In April this year, I introduced The Italian Leather Sofa model portfolio. As a reminder, here is the portfolio composition:
- 60% stocks (via NTSX)
- 40% bonds (via NTSX)
- 20% trend (via DBMF)
- 10% commodities trend (via COM)
- 4% Tail risk (via TAIL)
- -34% cash
The idea behind the portfolio is stolen from here. The link offers the best explanation to what I think is the most common question related to it, i.e. why the portfolio use leverage (and why in this context leverage decrease risk).
It represents the core portfolio I would invest in if I could access those ETFs (and if I was not so prone to slice and dice the equity and bond allocations to try several strategies like factors). Please note that the returns you find in the Model Portfolio series will always reflect the point of view of a USD-based investor. The ETFs are priced in USD and Composer, the app that tracks the portfolio, does not allow to change the reference currency. Besides these ‘technicalities’, the focus of this series is on how to build a great and simple permanent portfolio; there are various solutions an investor can employ in case they do not have the USD as their base currency and wants to eliminate the FX volatility. As I wrote here about the All Weather Portfolio, I am personally not bothered by the FX risk, given my investment horizon and the fact that I do not consider myself a GBP-based investor even if I live in London. Plus, I do not have any currency-specific audience that would make this series more helpful if run in EUR or GBP.
In Q1 the portfolio was down 2.6%. How has it performed in the last three months? Unfortunately, losses piled on and the portfolio closed Q2 with an additional 9.8% negative return [as a reminder, Composer allow users to share their symphonies models, send me an email/write in the comments if you want the link].
The yellow line represents the Model Portfolio, while the other two are functional references (cannot really call them benchmarks): the 60/40 portfolio (blue line) and the S&P500 (red line).
Below you can find details of each ETF price performance. Some of the ETFs paid dividends in the period that are included in Composer returns but not in my table:
Below is the YTD price graph for each component of the portfolio:
Despite the overall negative performance, the above picture is somehow reassuring in the sense that the portfolio elements are doing what I expected: they moved in an uncorrelated, sometimes even negatively correlated, way.
TAIL lost money even in a period when the S&P500 lost around 20%. TAIL works best when there are significant volatility events, when the market drops big and fast. In 2022, the descent has been pretty calm and steady, while the VIX remained capped under 35. So, nothing out of the ordinary here.
COM pays a quarterly dividend, so its “real” performance YTD has been almost double what you see in the graph: 11.7% instead of 6%. I choose COM over a standard long-only commodity index because it has a momentum tilt; we are in a period where almost all commodities are trending higher but hopefully the ‘protection’ will kick in when needed in the future.
DBMF is a managed futures strategy I wanted in the portfolio to provide protection for periods like the one we are in now. Glad to see that so far is doing its job.
It is not great to write quarterly updates when I know some of the themes I had in mind when building the portfolio might not work for decades. Portfolio choices are deliberate but the results, especially on such a short-term horizon, can be random. TAIL, COM and DBMF are all products that I included in the portfolio to protect from breaks in stock-bond correlation…or I should say when the correlation is positive and both assets are going down.
This week I found a great post from AQR on Stocks-Bond Correlation and I will include it here as bonus content. It provides further elements to understand why COM and DBMF pair really well with NTSX (a levered 60/40 ETF).
“For the past two decades the stock/bond correlation has been consistently negative, and investors have largely been able to rely on their bond investments for protection when equities sell-off. But this hasn’t always been the case, and macroeconomic changes – such as higher inflation uncertainty – could lead to a reappearance of the positive stock/bond correlation of the ‘70s, ‘80s and ‘90s.“
AQR demonstrates that two of the most cited bogeymen for SBC, low yields and high stock valuations, had in reality no impact on SBC in past.
“Intuitively, equities strongly prefer ‘growth up’ environments, while bonds exhibit the opposite relationship. With regards to inflation, both asset classes prefer “inflation down”, though bonds’ sensitivity is noticeably stronger.”
What drive SBC are growth and inflation shocks, unexpected news about growth and inflation. In other words, to drive stocks and bonds down at the same time, the dreaded scenario for the 60/40 portfolio, we need unexpected higher inflation, not simply high inflation. This is the scenario we will face in the future: higher volatility in inflation, big swings up and down in inflation levels.
In case the SBC increases, a simple stock-bond portfolio would see its risk go up. To maintain the portfolio risk/return profile, AQR suggests (not surprisingly) reallocating part of the portfolio to alternative diversifiers.
See you next quarter!
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