Thoughts on Picture Perfect's 10 Improvements to a RP Portfolio

Nomadic Samuel, writing over at Picture Perfect Portfolios, recently advocated for ten ways to improve RP portfolios. It's a great piece with sound advice, and I thought it might be nice to offer my thoughts and perspectives in response. Discussions on RP are how we push things ahead!

Since everything here is based on his post, probably a good idea if you read that first, if you haven’t already:

10 Ways Investors Can Improve The Classic Risk Parity Portfolio
Here are 10 ways investors can improve the classic risk parity portfolio by adding modeset leverage, managed futures and other strategies.

So nice to have Sam’s thoughts on this topic. We have collaborated before, as back in May I was an interviewee on his blog, offering my thoughts on RP portfolios (I actually knew of Sam even before this, though, as I have been a subscriber to his YouTube channel for quite some time - check it out!). The more people talking about RP in one fashion or another, the better, and this is a great contribution to the discussion. Incidentally, there was a moment where it looked like Sam had retired his writing fingers, so it is great to have him back in the game!

Starters: totally agree with the opener and then his comment at the end - that a risk-balanced, future-agnostic Risk Parity portfolio really should be the logical default portfolio. Even something as basic as a 60/40 should be clear about why concentration is superior and what fortune-telling powers the person has. Those are the portfolios that have some explainin’ to do, not the RP ones to my mind.

Now, onto the ten things Nomadic Samuel recommends to level up a RP portfolio:

1) Move from US only to Global Stocks.

Totally agree. On a theoretical level, there really is no “geographic” factor explaining why equities in country A are inherently better than country B, at least not in a way not already explained by a company’s fundamentals or risk factors. On a practical level, I must admit some home country bias in my own portfolio, but there are some pretty idiosyncratic reasons for this: path dependence from when I started, my 401k has way more to offer in terms of American stocks than ex-US, and the embedded leverage ETFs I do use are US-based. If I were starting from scratch, I’d be way more global than I actually am, and that’s the better approach.

2) Move from Market Cap Weighting to Minimum Volatility

Like this suggestion too, but I don’t have much experience with investing this way, so I’m not totally sold (yet?). I have been intrigued with a US Min Vol fund (USMV) for some time, and by the logic above, am intrigued by Vanguard’s Global Min Vol fund, VVO, and iSharres’ ICWV. At the same time, part of my approach to RP is to lean INTO volatility in the right circumstances, so at this stage, I might use a minimum volatility fund as a component of my equity allocation, but not necessarily the whole thing. Sam presents some compelling data for sure though, and my interest is piqued.

3) Move from Intermediate-term Treasuries to Long-term Treasuries

I see you, Nomadic Samuel, and raise you: ”How about then moving from Long-term to Extended Duration Treasuries?”

Sam presents a great case for why Long-term Treasuries can really have a shining role in a RP portfolio, as some of their supposed flaws can become strengths when in the right mix. The longer you go out with the duration of a bond, the more whipsawed its price will be going down and going up. Whereas most investors look at bonds and just want something flat, the RP investor wants an asset whose volatility will move opposite, or at least unconnected to, other types of volatility in the portfolio.

Under that logic, then, Extended Duration Bonds offer even more of that. As I have written, they are Spinal Tap’s version of the Long-term Bonds: turned up to 11. Extended Duration Treasuries are not perfect and not for everybody, but since Sam has already paved the way by noting the superior performance of Long-term Treasuries compared to Intermediates, I offer this, with EDV thrown into the mix as well (note: extended duration Treasuries ETFs haven’t been around as long, so the data here only goes back to 2008, unlike Sam’s look all the way back to 2000:

LT beats IT by 97 basis points; Extended Duration beats LT by 96 more. Also even more negatively correlated. Just something to consider!

4) Move from 10 Year Treasuries to TIPS

Ahhh, TIPS. These really do seem like they’d be great for a RP portfolio, but honestly, I have quite a bit of skepticism towards them, namely: are we sure they actually protect against inflation? They should, and the mission is in the name, but do they?

We have just experienced a great test of this, as the past year or so has featured some of the highest inflation numbers since the early 1980s. February 2021 was the last month with a low inflation print, at 1.7. We then got to 4% by April, 6% by October, 8% by March 2022, and now we’re at 9.1% here in July. And meanwhile…

Short-term TIPS have done alright, at +2.3% since March 2021, but the two other TIPS funds (total TIPS and then Long-term only) have both been underwater, during what should really be their time to shine. One might carry and carry TIPS for just such an occasion as we have recently witnessed, putting up with months and years of returns about the same as good ol’ Short-term Treasuries. This is the payoff?

Recently I did a series on Managed Futures, looking at their place in a RP portfolio, and am now in the middle of a series on REITs doing the same. I think a deep dive into TIPS may be next.

5) “Leverage Up, Buttercup”

Another great suggestion for improvements to a RP portfolio, though here I think the key thing to get at is how individual investors can leverage up a portfolio.

Nomadic Samuel has done a great job tracking how different multiples of leverage can impact a portfolio, and I really learned a lot in his “Battle of the Leveraged Portfolios.” That really is a must read.

So, I fully agree on principle, but actually getting that leverage comes with some real trade-offs. Portfolio loans (assuming you have the right brokerage) are one possibility, but in investing, one of my unshakeable rules is never risk yourself to losses beyond your purchase price (I never short, I would never borrow money from a friend to pursue a hot tip, etc. I don’t care what the reward is, 0 is my lower bound if it goes south). This may not be mathematically optimal, but behaviorally, it is (for me).

I use embedded Leveraged ETFs in moderation, but with those, you do have volatility drag, questions about how they might perform if interest rates are anything beyond minimal, and the psychology of staying in them if the market ever has something like the 1987 Crash, which, if you had UPRO at the time would have been a loss approaching 70% in a day.

So, using leverage is theoretically sound and I agree that RP strategies handle leverage better than just about anything I can think of, but I think there is room to explore the practical elements of it. I recommend lots of caution here.

6) Trend Following Managed Futures strategy

Agreed again. That’s been one of the biggest things I have learned over the past 8-9 months of researching Risk Parity enough to actually write stuff down about it: that managed futures have a lot of potential as a foundation in RP portfolios. A year ago at this time, I really didn’t even know what they were!

Managed Futures check the boxes: positive expected return stream, non-correlated to equities, and a plausible explanation of their uniqueness. I now see them as the third member in my “alts” category. It had just been long commodities and gold, and now managed futures are in the mix, as well, perhaps as an allocation that is the same size as long commodities and gold combined. In the past, I might have been 10% each for PDBC and GLDM, now I’m thinking more like 5% each for PDBC and GLDM, and 10% DBMF.

There is still some room for growth in the managed futures space, so I am really keen on where things will go over the next few years. Last time I checked, there were only four ETFs to choose from, and as I have learned, “managed futures” and “trend following” really can meet a lot of things. As the space evolves for DIY investors, I think we’ll get even more benefits from this broad strategy.

7) Global Systematic Macro + Options Strategies (Aside from Trend)

Never great to admit your ignorance publicly - but here I go: I still don’t know enough about these strategies to offer any opinion worth your time as a reader.

I mean, I know what they are, in an academic sense, but don’t have a great feel for them and how I might actually use them. I have been taking notes and could see a planned blog post that will force me to really get into them, but that’s a project for the future.

8) REITs

But, REITs… now you’re in my wheelhouse, Nomad Man!

As I write this, I have just published four blog posts on REITs, with two more ready to publish, and one more planned after that. What could possibly have motivated me to write a cumulative 7,000 words on REITs, you may ask?

I’ve always just assumed they were good for a portfolio, that they’d be a way to get exposure to the separate world of real estate in the convenient form of an ETF. I don’t think I’m alone in that.

But I never really examined it, and have been picking up dribs and drabs of info (such as this from Ben Felix) that REITs may not be doing what I have been hoping. So, with extra time on my hands this summer, I first looked at whether REITs meet my criteria for being a distinct asset class, and then I looked around at what the experts have been saying. I then ran some backtests and did a correlation study on whether VNQ (my preferred asset for investing in REITs) offered any meaningful benefits beyond a higher allocation to small-cap value with some IT bonds thrown in. Next was a comparison on VNQ with Utilities ETFs which basically found that everything you want VNQ to do, VPU can probably do better.

All this to say: I’m not actually sure if REITs are necessary, or really, even if they are a distinct asset class at all. Basically, they are just equities with a funky tax structure, and I don’t think they help investors invest in real estate any more than buying shares of Home Depot. May be a good idea, may be a bad idea, but you wouldn’t say you’ve captured real estate in any meaningful way. For all the things you need them to do, you can actually make a better case for other assets in their place.

But I’d love to read a counterpoint - anyone want to make the case for REITs?

9) Market Neutral Equities Strategy

See point 7. I’ll leave this strategy to the experts or for me in a few months/years when I’ve done my homework.

10) Mish-mash of Other Strategies

Quite a few in this, so speed round…

  • Merger Arbitrage: once again beyond my scope of knowledge.
  • Bitcoin: have been pretty disappointed with my experience, but not just for the price decline since I bought some. I expected that. I did think it would have some correlation benefit, though, and that has not been the case as they just seem to behave like meme-ish, over-caffeinated small-cap tech stocks. I’m not selling, but not biting at these “low” prices either. Also, a really great series on Bitcoin in the Rational Reminder podcast (especially episodes 5 and 6) has me re-thinking my cautious optimism. Only my Investor Policy Statement has kept me from selling.
  • Reinsurance: Haven’t invested in this yet, but am intrigued. Have a couple of reinsurance firms on my watchlist.
  • Tail Risk: Don’t do this myself, but I see the logic behind the great rebalancing opportunity. Again, I’m watching this space.
  • Credit Hedging: beyond my knowledge
  • Private Equity: been hearing a lot about PE lately, my impression is that it's hard to track. Mostly just illiquid. Higher fees. Not exactly for me, I think.
  • Private Loans: I do a version of this already - hard money loans for real estate (flipping, new construction, refinancing). If you’re ok with illiquidity, then lots of upside. Actually, I am writing about this for one of my posts on REIT alternatives - look for it coming up.

Summing It Up

Lots of overlap with Sam’s points and lots of points of agreement. A few questions in there, too, and I plead ignorance on a couple of your recommendations. TIPS and REITs would be my only real departures.

Anyway, as I think I wrote in the interview, RP is a field with fuzzy edges and it doesn’t just have to be one size fits all. I think the discussion is great and really pushes knowledge of RP forward through deliberation and conversation.