The key when applying leverage like this, I think, its not to increase risk of ruin but simply risk that you will have a bigger drawdown than expected in case it turns out the hedges didn't work as well. Thats what robust optimization is all about. So you dont leverage 200%, if your portfolio has some flaws in it, you will likely go bust (there is a decent amount of risk of ruin). You take on more modest leverage (say 10-20%) in a low risk asset class, like IG bonds and worst case, you will simply have a bigger drawdown than what you intended when you came up with your investment strategy. So you lose 22% peak to through instead of your intended 16%. That's an outcome one can live with
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This would be the basis of a great after dinner speech, to the right audience. Perhaps stay clear of too much heavy stuff like stdev, keep it more to game theory, human emotion and building wealth, with perhaps reference to behaviour of asset classes if the audience can handle at least that.I was reading about some game theory concepts like Maximax, Maximin and Minimax regret
https://cs.stanford.edu/people/eroberts/courses/soco/projects/1998-99/game-theory/Minimax.html
https://en.wikipedia.org/wiki/Regret_(decision_theory)#Minimax_regret
And that got me thinking about using this for investment. If someone only could pick 1 class, how would those tools help with a recommended an asset allocation?
Maximax tries to maximize payoff regardless of risks, so that would be a 100% equity portfolio (and if allowed more discretion, 100% in Emerging Markets), let's call this the Buffett strategy.
Maximin tries to minimize the worse possible case (drawdowns). It avoids it at all costs. The asset allocation would be 100% in T-Bills. Let's call this the Zerohedge strategy
Minimax regreat is more complicated because it looks at not only at positive payoffs but negative payoffs, it tries to maximize the DISTANCE between payoffs. It wants the most 'bang for the buck', it wants to give up the least in returns (relative to 100% in equities) while at the same time minimizing drawdowns relative to the alternatives.
Since only 1 asset class is allowed (which makes things more complicated), stocks are out because they can lose 50% or more of your money. You would be losing that while the guy in T-bills is probably not losing a thing. The 'distance' between them (the regret) is enormous. But T-Bills is also out because they return so little relative bonds or stocks that most years you will experience quite a bit of regret. You will make 1-3% when stocks or other assets are taking home 10%+ or more.
So there is also an issue that is raised here
https://en.wikipedia.org/wiki/Wald's_maximin_model
The blue decision has a worse worst case loss than the red line but it has a payoff that is better the vast majority of the time. So overall, you get more bang for the buck for it and is therefore a better decision. So its not only an issue of distance of payoffs but also FREQUENCY
Which asset class would be the holy grail according to minimax regret? I can think of two classes: investment grade corporate bonds and REITs
IG corp bonds because they return more than government bonds the vast majority of the time and have a return that is less than stocks but not by a huge amount (like T-Bills), while at the same time the drawdowns on them have historically been quite limited. Even in the Great Depression the default rates on IG bonds wasn't off the charts (IIRC it was 5%). If the duration in these IG bonds is kept lowish, that provides another layer of 'regret' protection
Similarly with REITs (but perhaps much less so), they will return more than bonds, less than stocks. Their drawdowns will be quite a bit worse than IG bonds though (especially in real estate busts).
In the past I even raised the possibility that investing in IG corp bonds could be pretty much the same as a 'balanced' portfolio/risk parity strategy. The difference is that it isn't as robust against inflationary bursts. But if the duration is kept lowish (but not too low) then there is some inflation protection as interest rates adjust higher. Looking at IG bonds returns, it resembles a risk parity type allocation quite a bit
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Where is this relevant? Well, sometimes you want to help someone and make a recommendation but to explain to someone what is a balanced portfolio and talk about standard deviations will drive them to sleep, but recommending a IG bond ETF is a lot easier. So I'm calling this the 'instant' risk parity
https://www.theguardian.com/media/2005/sep/06/politics.politicsandthemedia1
What is nice about IG corp bonds is that it seems to be a hybrid between stocks + gov bonds at the right balance. If you need to teach someone that 30% in stocks with 40-50% in bonds is a good allocation, that might be too complex. You put in rebalancing in it and you are talking Greek to them. But how easy is to recommend IG bond etfs? People seem to have this 'irrational' idea if that if they buy a bond and it goes down 'its not a big deal because I can just hold to maturity'. This effect doesn't play out (mentally) as much in bond ETFs but with these ETFs at least there is an yield that people can cling on to, to provide some 'irrational comfort'.
Stocks move around too much and people panic, also if you own several asset classes people might not account them as if they were all together. They might see stocks falling and bonds rising and feel an urge to get rid of the 'problem' in stocks. Most personal financers would probably be doing it a great service for their clients if they just recommended IG corp bond ETFs with the right duration (depending on where you are in the cycle). Its just one asset class and its like a nice hybrid of stocks and bonds. I would imagine it will be lost easier for most folks to hold this compared to most other investment strategies
Stocks move around too much and people panic, also if you own several asset classes people might not account them as if they were all together. They might see stocks falling and bonds rising and feel an urge to get rid of the 'problem' in stocks. Most personal financers would probably be doing it a great service for their clients if they just recommended IG corp bond ETFs with the right duration (depending on where you are in the cycle). Its just one asset class and its like a nice hybrid of stocks and bonds. I would imagine it will be lost easier for most folks to hold this compared to most other investment strategies
I think diversified bond ETFs in general are pretty awesome. The Barclays aggregate index (ETF AGG) seems to be returning something like mid to high single digits with occasional mid single digit (typically -5%) max drawdowns for quite a while. This has been a benign period for bonds and presumably an inflationary enviroment would be bad for it but still, its quite decent. There are a number of timing strategies that look at avoiding the stock market and parking money in treasury bonds until valuations improve. Usually these timing strategies dont work, they wont add much to returns to justify the taxes and hassle. But if you use a bond ETF like AGG instead of USTs, there will be an extra return there. I would imagine some timing strategies will start to work, maybe not all but some
I guess what I'm raising here is the possibility that the ZeroHedge's of the world would be better off following the minimax regret type portfolio (IG corporates or Bond indices) instead of going to cash or bills. Its okay to be defensive and afraid, what is not ok is to not be dumb about it.
So if you think there are asset bubbles and wants to be out of them, go defensive. Don't go from 50% long in equities to 0%. Go perhaps to 20-30% in equities and the rest in IG corporates. As things gets more and more out of line, you increase the IG corporates and decrease equities. Since cash over the long-term will return less than assets (and my data show that 93% of the time in the US, the yield curve is NOT inverted), you never want to be overweight cash and cash assets (T-bills). You can minimize drawdowns and risk quite easily by following the minimax regret approach.
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The 85% IG corporates or AGG ETF with 15% in gold is interesting because this could be a good 'benchmark' or at the very least the "cost of capital" for any new investment. You always got to measure things against that and only take on an investment if it promises to return more than that. IG corporates/AGG seem to be priced to return around 3% right now, so 0.85 * 3% + 0.15 * 2% (expected inflation is the return of gold) = 2.85%
Thats the minimum required return for any asset for be worth investing in. Also, its the rate in which if you can borrow bellow, its worth borrowing and investing in.
Libor is around 0.77% and 1% (1m to 3m), the effective fed funds is around 0.66%. So even though the Fed has been raising the returns on cash, its still a very benign enviroment for assets and there is still a fair amount of spread between non-cash assets vs cash assets
Thats the minimum required return for any asset for be worth investing in. Also, its the rate in which if you can borrow bellow, its worth borrowing and investing in.
Libor is around 0.77% and 1% (1m to 3m), the effective fed funds is around 0.66%. So even though the Fed has been raising the returns on cash, its still a very benign enviroment for assets and there is still a fair amount of spread between non-cash assets vs cash assets
So, at least with the current signaling from the Fed, it does not appear one has to be worried about the central bank killing off asset markets. The Fed is talking about a long-term fed funds rate of 3%(from the current 0.66%), and it will take years to get there. So presumably with assets returning almost ~3% (some more, some less) they will still return more than cash. The risk is the Fed changing its signaling and hiking more aggressively or even worse, signaling a much greater long-term neutral rate.
I think they would only do that to the extent that the Trump policies are inflationary, if they produce real growth, there is no need to hike to offset them. It comes down to the big question of how much of the Trump policies will produce in growth and how much they will produce in inflation
I got a position in GLD that uses a fair amount of cash, I'm considering switching from GLD to GLD futures (Single Stock futures) and buying something else with that cash. Potentially a IG corporate ETF or a generic bond ETF with low duration. I just need to see how tight is the spread for rolling over these contracts. It would also be nice if there was a way to automatically roll them over
This is why I like those Brazil USD bonds. They are yielding around 5% with resonable maturities (8-10 years). That's almost double the 'required return' derived from my minimax regret holy grail and I think they are pretty safe, plus they also have an inflation protection component in them as commodities tend to benefit the country.
But with regards to Brazil, its interesting because its accepted in the country that a good benchmark for a fund manager is the 'cash rate'. Effetively the central bank interest rate. To me that sounds ridiculous, pretty much any asset will beat the cash rate over the long-term. Common sense financial theory would say this, plus my data from 1968 also shows this (can you imagine a US fund benchmarked against libor?). A monkey throwing darts at asset allocations will beat the cash rate. A much better benchmark is something similar to the minimax regret holy grail, so perhaps 85% BRL bond indices with resonable maturities + 15% USD bond fund like AGG (the USD asset is an BRL inflation protection like gold, but that it returns more).
That's a MUCH harder to beat benchmark consistently, its so 'all weathery' and will beat cash by a decent margin most of the time. My guess is that if you judge brazil macro managers by that standard, most of them are not worth the fees that they charge
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These BRL bond indices are tough to beat (even though they dont have any corporate bonds in them) because they have some high duration bonds in them. Duration is a new thing to the country and its a 'risk asset'. As a result,it tends to move with the stock market. Its a backdoor way to 'invest' in stocks. During the crisis stocks plunged and these bonds also plunged, when stocks recovered these bonds also recovered. So that one its a quite diversified 'benchmark'. As a matter of fact, the largest macro manager of the country is now investing in duration saying the central bank rate is too high. Effectively he is buying stocks even though he talked shit about the stock market through 2016
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