November 26, 2014: Bond Duration as Leverage

The 30 year Treasury is a powerful tool because small movements in interest rates cause big fluctuations in the price of the bond. As I will illustrate in this post, the magnified exposure acts as a form of leverage. And by using risk parity principles you can use this magnification to lever/delever an entire portfolio. This is important because it allows you to first decide on your risk allocation, and later dial in the risk level. This is a complicated subject, but hopefully the charts will help and please feel free to follow up in the comments section!

 Thanks to the ETF revolution, investors can very easily target different bond durations. The table below shows the bond ETFs for consideration in this analysis with their respective duration
  • EDV: 24.8
  • TLT: 17.2
  • TLH: 9.6
  • IEF: 7.6
  • IEI: 4.5

The graph below shows the performance of each product. I have represented the longer duration bonds with darker shades. As you can see, the products are all highly correlated but the duration affects the magnitude of the movements.

Stepping back, remember that the cashless Permanent Portfolio is an equal split between 30 year Treasuries (TLT), US Stocks, and Gold. The allocation works because the three asset classes have roughly equivalent volatility, making the portfolio a risk parity solution. Balancing risk between the asset classes is attractive because it protects your portfolio from macro shocks. 

However, what if you appreciate this balance but want to take more or less risk while remaining balanced across the asset classes? The logic is simple, the stronger the bond the less of it you need to get the target exposure.
By using different bond durations and weightings you can implicitly lever / delever your portfolio. The following table shows allocations I created that take into account the relative volatility of the bonds compared with stocks and gold.

Although the dollar weightings might appear to offer different exposures, the risk allocation across the portfolios is almost identical. Essentially, the portfolios only differ by the amount leverage applied to them. The charts below illustrate that the principles of risk parity are preserved, while offering different degrees of magnification. This is verified quantitatively by looking at the correlation matrix.

In summary , risk parity strategies don’t have to be one size fits all allocations. You can dial in your risk level by using leverage, and the best leverage available to retail investors can be found on the other side of the bond desk. 

April 8, 2013: Shannon's Demon

If I offered you the chance to play a coin flip game with a 50/50 chance of doubling or halving your money, would you take it?

For a player who gambles his entire bankroll each round, it appears to be a wash. No matter the order of returns, if there are an equal number of heads and tails, the player ends up having exactly as much as he did at the start.

For example...

  • Starting bankroll: $100 
  • Round 1 (heads): $200 
  • Round 2 (tails): $100 
  • Round 3 (tails) $50 
  • Round 4 (heads): $100 

However, for a sophisticated investor this game would represent an incredible profit opportunity. Claude Shannon illustrated this by proposing that an intelligent player would wager only half of their bankroll each round. This seemingly small differences turns the game into a winner.

  • Starting bankroll: $100 
  • Round 1 (heads): $150 
  • Round 2 (tails): $112.5 
  • Round 3 (tails) $84.375 
  • Round 4 (heads): $126.5625 

Converting this game into investment-speak, Claude Shannon proposed a portfolio of 50% coin flip and 50% cash. This portfolio was rebalanced at the beginning of each round. The results of this game are quite profound. It shows that risk reduction has the ability to increase returns by bringing your realized portfolio geometric return closer to the weighted arithmetic returns of the portfolio's components.

Taking the bankroll management strategy in a slightly different direction, we can observe how a diversified portfolio of coin flip games that is rebalanced each round offers a return that is far greater than the weighted performance of the individual games.

(This chart will update automatically every 10 minutes or so, offering a new randomized experiment each time.)

Internalizing the benefits of diversification takes time, but I can’t imagine going back to a concentrated portfolio. Diversification combined with rebalancing offers the opportunity to increase returns while simultaneously decreasing risk. Although the real world is far more complicated than a simple coin flip operation, I think the game can help investors understand how looking at assets in isolation never makes sense. Sophisticated investors only care about what an asset will do to a diversified and periodically rebalanced portfolio. If you enjoyed the topic of this post, try Googling phrases such as “volatility pumping”, “volatility harvesting”, “Shannon’s Demon”, and “Kelly criterion.” Additionally a well done paper on the subject can be found here.

March 24, 2013: PP vs. Risk Parity Funds

Before jumping into the body of this post, please be sure to check out the new "long term performance" section. I have vastly improved it.

Risk parity is a buzzword in pension finance right now. Ray Dalio of Bridgewater popularized the concept and he has become one of the biggest names in the institutional investment community. His strategy is simple: 1) Don't try and predict the future. 2) Allocate your capital across different asset classes that respond differently to different economic environments so that you have a neutral portfolio.

This should sound familiar because it is exactly what the Permanent Portfolio does. The risk parity guys complicate things by weighting assets inversely to their volatility (which changes over time), but the principles are the same. After all gold, stocks, and LTT all have roughly equivalent volatility so the equal split with the PP's weightings is no coincidence. It is essentially a risk parity strategy.

AQR and Invesco have launched a couple of funds within the last few years, and I think it will be very interesting to watch their performance vs. the PP over time. Although they are guided by essentially the same framework as the PP, their execution of the philosophy is much more complicated (and expensive).
These charts will update automatically every month, so be sure to check back in the future if you are curious about the relative performances.