infrastructure development and various forms of tolls can still be collected. 

Maybe private infrastructure can offer crisis alpha or maybe it's just volatility laundering but I wouldn't count on getting crisis alpha from infrastructure stocks or ETFs. I use PAVE for clients with part of the thesis being, we need to invest a lot into our infrastructure, I believe the money is going to be spent no matter what is going on, even if it happens in fits and starts. I've talked frequently about my belief that publicly traded financial financial markets are also part of the infrastructure theme as toll takers. I use CBOE in this context which also benefits from VIX trading volume despite getting kicked very hard over the last couple of weeks or so. In 2022, PAVE and CBOE were only down 7.18% and 2.17% respectively but I am saying I would not rely on that to repeat....great if it does. 

The Ares paper explores leveraging up with a sort of portable alpha strategy to add 20% in infrastructure to a 60/40 portfolio. Here's how I built their idea out.

Compared to plain vanilla 60/40 comprised of SPY and AGG.

It does outperform but with more volatility and the max drawdown was much higher. The infrastructure portfolio went down less in 2022 but down more in every other significant drawdown available to look at. 

According to Copilot, the main driver of the outperformance is the leverage, then avoiding duration with FLOT and MERFX (both client holdings), we always avoid duration in these exercises, with the infrastructure exposure being the least important driver. While I believe in infrastructure, I am skeptical that it can do the sort of long term heavy lifting implied in the Ares paper. 

Kind of funny, on the flip side of a lost decade for equities, Robert Pozen made the case for 90% equities instead of 60%. We can get a sense of what 90/10 would look like versus 60/40 from the last two previous lost decades cited above. I'll use the IEI ETF for the fixed income allocation, testfol.io can't go back as far as we need with AGG.

If there is a lost decade anytime soon, I wouldn't want to rely on bonds helping as much as they did in the last two lost decades. In the most recent lost decade, the SocGen Trend Index compounded at 13.43%. The index was not around in the 70's but Gemini theorized that managed futures trend would have done better than 13.43 from 1968-1974.

Having some managed futures seems like a good idea to help with a lost decade and I would consider more than one fund to build out this part of the portfolio and maybe a higher volatility managed futures fund should be considered. 

Gemini thinks that global macro, equity market neutral, merger arb, commodities and reinsurance would also work in a lost decade. 

Selling volatility doesn't seem like a great idea but Gemini said that covered calls might be a strategy that could work. 

There isn't a great sample size to study on that point but I certainly wouldn't go heavy if at all into crazy higher yielders. 

It makes sense to think about what you'd do if equities start to sputter. Getting the timing exactly right seems like a low probability outcome so I wouldn't make dramatic changes. Dialing down equities a little and dialing up diversifiers a little can work to improve results in a lost decade without being completely left behind in case it's just a lost month. 

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.