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Summary­

• In this commentary, we revisit the idea of portable beta: utilizing leverage to overlay traditional risk premia on existing strategic allocations.
• While a 1.5x levered 60/40 portfolio has historically out-performed an all equity blend with similar risk levels, it can suffer through prolonged periods of under-performance.
• Positive correlations between stocks and bonds, inverted yield curves, and rising interest rate environments can make simply adding bond exposure on top of equity exposure a non-trivial pursuit.
• We rely on prior research to introduce a tactical 90/60 model, which uses trend signals to govern equity exposure and value, momentum, and carry signals to govern bond exposure.
• We find that such a model has historically exhibited returns in-line with equities with significantly lower maximum drawdown.

In November 2017, I was invited to participate in a Bloomberg roundtable discussion with Barry Ritholtz, Dave Nadig, and Ben Fulton about the future of ETFs.  I was quoted as saying,

Most of the industry agrees that we are entering a period of much lower returns for stocks and fixed income. That’s a problem for younger generations. The innovation needs to be around efficient use of capital. Instead of an ETF that holds intermediate-term Treasuries, I would like to see a U.S. Treasury ETF that uses Treasuries as collateral to buy S&P 500 futures, so you end up getting both stock and bond exposure.  By introducing a modest amount of leverage, you can take $1 and trade it as if the investor has $1.50. After 2008, people became skittish around derivatives, shorting, and leverage. But these aren’t bad things when used appropriately.

Shortly after the publication of the discussion, we penned a research commentary titled Portable Beta which extolled the potential virtues of employing prudent leverage to better exploit diversification opportunities.  For investors seeking to enhance returns, increasing beta exposure may be a more reliable approach than the pursuit of alpha.

In August 2018, WisdomTree introduced the 90/60 U.S. Balanced Fund (ticker: NTSX), which blends core equity exposure with a U.S. Treasury futures ladder to create the equivalent of a 1.5x levered 60/40 portfolio.  On March 27, 2019, NTSX was awarded ETF.com’s Most Innovative New ETF of 2018.

The idea of portable beta was not even remotely uniquely ours.  Two anonymous Twitter users – “Jake” (@EconomPic) and “Unrelated Nonsense” (@Nonrelatedsense) – had discussed the idea several times prior to my round-table in 2017.  They argued that such a product could be useful to free up space in a portfolio for alpha-generating ideas.  For example, an investor could hold 66.6% of their wealth in a 90/60 portfolio and use the other 33.3% of their portfolio for alpha ideas.  While the leverage is technically applied to the 60/40, the net effect would be a 60/40 portfolio with a set of alpha ideas overlaid on the portfolio. Portable beta becomes portable alpha.

Even then, the idea was not new.  After NTSX launched, Cliff Asness, co-founder and principal of AQR Capital Management, commented on Twitter that even though he had a “22-year head start,” WisdomTree had beat him to launching a fund.  In the tweet, he linked to an article he wrote in 1996, titled Why Not 100% Equities, wherein Cliff demonstrated that from 1926 to 1993 a 60/40 portfolio levered to the same volatility as equities achieved an excess return of 0.8% annualized above U.S. equities.  Interestingly, the appropriate amount of leverage utilized to match equities was 155%, almost perfectly matching the 90/60 concept.

Source: Asness, Cliff. Why Not 100% Equities.  Journal of Portfolio Management, Winter 1996, Volume 22 Number 2.

Following up on Cliff’s Tweet, Jeremy Schwartz from WisdomTree extended the research out-of-sample, covering the quarter century that followed Cliff’s initial publishing date.  Over the subsequent 25 years, Jeremy found that a levered 60/40 outperformed U.S. equities by 2.6% annualized.

NTSX is not the first product to try to exploit the idea of diversification and leverage.  These ideas have been the backbone of managed futures and risk parity strategies for decades. The entire PIMCO’s StocksPLUS suite – which traces its history back to 1986 – is built on these foundations.  The core strategy combines an actively managed portfolio of fixed income with 100% notional exposure in S&P 500 futures to create a 2x levered 50/50 portfolio.

The concept traces its roots back to the earliest eras of modern financial theory. Finding the maximum Sharpe ratio portfolio and gearing it to the appropriate risk level has always been considered to be the theoretically optimal solution for investors.

Nevertheless, after 2008, the words “leverage” and “derivatives” have largely been terms non gratisin the realm of investment products. But that may be to the detriment of investors.

90/60 Through the Decades

While we are proponents of the foundational concepts of the 90/60 portfolio, frequent readers of our commentary will not be surprised to learn that we believe there may be opportunities to enhance the idea through tactical asset allocation.  After all, while a 90/60 may have out-performed over the long run, the short-run opportunities available to investors can deviate significantly.  The prudent allocation at the top of the dot-com bubble may have looked quite different than that at the bottom of the 2008 crisis.

To broadly demonstrate this idea, we can examine the how the realized efficient frontier of stock/bond mixes has changed shape over time.  In the table below, we calculate the Sharpe ratio for different stock/bond mixes realized in each decade from the 1920s through present.

Source: Global Financial Data.  Calculations by Newfound Research.  Returns are hypothetical and backtested.  Returns are gross of all fees, transaction costs, and taxes.  Returns assume the reinvestment of all distributions.   Bonds are the GFD Indices USA 10-Year Government Bond Total Return Index and Stocks are the S&P 500 Total Return Index (with GFD Extension).  Sharpe ratios are calculated with returns excess of the GFD Indices USA Total Return T-Bill Index.  You cannot invest in an index.  2010s reflect a partial decade through 4/2019.

We should note here that the original research proposed by Asness (1996) assumed a bond allocation to an Ibbotson corporate bond series while we employ a constant maturity 10-year U.S. Treasury index.  While this leads to lower total returns in our bond series, we do not believe it meaningfully changes the conclusions of our analysis.

We can see that while the 60/40 portfolio has a higher realized Sharpe ratio than the 100% equity portfolio in eight of ten decades, it has a lower Sharpe ratio in two consecutive decades from 1950 – 1960.  And the 1970s were not a ringing endorsement.

In theory, a higher Sharpe ratio for a 60/40 portfolio would imply that an appropriately levered version would lead to higher realized returns than equities at the same risk level.  Knowing the appropriate leverage level, however, is non-trivial, requiring an estimate of equity volatility.  Furthermore, leverage requires margin collateral and the application of borrowing rates, which can create a drag on returns.

Even if we conveniently ignore these points and assume a constant 90/60, we can still see that such an approach can go through lengthy periods of relative under-performance compared to buy-and-hold equity.  Below we plot the annualized rolling 3-year returns of a 90/60 portfolio (assuming U.S. T-Bill rates for leverage costs) minus 100% equity returns.  We can clearly see that the 1950s through the 1980s were largely a period where applying such an approach would have been frustrating.

Source: Global Financial Data.  Calculations by Newfound Research.  Returns are hypothetical and backtested.  Returns are gross of all fees, transaction costs, and taxes.   Bonds are the GFD Indices USA 10-Year Government Bond Total Return Index and Stocks are the S&P 500 Total Return Index (with GFD Extension).  The 90/60 portfolio invests 150% each month in the 60/40 portfolio and -50% in the GFD Indices USA Total Return T-Bill Index.  You cannot invest in an index.

Poor performance of the 90/60 portfolio in this era is due to two effects.

First, 10-year U.S. Treasury rates rose from approximately 4% to north of 15%.  While a constant maturity index would constantly roll into higher interest bonds, it would have to do so by selling old holdings at a loss.  Constantly harvesting price losses created a headwind for the index.

This is compounded in the 90/60 by the fact that the yield curve over this period spent significant time in an inverted state, meaning that the cost of leverage exceeded the yield earned on 40% of the portfolio, leading to negative carry. This is illustrated in the chart below, with –T-Bills– realizing a higher total return over the period than –Bonds–.

Source: Global Financial Data.  Calculations by Newfound Research.  Returns are hypothetical and backtested.  Returns are gross of all fees, transaction costs, and taxes.  Returns assume the reinvestment of all distributions.   T-Bills are the GFD Indices USA Total Return T-Bill Index, Bonds are the GFD Indices USA 10-Year Government Bond Total Return Index, and Stocks are the S&P 500 Total Return Index (with GFD Extension). You cannot invest in an index.

This is all arguably further complicated by the fact that while a 1.5x levered 60/40 may closely approximate the risk level of a 100% equity portfolio over the long run, it may be a far cry from it over the short-run.  This may be particularly true during periods where stocks and bonds exhibit positive realized correlations as they did during the 1960s through 1980s.  This can occur when markets are more pre-occupied with inflation risk than economic risk.  As inflationary fears abated and economic risk become the foremost concern in the 1990s, correlations between stocks and bonds flipped.

Thus, during the 1960s-1980s, a 90/60 portfolio exhibited realized volatility levels in excess of an all-equity portfolio, while in the 2000s it has been below.

This all invites the question: should our levered allocation necessarily be static?

Getting Tactical with a 90/60

We might consider two approaches to creating a tactical 90/60.

The first is to abandon the 90/60 model outright for a more theoretically sound approach. Specifically, we could attempt to estimate the maximum Sharpe ratio portfolio, and then apply the appropriate leverage such that we either hit a (1) constant target volatility or (2) the volatility of equities.  This would require us to not only accurately estimate the expected excess returns of stocks and bonds, but also their volatilities and correlations. Furthermore, when the Sharpe optimal portfolio is highly conservative, notional exposure far exceeding 200% may be necessary to hit target volatility levels.

In the second approach, equity and bond exposure would each be adjusted tactically, without regard for the other exposure.  While less theoretically sound, one might interpret this approach as saying, “we generally want exposure to the equity and bond risk premia over the long run, and we like the 60/40 framework, but there might be certain scenarios whereby we believe the expected return does not justify the risk.”  The downside to this approach is that it may sacrifice potential diversification benefits between stocks and bonds.

Given the original concept of portable beta is to increase exposure to the risk premia we’re already exposed to, we prefer the second approach.  We believe it more accurately reflects the notion of trying to provide long-term exposure to return-generating risk premia while trying to avoid the significant and prolonged drawdowns that can be realized with buy-and-hold approaches.

Equity Signals

To manage exposure to the equity risk premium, our preferred method is the application of trend following signals in an approach we call trend equity.  We will approximate this class of strategies with our Newfound Research U.S. Trend Equity Index.

To determine whether our signals are able to achieve their goal of “protect and participate” with the underlying risk premia, we will plot their regime-conditional betas.  To do this, we construct a simple linear model:

We define a bear regime as the worst 16% of monthly returns, a bull regime as the best 16% of monthly returns, and a normal regime as the remaining 68% of months. Note that the bottom and top 16^thpercentiles are selected to reflect one standard deviation.

Below we plot the strategy conditional betas relative to U.S. equity

We can see that trend equity has a normal regime beta to U.S. equities of approximately 0.75 and a bear market beta of 0.5, in-line with expectations that such a strategy might capture 70-80% of the upside of U.S. equities in a bull market and 40-50% of the downside in a prolonged bear market. Trend equity beta of U.S. equities in a bull regime is close to the bear market beta, which is consistent with the idea that trend equity as a style has historically sacrificed the best returns to avoid the worst.

Bond Signals

To govern exposure to the bond risk premium, we prefer an approach based upon a combination of quantitative, factor-based signals.  We’ve written about many of these signals over the last two years; specifically in Duration Timing with Style Premia (June 2017), Timing Bonds with Value, Momentum, and Carry (January 2018), and A Carry-Trend-Hedge Approach to Duration Timing (October 2018).  In these three articles we explore various mixes of value, momentum, carry, flight-to-safety, and bond risk premium measures as potential signals for timing duration exposure.

We will not belabor this commentary unnecessarily by repeating past research.  Suffice it to say that we believe there is sufficient evidence that value (deviation in real yield), momentum (prior returns), and carry (term spread) can be utilized as effective timing signals and in this commentary are used to construct bond indices where allocations are varied between 0-100%.  Curious readers can pursue further details of how we construct these signals in the commentaries above.

As before, we can determine conditional regime betas for strategies based upon our signals.

We can see that our value, momentum, and carry signals all exhibit an asymmetric beta profile with respect to 10-year U.S. Treasury returns.  Carry and momentum exhibit an increase in bull market betas while value exhibits a decrease in bear market beta.

Combining Equity and Bond Signals into a Tactical 90/60

Given these signals, we will construct a tactical 90/60 portfolio as being comprised of 90% trend equity, 20% bond value, 20% bond momentum, and 20% bond carry. When notional exposure exceeds 100%, leverage cost is assumed to be U.S. T-Bills.  Taken together, the portfolio has a large breadth of potential configurations, ranging from 100% T-Bills to a 1.5x levered 60/40 portfolio.

But what is the appropriate benchmark for such a model?

In the past, we have argued that the appropriate benchmark for trend equity is a 50% stock / 50% cash benchmark, as it not only reflects the strategic allocation to equities empirically seen in return decompositions, but it also allows both positive and negative trend calls to contribute to active returns.

Similarly, we would argue that the appropriate benchmark for our tactical 90/60 model is not a 90/60 itself – which reflects the upper limit of potential capital allocation – but rather a 45% stock / 30% bond / 25% cash mix.  Though, for good measure we might also consider a bit of hand-waving and just use a 60/40 as a generic benchmark as well.

Below we plot the annualized returns versus maximum drawdown for different passive and active portfolio combinations from 1974 to present (reflecting the full period of time when strategy data is available for all tactical signals).  We can see that not only does the tactical 90/60 model (with both trend equity and tactical bonds) offer a return in line with U.S. equities over the period, it does so with significantly less drawdown (approximately half).  Furthermore, the tactical 90/60 exceeded trend equity and 60/40 annualized returns by 102 and 161 basis points respectively.

These improvements to the return and risk were achieved with the same amount of capital commitment as in the other allocations. That’s the beauty of portable beta.

Source: Federal Reserve of St. Louis, Kenneth French Data Library, and Newfound Research.  Calculations by Newfound Research.  Returns are hypothetical and backtested.  Returns are gross of all fees, transaction costs, and taxes.  Returns assume the reinvestment of all distributions.   You cannot invest in an index.

Of course, full-period metrics can deceive what an investor’s experience may actually be like.  Below we plot rolling 3-year annualized returns of U.S. equities, the 60/40 mix, trend equity, and the tactical 90/60.

Source: Federal Reserve of St. Louis, Kenneth French Data Library, and Newfound Research.  Calculations by Newfound Research.  Returns are hypothetical and backtested.  Returns are gross of all fees, transaction costs, and taxes.  Returns assume the reinvestment of all distributions.   You cannot invest in an index.

The tactical 90/60 model out-performed a 60/40 in 68% of rolling 3-year periods and the trend equity model in 71% of rolling 3-year periods.  The tactical 90/60, however, only out-performs U.S. equities in 35% of rolling 3-year periods, with the vast majority of relative out-performance emerging during significant equity drawdown periods.

For investors already allocated to trend equity strategies, portable beta – or portable tactical beta – may represent an alternative source of potential return enhancement.  Rather than seeking opportunities for alpha, portable beta allows for an overlay of more traditional risk premia, which may be more reliable from an empirical and academic standpoint.

The potential for increased returns is illustrated below in the rolling 3-year annualized return difference between the tactical 90/60 model and the Newfound U.S. Trend Equity Index.

Source: Federal Reserve of St. Louis, Kenneth French Data Library, and Newfound Research.  Calculations by Newfound Research.  Returns are hypothetical and backtested.  Returns are gross of all fees, transaction costs, and taxes.  Returns assume the reinvestment of all distributions.   You cannot invest in an index.

From Theory to Implementation

In practice, it may be easier to acquire leverage through the use of futures contracts. For example, applying portable bond beta on-top of an existing trend equity strategy may be achieved through the use of 10-year U.S. Treasury futures.

Below we plot the growth of $1 in the Newfound U.S. Trend Equity Index and a tactical 90/60 model implemented with Treasury futures.  Annualized return increases from 7.7% to 8.9% and annualized volatility declines from 9.7% to 8.5%.  Finally, maximum drawdown decreases from 18.1% to 14.3%.

We believe the increased return reflects the potential return enhancement benefits from introducing further exposure to traditional risk premia, while the reduction in risk reflects the benefit achieved through greater portfolio diversification.

Source: Quandl and Newfound Research.  Calculations by Newfound Research.  Returns are hypothetical and backtested.  Returns are gross of all fees, transaction costs, and taxes.  Returns assume the reinvestment of all distributions.   You cannot invest in an index.

It should be noted, however, that a levered constant maturity 10-year U.S. Treasury index and 10-year U.S. Treasury futures are not the same.  The futures contracts are specified such that eligible securities for delivery include Treasury notes with a remaining term to maturity of between 6.5 and 10 years.  This means that the investor short the futures contract has the option of which Treasury note to deliver across a wide spectrum of securities with potentially varying characteristics.

In theory, this investor will always choose to deliver the bond that is cheapest. Thus, Treasury futures prices will reflect price changes of this so-calledcheapest-to-deliver bond, which often does not reflect an actual on-the-run 10-year Treasury note.

Treasury futures therefore utilize a “conversion factor” invoicing system referenced to the 6% futures contract standard.  Pricing also reflects a basis adjustment that reflects the coupon income a cash bond holder would receive minus financing costs (i.e. the cost of carry) as well as the value of optionality provided to the futures seller.

Below we plot monthly returns of 10-year U.S. Treasury futures versus the excess returns of a constant maturity 10-year U.S. Treasury index.  We can see that the futures had a beta of approximately 0.76 over the nearly 20-year period, which closely aligns with the conversion factor over the period.

Source: Quandl and the Federal Reserve of St. Louis.  Calculations by Newfound Research.

Despite these differences, futures can represent a highly liquid and cost-effective means of implementing a portable beta strategy.  It should be further noted that having a lower “beta” over the last two decades has not necessarily implied a lower return as the basis adjustment can have a considerable impact.  We demonstrate this in the graph below by plotting the returns of continuously-rolled 10-year U.S. Treasury futures (rolled on open interest) and the excess return of a constant maturity 10-year U.S. Treasury index.

Source: Quandl and Newfound Research.  Calculations by Newfound Research.  Returns are hypothetical and backtested.  Returns are gross of all fees, transaction costs, and taxes.  Returns assume the reinvestment of all distributions.   You cannot invest in an index.

Conclusion

In a low return environment, portable beta may be a necessary tool for investors to generate the returns they need to hit their financial goals and reduce their risk of failing slow.

Historically, a 90/60 portfolio has outperformed equities with a similar level of risk. However, the short-term dynamics between stocks and bonds can make the volatility of a 90/60 portfolio significantly higher than a simple buy-and-hold equity portfolio. Rising interest rates and inverted yield curves can further confound the potential benefits versus an all-equity portfolio.

Since constant leverage is not a guarantee and we do not know how the future will play out, moving beyond standard portable beta implementations to tactical solutions may augment the potential for risk management and lead to a smoother ride over the short-term.

Getting over the fear of using leverage and derivatives may be an uphill battle for investors, but when used appropriately, these tools can make portfolios work harder. Risks that are known and compensated with premiums can be prudent to take for those willing to venture out and bear them.

If you are interested in learning how Newfound applies the concepts of tactical portable beta to its mandates, please reach out (info@thinknewfound.com).