Now that we covered the basics of blended capital efficient funds, how can we use them in a portfolio? Here is another “Risk Parity Basics” post - this time showing NTSX and GDE, two great examples of the strategy, in action.
To reiterate the main point of my intro post, blended capital efficient ETFs enable investors to put up less actual capital to get a certain level of exposure to a given market. They do this by using modest amounts of leverage and investing via the futures markets to simultaneously invest in two asset classes, say equities and gold, or bonds plus managed futures.
They are different from concentrated capital efficient funds like UPRO or TMF which use their leverage for greater total exposure to one asset class. Those are interesting too, but a slightly different kettle of fish and I’ll focus on those some other time.
Here, I’ll cover a few scenarios showing how investors can use capital efficient ETFs in a portfolio. I’ll focus on two specifically: first, WisdomTree’s US Efficient Core Fund (NTSX), which uses +50% in leverage to turn a 60/40 stock/bond portfolio into a 90/60, and second, the same shop’s Efficient Gold Plus Equity Strategy Fund (GDE), which uses +80% leverage to get a 90/90 equity/gold mix.
I’ll use proxy funds to show how capital efficient funds may have performed in the past. Since they haven’t been around that long, NTSX since August 2018 and GDE since March 2022, I have used VTSAX (Vanguard Total Stock Market Fund) as the equity fund, VBMFX (Vanguard’s Total Bond Market Fund) for fixed income and GLD (iShares Gold Shares Trust) for the gold. All three have long histories, enabling me to backtest to 2004.
I then simulated the added leverage in the portfolios that comes with capital efficient portfolios by subtracting a cash allocation in the portfolios. Note: I use these three funds for the backtest, but I wouldn’t choose these if I were starting one of these portfolios now (see my preferred assets series for my thoughts on better funds).
My backtests here could very well be overstating their case, but since I’ve kept the inputs the same, the differences in portfolios should be directionally correct. The time period has also been a great one for two out of the three asset classes, so please don’t get overly excited for the results. I can’t predict the future, but it would seem more likely that the next nineteen years will be worse, not better, than the past stretch.
The Four Portfolios
1) Simplified Golden Butterfly
A nice, classic Risk Parity portfolio here, with two-fifths each to stocks and bonds, and remaining fifth in gold, with one simplification: instead of having two equity or bond funds, each a fifth, this simple version compresses both into just one larger fund for each asset class. The original Golden Butterfly divides the equity portion between a S&P 500 fund and a small-cap value stock fund, and the bond portion between Long-term and Short-term Treasuries. The gold portion is the same in both.
There are no capital efficient funds in this portfolio, and no leverage, so it’s a baseline portfolio for our purposes. This is also a good example of the first path for Risk Parity: more stable but probably lower performing portfolios with a high degree of diversification.
2) Capital Efficient Golden Butterfly
This is a capital efficient version of the previous portfolio. Adding the asset classes together, you get about 57% to stocks, 56% to bonds, and 28% to gold. I maintain the 2:2:1 ratio of the Simplified Golden Butterfly, though this time boosted with almost 41% extra leverage. This should give me a portfolio that has a similar outlook in terms of risk and reward, but with higher expected levels for both.
This portfolio is a good example of using modest leverage to boost the returns of what is still a diversified, balanced portfolio, which is the second path for Risk Parity.
3) 60/40 with a Gold & Equity Bonus
This time, I strayed from the 2:2:1 ratio of the Simplified Golden Butterfly and instead looked at this one as just a 60/40 with extra room created by the capital efficiency. The result is a 90/40/30 mix, so I expect more return and more volatility in this portfolio compared to the first two. It really is a bit like getting the extra 30% of equities and the 30% slice to gold as ice cream scoops on top of the slice of traditional -apple pie. I replicate a simple 60/40 with one capital efficient fund; I use the second one for boosting returns and getting more diversification at the same time.
4) Vanguard Balanced Index (VBIAX), a.k.a. The Classic 60/40
This is the built-in baseline portfolio: 60% in stocks, 40% in bonds, no leverage, no capital efficiency. Not much to say, other than to pay attention to how it compares to any of the three above, even the first, which is also unleveraged.
Among the four, the first two are comparisons to each other, and then the second two also represent a competing pair. I’ll look at all four together, but in terms of portfolio construction, the second is just a capital efficient version of the first, and the third is a capital efficient version of the fourth.
Here is the link for the backtest since 12/2004, done on Portfolio Visualizer. I also put in the performance of the three funds in the portfolio separately for comparison.
- For total return in terms of CAGR (Compound Annual Growth Rate), the Capital Efficient Golden Butterfly beats its simple counterpart by more than 2%, and the Capital Efficiency 60/40, the one with the Gold & Equity bonus, beats its counterpart by 4.4%.
- They do this with either about the same amount of Sharpe Ratio in the first pairing, or a better Sharpe Ratio in the second painting. Recall that Sharpe is a measure of return, adjusted for volatility, with the higher meaning you get more return for a given unit of volatility. Notice that of the four, the plain ol’ 60/40 is the worst. You get the same return with that one as the Simplified Golden Butterfly, but with more volatility and a maximum drawdown twice as severe.
- The second portfolio is really just the same as the first, but with leverage, and this comparison is a good illustration of how it works. More volatility and steeper drawdowns, but you’re compensated for it in terms of Sharpe Ratio. In this case, the investor is wise to think about how much volatility they are willing to tolerate, and then can lever up from there using capital efficient funds. If one likes the calmness of the simplified Golden Butterfly, fine, but you see here how you can dial things up using capital efficient funds.
- One great aspect of dialing things up is that it can boost your perpetual withdrawal rate - my favorite number for assessing a portfolio. If you compare the second portfolio to the fourth, you see that you could have pulled out an additional 1.8% per year since 2004. The kicker is that the worst case scenario over that time period would have been shallower. True, it would have been slightly bumpier along the way, but the fact that the worst point was higher is probably more important.
- Meanwhile, you could have pulled out almost twice as much from the 60/40 with the Gold & Equity Bonus, though that extra return would have come with more stress - more volatility and a steeper drawdown. Still, that portfolio would have led to better nights sleep than the 100% stock or 100% gold investor would have experienced, and provided much higher returns.
- Taking a step back, this simple test is also one more data point for the idea that portfolio construction matters, and it matters a lot. I didn’t set out to choose the best assets, and didn’t even use particularly good ones. Yet, by changing the proportions of the different funds and using targeted capital efficiency, I was able to get widely different results. Score one more for the idea that it is the “forest” that matters more than the “trees.”
Which portfolio’s profile is best is in the eye of the beholder, and if the takeaway is that the Simplified Golden Butterfly outperforms the Classic 60/40, that’s fine. No capital efficiency is needed in that case, and you still have a better portfolio.
The issue with the Classic 60/40 is that it’s actually quite concentrated in terms of risk, with the equity portion dominant (learn more here). Without an alternative asset class such as gold (or commodities, or even better, managed futures), the Classic 60/40 is just a watered down equity portfolio, offering you pretty weak performance for the volatility, or maybe too much volatility considering the performance. Risk Parity as a conceptual framework wins in another back test yet again. All three RP-influenced portfolios are better than the lone non-RP version.
Another victory lap could be after seeing that a little bit of capital efficiency in a Risk Parity framework goes a long way. If you can stomach the higher degree of volatility, you can use capital efficient funds at the +40% level or the +60% level to create meaningfully better portfolios. The gains do not come at the expense of taking on out-sized risks: the +40% version has a volatility equivalent to about a 70/30 or maybe 75/25 portfolio, while the +60% version is just a hair beyond 100% Equities.
Of course, as the old saying goes, past results are no guarantee of future returns, and as I stated above, the period from 2004 to now has been a particularly good one for these strategies.
Still, it’s a pretty awesome time to be an investor, with new tools like these!