Asymmetry As An Asset Class?
Exploring different ways to build asset allocations has always been a fun and fascinating topic. It's not so much that I want to deviate very far from some mix of stocks, bonds and cash but small deviations, which I believe I've been practicing, can be constructive for improving risk adjusted results, avoiding trouble spots (how excited would you be about lending the government money for 30 years in exchange for 1.85%?) and better managing volatility.
I recently started following @trader_ferg on Twitter. He has some interesting opinions on asymmetry which is something I've written about a lot over the last few years. In a recent Tweet he cited some rules he's come to learn and incorporate into his trading process including "asymmetry in all positions." From what I can tell, he specializes in energy and is currently focused on the uranium space. Having asymmetry in all positions probably doesn't work in a typical individual investor's portfolio. If you're starting point is a mix of stocks and bonds and building out from there, you're not realistically going to find an asymmetric opportunity in bonds or bond proxies.
In trying to come at asset allocation with a completely different framework than 60% stocks/40% bonds, the first sleeve might be bond proxies. In this category we'd be looking for something or things that has similar volatility and return attributes but without the interest rate risk that goes with lending money with rates very close to all time lows. Trying to trade bonds for capital gains in a portfolio for an individual investor seems like it would be very difficult and has a picking up nickels in front of a steamroller feel to it. For my money, literally, client and personal holding Merger Fund (MERFX) fits the bill as a bond proxy. In the last ten years per Morningstar it has only had one down year, 2015 when it was down less than 1%. For the ten years it is up a shade over 38% which simplistically averages out to 3.8% per year and it's deviation from that simple average has been modest. Draw your own conclusion of course but I am thrilled with how boring and steady MERFX has been.
One thing that MERFX is not is asymmetric.
A few investors who I have respect for are big believers in using tail hedges. This is something I've written about quite a few times and have been implementing in client portfolios for many years. This has become easier with the Cambria Tail Risk ETF (TAIL) which again is a client and personal holding. It is essentially a treasury portfolio with some S&P 500 puts. It has generally gone from the upper left to the lower right which is not ideal in nominal terms but it does spike up when it is supposed to, when the market turns lower and I expect that to continue to be the case going forward. Also it's deterioration in up markets is much less than inverse funds. Obviously if managing volatility does not resonate with you then you probably would have no interest in a tail hedge but I think a small allocation can be effective but not asymmetric.
Interestingly, TAIL doesn't look very much like gold as measured by client and personal holding SPDR Gold ETF (GLD). Over the last 15 yeas Morningstar shows the S&P 500 up 298% and GLD up 200% but they have taken very different paths to those results. Occasionally the correlation does tighten up as was the case in the middle of 2020. The way I have worded it is to say that gold has the historical tendency of not looking like the stock market very often. They trade differently often enough that I believe gold does offer diversification but despite what touts might say, gold is not asymmetric...unless you want to bet on the end of the world and turn out to be right.
In the context of this exercise, a large allocation needs to go to broad based equity exposure even if I don't have more clever term for it for this post. Specifically I am talking about indexes like the S&P 500 or S&P 1500 or a global index, whatever, something or things that capture beta, this will not beat the market or lag the market it is the market. If the US stock market has an average annual return in the sevens, then an investor with a decent savings rate and adequate time horizon can accumulate a sizeable nest egg just by owning that beta. It is that reality, that ergodicity, that keeps me from wanting to get crazy with this stuff. 15 years ago there was plenty of chatter about have 15-20% allocations to things like REITS, MLPs and gold which I said at the time was a terrible idea. Those would have been very large bets on narrow outcomes after big moves up for all three niches, kind of the opposite of asymmetry in that asymmetric investing involves small allocations to potentially huge payoffs. I would add that I don't think of broad indexes or portfolios constructed to generally capture the index effect as having asymmetric potential. I'm assuming no one would think of the Russell 1000 or Russell 3000 that way.
In looking for asymmetry, things like Bitcoin, lottery ticket biotech stocks, maybe even miners with unproven reserves could all be thought of as having asymmetric potential. How much should you allocate then to asymmetry. Many years ago I stumbled into this concept as expressed by Nassim Taleb who said 90% should be in T-bills from around the world and then go berserk (my word) with the other 10%. Back then, I didn't use the word asymmetry to describe the idea.
The details from Taleb seem to have evolved but he still believes in an allocation to asymmetry. I would add that he's been talking a lot more in recent years publicly about an allocation to tail hedge too.
I will have a little more to say in a subsequent post about Game Stop (GME) but I don't think that stock, or the other ones caught up in the r/wallstreetbets mania, is an example of asymmetry. The price action certainly has shown the attributes but there is no path to a great outcome. The company can pay it's bills but the underlying business is struggling because of the pandemic and because more games can be downloaded or otherwise accessed without buying a physical product like a cartridge or disk. The reasonable outcome is that the business evolves in such a way that it can survive which is far from an asymmetric opportunity. The momentum/mania certainly could continue for many more hundreds or percent, I have no idea, but this seems destined to end badly.
Compared that to a lottery ticket biotech. A company thinks they can cure all cancer with a pill that has no side effect. If it works, the company goes to a bazillion. If it doesn't work and that is their only project then it will get close to zero until it runs out of money or finds another drug to build around.
I will close with a thought about expectations for anyone wanting to make meaningful changes to how they allocate assets. I often refer to investors relying on normal stock market returns for their financial plans to work, I refer above to ergodicity. If you make some good decisions when you're young, you may find yourself at 50 or 60 not needing to rely on normal stock market returns from a typical allocation to equities like 60%.
It is that scenario where an alternative allocation can make more sense. There are mutual funds that target inflation plus X% like CPI plus 3%. Think about what that means in practice if over long periods of time the stock market average annual return is in the sevens; CPI plus 3% or even 5% is going to lag the stock market. Investors who are lucky enough to be ahead of where they need to be because they are wealthy or live below their means don't need a "normal" exposure to the volatility that goes with delivering a long term average of 7%.
You might be happy about that when the market is doing poorly but in a year like 2019 when equities are up huge, you might be pretty bummed out. Focus on your plan being able to do what you need it to do and your path to that outcome not nominal numbers put up by stock market indexes or what your friends might boast about.