ETF Analysis

NTSX: Protecting Your Equity Allocation

Without Sacrificing Growth
Aug. 02, 2021 6:02 AM ET | WisdomTree U.S. Efficient Core Fund (NTSX) | 79 Comments | 41 Likes

Summary
The death of the classic 60:40 portfolio has been greatly exaggerated.

With a judicious use of leverage, WisdomTree U.S. Efficient Core Fund (NTSX) offers
90:60 exposure to large-cap domestic equity and US treasuries in a tax-efficient ETF.

The fund has matched the returns of the large-cap domestic equity market with
reduced volatility and reduced downdraws.

The fund has been able to sustain high levels of income in its three-year existence
and analysis of a surrogate construct suggests strongly that the strategy is
sustainable for high withdrawal rates.

With equity markets seemingly stretched and ripe for correction, NTSX offers an
attractive alternative to a 100% equity index fund.
Filograph/E+ via Getty Images

NTSX: Protecting Your Equity Allocation Without Sacrificing

Growth
By most measures the domestic equity market is being stretched. A breaking point is
inevitable. As we know, inevitable does not mean tomorrow, next month, or even next
year. But it could be any of the above. Even so, growth today comes from domestic
equity. No asset class had delivered anything close to the returns of the domestic equity
market. Furthermore, the US equity market’s outperformance has been marked by lower
volatility than any major asset class outside the fixed-income categories.
We can speculate on the reasons for this extraordinary performance from domestic
equity. We can remind ourselves that this whole analysis is plagued by recency bias. We
can even predict that these discrepancies are historical anomalies. But the fact remains
that domestic equity has been the unquestioned champ for a decade and a half, and
betting against domestic equity is done at one’s peril.

So, on one hand we have a broad consensus bordering on certainty that domestic
market is inevitably approaching a major drawdown, but with no clue as to when. On the
other, we see domestic equity consistently outperforming every other asset class. What
is the self-directed investor to do? There are multiple prudent approaches, but few retain
exposure to domestic equity’s full gains while providing some protection against sharp
and sudden losses.
Diversification is an obvious and time-tested fallback: Balance equity with uncorrelated
asset classes that will modulate portfolio declines in poor stock markets. The investing
literature is awash with asset-class portfolios that modulate drawdowns. But they all
mean giving up some of equity’s strong growth.

My choice for asset-class diversification is the simplest and time-tested, the 60/40
stocks/bonds portfolio. And my choice for bonds for those of us who are not
exceptionally adept at bond investing is treasury bonds. This next chart shows why.
A look at the chart above shows us that treasury bonds are deeply negatively correlated
with domestic equity and long-term treasuries provide the strongest gains over the past
decade and a half. Also true is that they are the most volatile fixed-income asset class,
but when paired with equity that volatility can work to an investor’s advantage due to the
strongly negative correlation between the asset classes. It may not make intuitive
sense. So, we see comments like this from a wise and prudent investor: “The 20% or
40% in the typical 80-20 or 60-40 formulas is the killer, since it usually includes long
duration bonds and other hedging or 'balancing' assets that are essentially like rocks
dragging your overall returns down in the name of ‘stability.’".

How Much Has Reducing Volatility Via A 60:40 Allocation Really

Cost?
Most of us have a pretty good idea of what to expect from a 60/40 equity treasury mix.
If I asked the class, hands would shoot up with everyone wanting to say, “reduced
returns from equity with lower volatility.” Let’s go to PortfolioVisualizer quickly to
confirm.
Sure enough, we give up gains from equity—a squeak over a percentage point of CAGR
over nearly two decades, mind you—in exchange for greatly reduced volatility and
drawdowns. Note especially the Worst Year stats: Going back nearly two decades worst
year performance drops -8.5% for the 60:40 portfolio. Compare that to -38.8% and
-21.8% for equity and treasuries. That is the power of those negative correlations.

Perhaps even more relevant to some of today’s anxieties is the case of the unfortunate
investors who happened to enter the market at the beginning of 2008 (next chart).
Investing (and holding) SPY at that point would not have broken past an investment in
the 60:40 portfolio until late last year. And there's no clear indication that it will stay
ahead for any length of time.

Retaining Equity Returns

Can we agree at this point that a 60:40 Equity:Treasuries portfolio is a solid choice for
growth with safety? I know many readers have rejected this option encouraged by the
strong returns of the equity market and not wanting to give up that percentage point of
CAGR. To be fair, in strong bull markets it will be a greater differential than it has been
over that full two-decade stretch, but the point remains.
Here, I could drag out any number of admonitions against greed, but let’s forget them
and go with the greed-is-good approach. Can we fully sustain the equity-levels of growth
with the protection that the 40% treasury bond allocation affords?

One path to that end is leverage. I realize that word will make many readers
uncomfortable and to them I’d say stick with the 60:40, a portfolio mix that befits
prudent money management. Or go to PortfolioVisualizer and tweak those percentages.
Maybe you’re more comfortable at 50:50 or willing to extend the risk to 80:20. If so, stop
reading here. But before you do consider that I'm not going to suggest extreme and risky
levels of leverage, and that risk will be strongly modulated by those negative correlations
we opened with. Indeed, the leveraged portfolio will have risk:reward ratios barely
discernible from its unleveraged counterpart.

Leveraging the 60:40

For those of us still in the room, let’s look at a Greed-Is-Good scenario, but not at the
Pigs-Get-Slaughtered level: 1.5x leverage or 90:60 SPY:TLT.
As we see above, the historical record supports this approach. The 90:60 portfolio didn’t
just meet SPY’s performance, it beat it handily, and it did so with reduced volatility and a
fraction of the worst drawdown. The four percentage-point gain in CAGR over the
unleveraged 60:40 portfolio sufficiently offsets the increased volatility that it clocked
Sharpe and Sortino Ratios only trivially below that of the 60:40. More meaningful to
most investors is the much greater increase in those risk:return metrics relative to the
equity index fund.

I usually prefer to look at rolling returns rather than cumulative returns over long periods
of time. Here is PortfolioVisualizer’s report on rolling returns for the three scenarios.

Yes, past performance does not guarantee ... yada, yada, yada. But the past
performance over nearly two decades is certainly screaming for attention here.

Of course, what’s not in these models is the cost, both financial and in management
attention, of maintaining a 90:60 1.5x portfolio. There is considerable friction in those
models as constructed that I've not tried to estimate. And we haven't considered the tax
inefficiency of such a strategy. Devilish details indeed.

NTSX: An ETF Implementation of the 90:60 Portfolio

Regular readers will be aware that as a retiree, I’m working to simplify my portfolio
management. Managing a leveraged portfolio, even one as simple as this two-
component one, consumes time, effort and expenses. Which brings me (finally, you
must be saying) to today’s subject: WisdomTree U.S. Efficient Core Fund (NTSX), an ETF
that implements the 90:60 portfolio.
The fund is relatively new—inception of Aug 2, 2018, so three years ago to the day—but
enough time to at least see how its implementation of the 90:60 portfolio compares with
the results above.

Not bad if we only look at the table. CAGR falls short of the SPY:TLT 90:60 model but not
by much, considering these results do not include leverage costs for that portfolio which
would certainly be greater than NSTX’s 0.20% expense ratio, so let’s call it a wash for
now.

What is disturbing is the fund’s performance in the Spring of 2020’s COVID-panic

downdraw where it gave up 3.5 percentage points to SPY:TLT 90:60. It did not, however,
give up as much as SPY, which is not a bad showing considering the leverage. And, by a
year later it had recovered sufficiently to catch up to the SPY:TLT 90:60 implementation.
As we know, the market’s recovery from that drawdown was swift, so it’s hard to
extrapolate from this one event to how each might have done in a more sustained bear
market situation. I suspect that the lesser downturn by the SPY:TLT portfolio reflects a
strong flight to the safety of long-duration bonds as the market panicked and NTSX's
intermediate duration stance did not see nearly the pop TLT did.

NTSX: Holdings
Let’s look at NTSX. I’ve said that it is a 90:60 domestic-large-cap:treasury-bond blend
fund. The fund achieves it goals by holding 90% of its assets in 500 large-cap U.S.
stocks, 10% in cash, and 60% in bond futures.

Here’s WisdomTree’s discussion of the portfolio (from the fund’s FAQ):

Effectively, the fund creates a 90:60 portfolio by holding equity (at 90%) and leveraging
treasuries using derivatives to create a 60% exposure to intermediate duration
treasuries. The duration explains why it underperforms the model 90:60 SPY:TLT. From
the chart at the top of this article we see that intermediate treasuries give up 250 bps of
return to long-term treasuries, which I use in that model. But with current anxieties on
the potential for increased duration risk, that may not be a bad thing.

What we get with NTSX is a fund that implements a 90:60 portfolio at modest cost. The
record is short, too short to really have fully tested the fund, but the strategy is sound,
and has a long record of strong performance.

Tax Efficiency
We also get a fund that can be held in a taxable account. Some readers will be familiar
with an earlier article where I offered for your consideration a much more aggressive
balanced equity and bond fund, PIMCO StocksPLUS Long Duration Fund (PSLDX) but
cautioned strongly that it would be best to hold that one in a tax-advantaged account.
PIMCO manages the fund with no regard for tax efficiency and its open-end mutual fund
format is particularly tax unfriendly. Their bond allocation derives from PIMCO's strength
in bond investment management. Bonds are held across the global spectrum, traded
regularly and aggressively, generating interest income and long- and short-term capital
gains, all of which are taxable. Nearly all of PSLDX's gains (and they have been
substantial) are taxable gains.

By contrast NTSX holds its bond component as futures which have a different tax
liability relative to holding bonds outright. Bond returns are driven primarily by interest
income, so they are treated as ordinary income for tax purposes (although treasury
interest income is tax-exempt at the state level). Futures generate income as capital
gains and are taxed at 60% long-term, 40% short-term capital gains rates. Cash bonds
can experience unrealized principal losses if the bonds’ prices decrease, yet taxes still
must be paid on coupon payments. With exposure via futures there is no tax liability if
positions decline in value and any losses can be carried forward to offset future gains.

NTSX As an Income Investment

One of the things I did when discussing PSLDX was demonstrate that over its long
history it could have comfortably sustained high levels of withdrawals for income. That
strategy involved reinvesting all distributions as received and taking income by
redeeming fund shares on a regular schedule.

Let’s see how that would have worked out with NTSX. We don’t have the long history we
had with the PIMCO OEF but we do have a model 90:60 we can use as a surrogate to
extend the history. If we put $100,000 into NTSX at the beginning of September 2018,
and withdrew $750 the first month (9% initial annual withdrawal rate) and continued to
do so adjusting that monthly draw by the rate of inflation, the fund would have sustained
the 9% inflation-adjusted income and grown its capital value to $130,166. It would have
generated $26,922 in income (average $769.23 a month).
We can take the SPY:TLT 90:60 surrogate back to Aug 2002 and apply the same start
conditions (withdraw $750 the first month and adjust for inflation for subsequent
withdrawals). In this case the capital value would have grown to $224,616 while
withdrawals generated a total $213,286 in income, with the most recent month's draw
being $1112.

Source: Data from Portfolio Visualizer. Chart by author

Summary
Large-cap domestic equity has been the strongest asset class for growth for the recent
past. Prudent investors will seek strategies that moderate the volatility of equity growth.
Bonds, especially treasury bonds, are negatively correlated with equity. The classic
60:40 portfolio using large-cap domestic equity and treasury bonds moderates volatility
and drawdowns but decreases gains compared to 100% equity. Leveraging the 60:40
portfolio at 1.5x (90:60) has captured fully the equity gains of an unleveraged equity
holding with meaningful reduction of volatility and drawdowns.
WisdomTree’s U.S. Efficient Core Fund provides tax-efficient exposure to such a 90:60
portfolio by holding a broad, large-cap, domestic equity portfolio combined with futures
on US treasury bonds. Over the fund’s relatively brief existence it has delivered capital
returns equivalent to the S&P 500 with meaningfully reduced volatility and drawdowns.
Over that period the fund would have sustained a 9% inflation-adjusted income stream
via withdrawals. And a surrogate portfolio dating to 2002 shows a similar performance
record both in matching the equity index and in sustaining the 9% inflation-adjusted
income.

NTSX is an outstanding candidate for a core holding in either a tax-advantaged or a

taxable account, providing equity returns with moderate volatility and capable of
providing sustainable high income.

This article was written by

Left Banker
12.45K Followers

I'm a retired individual investor.

Disclosure: I/we have a beneficial long position in the shares of NTSX PSLDX either through stock
ownership, options, or other derivatives. I wrote this article myself, and it expresses my own
opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no
business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article does not constitute investment or tax-planning advice. I am
passing along the results of my research on the subject. Any investor who finds these results
intriguing will certainly want to do all due diligence to determine if any fund mentioned here is
suitable for his or her portfolio. Any investor who has concerns about the tax status of an
investment will want to consult with a tax professional on that topic.

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