Global Macro Trading Journal

[Daal]

"When does this approach lose money?

Risk parity loses money when the diversified portfolio of assets has a lower return than cash.

What are the risks of this happening?

A well-diversified portfolio of assets will underperform cash when a central bank’s tightenings are enough to raise the discount rate used to calculate the present value of the assets’ cash flows (thus lowering their present values), and cash rates are high enough to drive money from other assets to cash because the risk premia in the other assets are not adequate.
While any one asset might underperform cash for a while, it is rare that a welldiversified portfolio of assets will underperform cash for long because it is intolerable for the economy, which leads central banks to ease monetary policy and fix things. That is because the world economic system depends on central banks making cash available at interest rates that people can borrow at so they can use the cash to do things that produce higher returns than the cost of the cash that they’re borrowing. That is not just a theoretical statement; throughout history, the times in which a well-diversified portfolio of assets underperformed cash for any significant period of time were times of depression and were always followed by central banks doing all in their power to rectify that. The worst performing periods were in the Great Depression and in the 2008 financial crisis, and in those periods our balanced portfolio did materially better than stocks or a 60/40 portfolio."

 

[Daal]

They use the Sharpe Ratio quite liberally instead of the Sortino ratio. If you consider the Sharpe Ratio, then that Dalio portfolio gets quite close to my finding of the best Sharpe ratio portfolio since 1928

Dalio is more heavy in long duration bonds but that could because of the 'synthetic' leverage that they provide. My sample didnt had access to long durations like that, its possible that juicing the return of the portfolio through duration was a way to get even better Sharpe ratios historically

 

[Daal]

Dalio:
"Is there a downside? Leveraging asset classes and holding a balanced portfolio creates a different type of risk than holding a traditional portfolio with lower expected returns and a higher concentration in equities. Whereas the risk of the traditional portfolio is largely a function of the risk of equities, the risk of this portfolio is that other asset classes will, on average, underperform cash. We are comfortable with this risk for reasons previously explained; and, while we can’t predict with certainty how things will play out in the future, we have stress-tested these concepts back to 1925 across multiple countries. Further, the amount of leverage required to create this type of portfolio is typically very low. If investors can get used to looking at leverage in a less prejudicial, black-and-white way – “no leverage is good and any leverage is bad” – I believe that they will understand that a moderately leveraged, highly diversified portfolio is considerably less risky than an unleveraged, non-diversified one"

http://orcamgroup.com/wp-content/uploads/2012/10/pmpt-engineering-targeted-returns-and-risks.pdf

 

[Daal]

Leveraging my portfolio in a way that makes sense is something that I need to explore, it would potentially help me boost my returns while keep my risk controlled and I would be able to pretty much retire from other, more intensive forms of trading such as daytrading.

 

[Daal]

That article is pretty interesting because Dalio talks about the 2 different ways one can use to juice returns to achieve the return embedded in equities. One is by building an Optimal Beta portfolio (something like the Tangency portfolio) and levering it up to the same level of return as equities. The portfolio is still likely to have a better Sharpe Ratio as being invested 100% in equities
And the other way (if the investor doesn't like that first way) is to achieve an Optimal Alpha portfolio. To choose managers and diversify across many of them to try to achieve higher returns. Those higher returns can be choosen with beta overlays (I want to put 30% in stocks and choose managers/funds in that 30% bucket to equity market beating managers) or to choose managers regardless of their beta (so, one would split their money in 15-20 hedge funds/managers that one believe can beat the market without a lot of correlation amongst each other, regarless of the asset class that they are in)

That's sorta what I'm doing with my investment in the Ackman fund, Berkshire Hathway and OAK (Howard Marks's company) but I do see his point in the need for diversification in the Optimal Alpha portfolio. I probably need to cease increase my exposure to these 3 managers and try to find other ones (or alternatively, leverage my portfolio in a way that makes sense). I'm doing that a little bit with my bet in brazilian assets (where I'm the "manager" of the fund)
But if I increase that diversification of "managers" further COMBINED with some modest leverage when I can't find a good manager, I can potentially really juice returns with low risk

 

[Daal]

Looking at these Bridgewater ideas on optimal portfolios its clear that I'm probably too concentrated on equities right now with a 53-55% allocation plus some of them are leveraged, bringing my actual exposure to more like 66-70%. Thats sort because of that theme that I got going on that Trump will be good to the US stock market and Brazilian equities will do well. However, it is probably prudent for me to hedge some of the US stock market exposure by buying more US bond duration, maybe using futures. On the Brazil side I'm already resonably well hedged use my 45% exposure to the USD plus my USD income that comes from my short-term trading. But on the US side, I will have to make a decision soon to hedge that
Of course, as I type bond futures are down 1%, so it might be bumpy, especially because the Fed could surprise on the hawkish side given Trump's fiscal plans
In any event, I plan to do some backtesting of optimal portfolios with leverage included since 1928 to see how well does that do

 

[Daal]

Looking at these Bridgewater ideas on optimal portfolios its clear that I'm probably too concentrated on equities right now with a 53-55% allocation plus some of them are leveraged, bringing my actual exposure to more like 66-70%. Thats sort because of that theme that I got going on that Trump will be good to the US stock market and Brazilian equities will do well. However, it is probably prudent for me to hedge some of the US stock market exposure by buying more US bond duration, maybe using futures. On the Brazil side I'm already resonably well hedged use my 45% exposure to the USD plus my USD income that comes from my short-term trading. But on the US side, I will have to make a decision soon to hedge that
Of course, as I type bond futures are down 1%, so it might be bumpy, especially because the Fed could surprise on the hawkish side given Trump's fiscal plans
In any event, I plan to do some backtesting of optimal portfolios with leverage included since 1928 to see how well does that do

However, this is all very complicated because as Dalio says, it depends on whether the manager is benchmarked and if he has a tracking error. Both Ackman and Buffett are not really tied to the S&P500 because they got permanent capital and can do almost whatever they want, so that allocation is more like an Alpha allocation rather than a leveraged beta. Or perhaps its a combination of the two but with a dominance for the Alpha side. If I'm going to think about it that way, then my true stock exposure is less than 66-70%. What do I have is a high Alpha exposure to these managers.
And with OAK, that is more tied to the corporate/HY bond market than to the stock market, so perhaps I shouldn't consider that 1 for 1 "stock" exposure at all

This is all very complicated but I think, its the type of hard work that pays off for the rest of the live of an investor, so I plan to do more thinking and rambling about it until I figure things out!

 

[Daal]

On the BRKB side, I got to count that more as a 'true stock' rather than Alpha because his portfolio is now so big is quite correlated to the S&P500. Both BRKB and the S&P500 will collapse or prosper together but BRKB should have an small edge over the years
With PSH, thats more true a Alpha exposure because that lives on a world of its own due concentration, activism, discount to NAV dynamics. So perhaps, I dont need to count that as much a "stock allocation" but more as an Alpha allocation

 

[Daal]

A huge question that I have, Dalio says that in his All-Weather fund they deliver beta but give some alpha for free (by overriding it ocassionally). One of the risk controls is to implement portfolio changes when they think cash/risk free rate assets will outperform risk assets , which COULD be starting now that Trump took over and the Fed is hiking/planning more hikes. Dalio has been sounding quite bearish in the bond market in recent weeks, what I want to know is, is he overring the All-Weather 'secret sauce' allocation by cutting down in bond duration? Perhaps unlevering the portfolio by selling bond futures? I think might very well be doing that

 

[Daal]

I"m in a good position because even though the US could be in this situation where the return on cash can be higher than in other places like bonds, gold, etc. Brazil is likely to be facing the opposite scenario, the return on cash has been good for a few years and this has put pessimism in other asset classes like stocks, so its quite possible stocks will beat cash handly over the coming years, this puts me in a good position to diversify away that risk. In fact, maybe thats the place I ought to be levering my exposure