Have you ever heard about the Cockroach Portfolio? It is novel perspective on the Permanent Portfolio, four quadrant investment strategy.
When you make an investment, you evaluate the potential return against the risk you are taking. Volatility is the most used risk measure but it does not give you the full picture.
For example, investors with a long time frame do not care about volatility, they care about this:
A permanent loss of capital (if you include dividends, the total return of the Italian Index is close to 0 in that period, so better than the pic…but you get the point).
While if this is high volatility, you would take it every day:
Volatility, or standard deviation, as a measure of risk is a good place to start the discussion: if we take Markowitz theory, volatility predicts that investors want to diversify because they are worried about portfolio volatility. But as in the GameStop example, volatility is a rather crude measure of risk because it penalizes upside moves as much as downside moves. It is also hard to estimate volatility because of rare tail events: financial assets have heavy tails (their return distribution is not a normal distribution, statistically speaking) and investors have to keep reminding themselves that just looking at realized volatility over a given period of time can be misleading.
If I have a long time horizon, let’s say I’m 30 and saving for retirement, in an Excel world I would not care about volatility and simply invest in a broad basket of the highest returning assets out there: this is why my portfolio should be 100% stocks. The main risk here is a permanent loss of capital, like investing in a single company and then the company going bankrupt. If I hold the investment for 40 years, one or several drops of 30% do not matter as long as at the end of the journey my returns are close to the initially forecasted figure: if the original hypothesis is respected, I am investing in an asset with positive expected returns, over a long period I should achieve my goal. In this case, volatility matters only for those investors that cannot stomach the ride and are prone to take the wrong decisions, as Michael Mauboussin recently put it:
Paul DePodesta, a protagonist in the book Moneyball and now the chief strategy officer for the Cleveland
Browns of the NFL, says that owners indicate that “we want this disciplined approach to what we’re doing.
But then when it comes time to making that hard decision, they say, ‘I don’t want any part of this.’”
He compares the decision-making process, with its inevitable successes and failures, to riding on a big
and terrifying roller coaster. He discusses the ideal owner: “I need someone who’s going to want to get on
the roller coaster with me knowing that it’s not always going to be fun. There are going to be parts of the
roller coaster that are going to be scary, that are going to be uncomfortable, but hopefully at the end of
the ride when we get off, you’re going to want to say, let’s do that again.
Volatility represent an issue for different group of investors: risk adverse people (as described above) and people that are using their portfolio as a source of income. A stock portfolio volatility is way higher than the average pensioner cost base: if the market dives 30%, a retired person cannot simply live with 30% less income. This is why different portfolios, like 60/40 or the glidepath of Target Day funds were introduced in the past. Unfortunately, 30 years of bull bond market brought the bond part of those portfolios to such low yields that cannot even match inflation.
This prompted several investment managers to create different, more resilient portfolios and the introduction of additional, downside risk measures. These portfolios can be useful for retiree, rich people that want to stay rich, risk adverse investors but also for risk seeking investors that can use leverage to increase their returns, given that volatility and drawdowns are (should?) be limited and controlled.
As a first step forward, we should consider skewness. The aggregate stock market has earned a high risk premium historically and doing so it exhibited negative skew, longer and fatter tail on the left side of the return distribution. Or, as a non statistical person would put it, “the markets take the stairs up and the elevator down”. So one interpretation of the high premium is that it is compensation for the negative skewness, which people find unappealing. On the other hand, IPOs and out-of-the-money options earn low average returns. These are positively skewed assets, so one interpretation of their low returns is that investors really like the positive skewness and are willing to pay a high price for it.
Investors preference for ‘lottery tickets’ investments like high growth (and high volatility) stocks is as well the reason why Low Vol as a factor overperform the market. This puzzle some people because in theory low volatility is a desirable feature, therefore should demand a premium and lead to underperformance. In reality, not all investors have easy access to leverage, therefore chase high volatility stocks because they are their only way to enhance their portfolio returns.
Investors preference for positive skewness led, for example, to the study of trend-following. By trying to ‘let the winners run and cut losses early’, this risk management strategy is appealing as it results in better skewness and drawdown characteristics than simple passive strategies. A simple example can be represented by a strategy that stay invested in the S&P500 if the index is above its 200 days moving average and go to cash otherwise. Following this strategy, your maximum drawdown is limited by the distance between the index all time high and the 200MA, not the bottom of the bear market as for a passive strategy. Obviously this comes at a cost: you trade more frequently, you have to follow the market to act on the signals and if the S&P500 is range bound and moves over and under the 200MA the strategy brings you to buy high and sell low.
An example of these ‘new’ portfolio strategies is risk parity. The ingredients are widely available as low cost index ETFs but it is hard to define and maintain asset target volatility, long and short term variance-covariance matrix that runs behind to define the weights of the portfolio. The unlevered portfolio volatility is also equal to the lowest volatility between the assets: to achieve meaningful returns you need leverage. Levered ETFs might do the job but require additional maintenance. Wilshire created some indexes that show what is possible to achieve in terms of returns:
This returns are anyway more theory than practice, this is an index that cannot be traded as is. Even if you manage to create your own matrixes and find an effective way to maintain leverage, this strategy has an issue when presented with meaningful short-term volatility shifts. Wilshire uses VIX as a daily equity volatility dampener: when stocks goes down, and VIX/volatility goes up, the index buys more VIX, in theory to lower the portfolio riskiness but in reality fuelling and further precipitating the current crisis. In short, a risk management technique can cascade and create a huge systemic risk.
The DIY alternative are ETFs that do the strategy for you:
As you see, this ETF is quite new and does not have a lot of history; plus, being listed in the US, you can access it only if you dodge MiFiD.
Portfolio Charts is maintaining a simplified version of the Risk Parity portfolio. If you manage to not close the page when you read ‘Tony Robbins popularized this’, you can see that this simple, 5 ETFs allocation generated a 5.6% average annual return with an annual loss frequency of 25% and max drawdown at 16%. Not bad!
The only problem, as everything in finance, is that what you read are past results. At current yields, can a portfolio that invest 55% of its assets in bonds generate enough returns for the next 10 years? The Portfolio Charts database goes back to the ’70, how much of these returns are a product of a 40 years bull market in bonds? Can I draw a skier with my mouse?
The Cockroach Portfolio
Let me introduce you the cockroach portfolio, Jason Buck of Mutiny Funds latest product. Yes, the name is cool and no, if you are not already multi-millionaire you cannot invest in it. So, why are we talking about it? Because I think in their white paper there are useful ideas even for us poor folks in Europe.
Starting from the idea of the Permanent Portfolio (25% each in stocks, bond, cash and gold), the Mutiny team arrived to a revised 4 quadrants approach:
Unfortunately there are not a lot of instruments available on the market in this segment, proof is the Mutiny folks created their own. Instead of running your own option book, we can use the TAIL ETF in our analysis, which was created by Med Faber exactly for this purpose.
The second change Mutiny does is to substitute Gold with trend strategies on commodities, stocks and bonds. “By focusing on a broad basket of commodities instead of just gold, commodity trend strategies can capture inflation wherever it shows up. By utilizing trend strategies on financials such as stocks and bonds, they can do well in an extended recession or bear market.“
As a (very limited) proxy of this strategy we can use the Direxion Auspice Broad Commodity Strategy (COM US), an ETF that allows investors to take advantage of rising commodity prices, in addition to mitigate risk by going flat (cash) when individual commodities are experiencing downward trends. Here what happens if we add Portfolio 3: 25% stocks, 25% bonds, 25% COM US, 25% TAIL.
Great, no? No.
Because this is a rubbish analysis, we only have a very limited time-frame to play with. But you can sense the possibilities. And this is done with only 4 ETFs, imagine if you can further diversify within each quadrant:
While the choice of ETFs is not that big now, new (and old) issuers are coming to the party. Simplify ETFS is launching a tail risk strategy and a volatility premium strategy. Meb Faber (again) runs since a couple of years its Trinity ETF, that combines elements of the Permanent Portfolio with trend and value. More will come and some (I hope) will also remember of us in Europe.
What I am reading now:
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