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Building Hedged Portfolios With Alternative Investment Styles
We employ scenario frequencies to build all-weather portfolios. There are hedges to help us endure our four seasons. We weight 64% of assets to match four scenario frequencies. We are free to allocate 36% to match the scenario expected the most or to reflect other (normal) times. Today, we would allocate 4% to 5% to a contingency reserve. The rest of the portfolio is overweight to bust and boom scenarios because normal times are not expected until after 2016 (financial restructures take at least a decade). We also could employ an alpha overlay with 5% to 10% in short-term Treasuries to collateralize long/short commodity, bond and currency exposures. We will review this soon.
Follow your gut and research. The Arrow Insights (AI) 75/50 Portfolio is positioned mostly for an inflationary bust with a 72% allocation to inflation hedges—gold bullion, emerging markets, energy, agricultural stocks and Treasury inflation-protected securities (TIPS)—while short the 20-year T-notes as well as foreign and consumer discretionary stocks. The portfolio is balanced with half of the assets defending against an economic bust and half positioned to profit from a boom.
Figure 2 displays our scenario strategy for building a hedge fund of funds allocation and the AI 75/50 Portfolio. By example, to hedge a deflationary bust we would allocate 9% of assets to no- or low-leveraged assets, bond-timer hedge funds, short-biased hedge funds, market-neutral funds and managed futures. Experts often recommend a similar amount to these hedges. In the bottom left-hand corner is a red-shaded box labeled Deflationary Bust with a big-picture tip. Here we suggest that investors buy government bonds and gold while selling stock and negative cash flow assets (new ventures and junk bonds).
There are red (deflationary) and green (inflationary) shaded boxes in Figure 2 with tips for each scenario. Portfolio allocation headings are at the top of the center boxes along with the scenario's frequency. Under each is a bulleted list of manager styles appropriate for each scenario. Hedge fund managers and exchange-traded funds (ETFs) best suited for deflationary and inflationary times receive 25% and 39% of portfolio assets.
Current ETF allocations listed are for the AI 75/50 Portfolio. These ETFs are at the bottom of the middle boxes. For example, for a deflationary bust there is a 20% allocation to EFU, GLD and SCC. This is an overweight allocation to this scenario because it exceeds its frequency by 11%.
If you add the AI 75/50 allocations at the bottom of the four middle boxes, you get 185% in ETF exposure. On March 31, 2009, exposures were 146%. The discrepancy is from ETFs that hedge more than one scenario.
Besting MPT
This process is tedious, but it works. Passive allocations that employ this process beat MPT optimizers hands down! Why? Because alternative investments are a mixed bag of active styles with changing asset exposures making it hard to make the right inputs for optimization. Another alternative is to substitute managers for manager style replications appropriate for each scenario (more on this later).
Our RAA process maintains core allocations appropriate to each scenario. Doing so limits observer bias and adds structural reflexivity. Management does not have to predict the future. The portfolio is positioned for climates that eventually pass our way. Sources of return must be varied and rich enough to limit losses. In future newsletters, we will demonstrate RAA results.
A New Partner
A huge factor in asset allocation decisions is government influence in our investment world. It causes us to hedge an inflationary bust more than other scenarios. Since September 2008, Uncle Sam has been the single largest investor in our economy, with more than $14 trillion in commitments to private-sector businesses.
This factor overrides our concern about our entrance into a deflationary bust in December 2008. We entered this climate for the first time since 1954. The 1954 sojourn was brief, as were those in 1949, 1939, 1928, 1929 and 1921. We are very concerned because our only enduring trip into this climate after 1920 was the Great Depression from 1931-1933. Recent rates of change in YOY inflation and RGDP declines have been the most severe since then.
In spite of our concern about a deflationary bust, for now we are very committed to an inflationary outcome. From October 2007 through October 2008, we were in an inflationary bust due to past accommodative fiscal and monetary policies. Trillions more in government commitments to the financial system and huge fiscal deficits will only get larger as we continue the status quo. Governments have historically opted to repay debts with a cheaper currency. Federal Reserve Board actions and the Fed's stated strategy will reinforce the inflationary bust cycle that was in place prior to November 2008.
However, past debt accumulations limit our options and place us on a path toward an inflationary bust. The chickens have come home to roost since they flew the coop during the 1980s (the birth of our debt bubble).
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