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JM
February 18, 2010
Survival is the name of all games. Investing is a rather serious game with a twofold objective: 1) the
portfolio must avoid extinction, and 2) the portfolio must increase in value. Because of the nature of the
nature of the universe, these two objectives often come into collision. To survive, allocations must
avoid, hedge or exploit unpredictable, often catastrophic events. To grow, capital must long risk to
some degree.
There are better ways to insure portfolios and limit risk than naked shorts and longing ATM puts. Given
enough time, these are money losers. Worse, you get exposure to anti‐meltups, before you profit from
any meltdown. Presented are some extinction proof strategies for how to do it. Also are some
implementation strategies I tried to work through.
The Talmud 1/N rebalance (long only strategy):
This rule comes from the Babylonian Talmud circa 500 B.C. Millennia‐old traditions survive because they
are made of disaster retardant material. The strategy is one of optimal diversification by investing
equally in every asset class. It says: “I don’t know what the future holds, but I want to be ready for it.”
Such agnosticism admits no notion of alpha generation. That combined with prohibitive transactions
costs associated with longing every possible asset makes it the perfect wife of index investing.
There has to be some human judgment about appropriate diversification and management of
transactions costs. These implementations could be optimized by taking a view on the business cycle
and the asset classes that work best in a given cycle environment. This is diagrammed below.
Asset Classes ranked by return from highest to lowest at a given point in
the business cycle
Source: PIMCO, Product Focus August 2009
80/20 Dispersioning:
This is a stock‐picker strategy with down side insurance. The amount of insurance is a function of your
alpha generating function, and the basis point cost one can tolerate.
The rule is simple. Pick a stock or stocks that you think the market is wrong about with 80% of your
money and with the other 20% buy an etf that shorts the index of that stock(s) sector(s). For example,
long Goldman Sachs, and buy a short financial ETF. You get the idea. I’m not the best trader so I’ll stop
here.
Index Home‐Brew (Capital Structure Arbitrage):
Boaz Weinstein was probably not the first to do this, but he is credited with the innovation. The
strategy exploits mispricing across the capital structure of a firm, or in this case, the approximate capital
structure of sibling indices. Long one side, short the other. Two examples are presented below, one a
lesson in pain and the other a cleaner kill.
”Tyson’s You Don’t Know My Pain”: Long High‐Yield Debt (HYG), Short Russell 2000 (RWN)
There is a clear cap arb divergence story, and one gets some yield generation from the long. The
divergence (meaning the pricing of the long position is not enough to compensate for the downside risk,
especially as speculative grade behaves somewhat like equities with limited upside.
The key to success here in my view is 1) a wide divergence and 2) good yield/price profile in the long
position. Like below.
The Love Train: Long Investment Grade Debt (LQD), Short Dow Jones (DOG)
This is a very conservative strategy, as it allows for no melt‐up appreciation. But the divergence is huge,
and investment grade credit looks nice on a risk‐adjusted basis right now. Shorting the Dow has a
massive pay‐off in the position as well. This can be optionalized.
Talebesque (Risk positioned, crash neutral): Using half of the interest payments from 5 year Swedish
government bonds, Scotia preferred stock, and the 10 year senior debt of a BBB+ uranium
producer/refiner, short ATM puts and long OTM puts @ moneyness .90 on an equity or ETF. Because
the OTM put limits the downside risk, the position’s loss is at most ‐10% whether market return is ‐10%
or ‐50%.
Arbing the commodity space?
Think of this as a variation on pair trading. I like getting creative, and I can see how this strategy can
play out in the commodity space. Knowing that gold (maybe oil?) acts as a bell‐weather to other
commodities, first calculate a beta for each commodity around one’s chosen anchor. One can short or
long “high beta” commodities around the anchor depending on their price. See below: an example of
the highest beta commodity relative to gold. This is not extinction proof, only a stocking stuffer. ETFs
combined with options make implementation efficient IMHO.