Bring Me Fama's Head
As the Twitter war between Nassim Taleb and Cliff Asness appeared to be dying down, Nassim went after Eugene Fama who is most known for the efficient market hypothesis and was one of Asness' professors at the University of Chicago. Apparently Taleb and Fama had an email exchange in 2005 about tails (outlier events that cause extreme market movements). Taleb didn't show the entire conversation but highlighted the following quote from Fama; "I didn't abandon them, and indeed think they are entirely relevant for almost all economic variables. I just got frustrated with the awkward statistics of fat-tailed distributions..." Taleb's Tweet said " Fama's reasons was that Fat Tails were "incompatible with the tools in social science". It's like using the map of Tokyo in Mexico because "here is a map" and Mandelbrot saw Fama never understood the CONSEQUENCES of tails. Mandelbrot refers to Benoit Mandelbrot, a mathematician whom Taleb greatly respected (he passed away in 2010). Taleb laced into Fama for a few more Tweets.
Of course I have no idea what Fama's understanding of tails was in 2005 or what it is today. In the realm of the typical investor just trying to have enough when they retire, the question of whether it makes sense or not to try to navigate around severe market movements is something we've explored many times. Based on the Tweet thread, Fama appears to not want to try to, as I would describe it, take defensive action to mitigate the full brunt of large declines while Taleb had long advocated for tail risk protection.
There are a couple of layers to defensive strategies; whether or not to do it and if you want to do it, how to get it done.
To the first question, it is perfectly valid to buy, hold on no matter what (ignoring tail events in the context of the first paragraph) and then rebalance based on some sort of time gone by or price movement. I don't think it is optimal because it exposes people to the largest emotional reaction they might have which could lead to panic sales after a large market decline. Additionally, even if someone is not panicked after a large decline, there can be unexpected life circumstances that require a relatively large withdrawal coinciding with a large market decline. There can be no guarantee that a defensive strategy will be effective in a given market event but you have no shot at mitigating the full brunt of a large decline if you don't try. That either resonates or it doesn't, if it doesn't then don't do it.
Barron's has an article in the current issue about how difficult hedging with liquid alternatives can be. A lot of the funds don't do what prospective holders would hope for. This happens because the strategy isn't robust enough or the investor may not understand it well enough. Barron's includes a couple of quotes from advisors who it seemed like wanted liquid alts to work but were disillusioned with the results in this last go around and are not going to try to use them anymore. The article looked at managed futures which is a popular trend following strategy that typically goes long futures that have a favorable intermediate trend and short futures that have an unfavorable intermediate trend. The futures can be on commodities, currencies, bonds and I've seen one or two instances where equity futures were also included. Managed futures has the long term tendency to have a negative correlation to equities. The strategy generally did well during the 2000's, struggled over most of the last ten years as equities rocketed higher but per the article have done well during the current event.
I've been a fan of long/short for a while. Most clients own both the Merger Fund (MERFX) and the AGFiQ US Market Neutral Anti Beta ETF (BTAL) which are down 0.47% and up 12.37% YTD respectively per the chart below versus an average decline of 10.8% since Feb 19 for the long/short category. Yes that is not the same time period but you can see the two I mentioned are up to varying degrees since that date (MERFX up less than 1% and BTAL up close to 10%. The simple point is that not all long/short equity is market neutral or otherwise defensive. This is easily discovered in doing initial research. Some long/short funds are trying to be equity market proxies that outperform the equity market. There is nothing wrong with that but if you're looking for portfolio protection, that type of long/short won't provide it. This is about making sure you have the right expectations which comes from a proper understanding the strategy.
The article had a lot of good things to say about the Cambria Tail Risk ETF (TAIL), which is another client holding and is included in the chart. It owns a few put options and a lot treasuries. This is in the same ballpark as what Universa does, Universa being the tail risk hedge fund that Taleb as aligned with. Put options expire worthless if the market doesn't go down which everything else being equal will be a drag during bull markets but I think the reason it was doing so well before the Coronapocalypse is because put options were cheap so the loss would have been a little less. If anyone from Cambria sees this post and has a different answer, I'd love to hear it.
One interesting point in the article was the possible dissatisfaction of a liquid alt being down slightly in the face of a 30% crash, "a loss is a loss." There can be no guarantees for any particular market event that a given strategy will "work" which is why I think it makes sense to own a few, adding more and then taking some off as market conditions change. Static allocations usually are not ideal.
Because it seems relevant, JP Morgan is closing four liquid alt ETFs because they haven't done well. I've said repeatedly there is an element of luck in picking funds like this. I never looked very closely at the JP Morgan funds so I am not sure why they struggled but if you dig in to what a specific fund is actually trying to do and how they go about doing it then you have a better chance of being lucky.
For disclosure, the first five funds on the chart in my ownership universe one way or another, DBMF and WTMF are managed futures ETFs that I don't own anywhere.