Todd Hawthorne of Frontier Alpha joins IBKR’s Senior Trading Education Specialist Jeff Praissman to discuss why the 60/40 classic allocation strategy is broken and how investors can use volatility to add yield and diversify their portfolio.
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Note: Any performance figures mentioned in this podcast are as of the date of recording (December 15, 2022).
Summary – IBKR Podcasts Ep. 54
The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.
Hi everyone and welcome to IBKR Podcasts. I’m your host Jeff Praissman, Interactive Brokers senior trading education specialist. It’s my pleasure to welcome back Todd Hawthorne and discuss why the 60/40 classic allocation strategy is broken and how an investor can use volatility to add yield and diversity to their portfolio. Todd’s been trading and managing equity and equity derivatives for over 20 years. He began his career at Morgan Stanley, designed and managed the Redwood Alternative Yield Strategy at Boston Partners and most recently launched Frontier Alpha Money Management and Consulting, which seeks to provide volatility as a source of yield for investors and uses AI and machine learning to analyze and project volatility and manage risk.
Welcome, Todd, thank you for joining us. It’s great to have you back in the studio.
Thanks for having me Jeff, appreciate it.
I’m really excited for today’s topic. Let’s start off with what exactly is the 60/40 allocation and where did it come from?
Sure, that’s a great question. The 60/40 asset allocation was actually popularized by Jack Bogle, who was the founder of Vanguard, and very simply, this portfolio it consists of 60% in equity exposure and 40% in fixed income. And it’s been a staple I should say of basic portfolio construction for decades now and up until recently this strategy has worked very well primarily because when equities have experienced volatility, the fixed income side of the portfolio has provided some downside cushion but over the last few years, this relationship has begun to break down.
So why do you think the 60/40 allocation is challenged?
It seems that this traditional asset allocation is under duress in the current marketplace. First, let’s take a look at the fixed income side of the equation and it’s really challenged due to the coordinated easing from central banks and that’s happened over the last 10 years. For example, in 1995 the ten year was trading at 9.5% and over the next 10 years essentially trended to 0, where we were actually experiencing negative real rates. And this fall in yield … it was a long, long, long trend and we’re now in a situation where yields are rising and the Fed is raising rates and also fixed income volatility pricing, the pricing of those assets is experiencing extreme volatility.
So, remember that in fixed income as rates rise and the Fed is raising rates, the value of your current bonds declines and again, these are very, very long trends and it’s going to take a long time to unwind. But what’s been happening is that as volatility increases in fixed income, and as rates are rising, what we’re seeing is that the fixed income side of that 60/40 asset allocation is actually becoming correlated with equities and is not providing a hedge against those equity returns anymore. And then secondly, is the current valuation of the 60% or the equity markets. Equities also benefited from the global easy money doctrine because money was so free and so readily available, risk assets were inflated and now we find ourselves in a rising rate environment which tends to portend the declining economic activity, potential recession, lower earnings as that economic activity declines. That usually results in lower multiples and higher volatility in that asset class, and this is occurring right now when valuations are actually still quite elevated, and earnings estimates haven’t been properly adjusted yet. So, we have 40% of that asset allocation in fixed income, which used to not be correlated to equities but is currently at the moment. We are in a situation of rising rates and as rates go up, the value of those fixed income assets go down and equities right now are very expensive and we’re looking into the teeth of at least lowered economic activity, if not in fact a recession and usually what happens is equity valuations decline during those periods. So, both sides of the 60/40 asset allocation are under duress at the moment.
So, it really seems that this classic “safe” long term investment strategy is no longer performing efficiently or the way it’s supposed to. So, what do you think the solution to the current situation is?
I believe actually that volatility as an asset class is at least a partial solution to the problem and I term volatility as a true frontier asset. And what do I mean by that? It comes from the Markowitz idea of efficient frontier. And volatility as an asset class has a number of desirable characteristics. It has returns that are in the equity market bucket and a volatility of returns that skews toward the fixed income side of the equation. So, what does that mean? It means it’s very advantage from a risk-return perspective. It’s also one of the most mean reverting assets which means that it delivers those returns in a very, very consistent way.
And the last attribute is that it tends not to be highly correlated with either fixed income or equity over time. So, putting volatility as an asset class into one’s asset allocation… number one, provides superior risk-adjusted returns, so it improves the Sharpe ratio and Sortino ratio of your portfolio. And maybe more importantly, it really delivers true diversification benefit because it isn’t correlated to that either side of that traditional 60/40 asset blend. I personally tend to recommend that a volatility strategy occupy over 10% of an asset allocation, but in my work, benefits are realized with allocations as low as 5%. You really see that diversification benefit and improvement in risk adjusted returns.
So, how do you create volatility as an asset class then? Where exactly did you come up with this idea?
Yeah, it came out of the crisis in 2008. I was speaking with investors, and they were really speaking with a singular voice. They had these actuarial assumptions for their asset allocations which were frankly, just not being met. I’ll pick on equities, for instance. The default return for an equity asset is usually approximately 7%. However, equities really never returned 7%. They swing wildly through that mean they can go up 20% one year and then down 20% the next and, in that situation, that actually means that you’re losing principle. So, depending on when you’re retiring, that downside volatility can become a real problem because you don’t have the time to earn your way out of that, and this is especially true if the 40% of your fixed income portfolio becomes correlated on the downside, as it has over the last few years. So, I started thinking about that, what are clients really asking for? Well, they’re asking for consistent returns. And so, I thought about what are the attributes for consistent returns and how could we provide that? And I chose to define that with really three very important investment tenants and the first is that it had to produce returns that were consistent with equity. So, I define that as somewhere in that 5 to 10% bucket. And secondly, it had to provide those returns at a greatly reduced volatility. Another way to say that is at much lower risk and with more consistency than equity as a whole. And lastly, the last attribute is that it had to have a built-in hedge to the instrument itself so that investors could stand a very good chance of keeping their principal during periods of market stress.
So, when I was looking around for ways to create a portfolio that had these three attributes, I came across a clue which came from reading a 1974 Robert Merton article where he examines the credit risks of a given company using equity options and equity options are my background. And in this article, calls are a stand in for equity exposure and short puts become a proxy for fixed income. Specifically, Merton equates short puts with a zero-coupon corporate bond. And I took this idea, and I applied a quantum mental bottom-up research approach to control risk to this and we’ll describe the construction of these instruments in a moment, but the outcome of this approach really satisfied, the three investment tenants.
So again, what is this? We are selling short puts in the portfolio and doing this with a fundamental bottom-up risk control produces returns that were really right in the belly of that equity bucket, again, between that five and 10. And interestingly, it produces those returns less than half the volatility of the equity markets. So again, you’re doubling your return per unit of risk. If this approach yields that same 7% return, half the volatility, that’s again doubling your return per unit of risk, which is a pretty good place to start.
And lastly, it has this embedded hedge that I talked about of approximately 20% built into the structure itself, and again we’ll describe exactly what that is. But what it means factually is that the average position in the portfolio can decline by 20% before any principal is at risk. And lastly a zero-coupon bond, the yields that are achieved in this structure are much higher than the corresponding zero-coupon bonds that you would see of similar duration. So, if you take a company and you look at a similar duration zero-coupon corporate bond, you might get something on the order of 2 or 3% and if you create synthetic yield using this approach of the same duration and the same risk, you’re actually getting corresponding yields that are in the low double digits to low teens. So, you’re getting almost 10 times the amount of yield as you would in a traditional zero-coupon corporate structure.
And I just I just want to take a step back real quick, just for our listeners that may not be familiar with the options. A call option is the right to buy the stock at a certain price and a put option, when you buy a put it’s the right to sell a stock at a certain price. But if you’re selling the put you would end up buying that stock at a certain price, so Todd if you could kind of walk through our listeners maybe through an example of what you’re describing and how it works and how selling puts creates yields. I think that would be great.
Absolutely, absolutely. So how does selling puts again create this type of synthetic yield and what can you really do? So, the first thing is to find a company that you like from a fundamental basis. You like XYZ company, and you think that there is value in that name and then what we tend to do is we take a Murphy’s law approach to that company. Just by virtue of the fact that the company has a stock price means that it is discounting the future in some way. And so, what we do is we actually look at the model and say what kind of a future, how rosy is that future that it’s discounting? And if that stock does not achieve the expectations embedded in the model, where will that find valuation support? Another way to say that is if everything goes wrong in that Murphy’s law approach, where will all that bad news be baked into the stock price? And in this example, let’s say we buy XYZ stock trading at $100 and we again look at the model and say what can go wrong if it does? Where will the risks be out of that name? And in this example, let’s say that’s $85. So, what we can do is we can sell that 85 strike put and again in that example, let’s say we sell that with a 3-month duration for $5. What the investor is really committing to is that at any stock price above 85, at expiration, that investor is going to collect the $6. So how much is that risk? Well, it’s 85 if the stock below trades below 85 or down 15%, the investor is committing to buying that stock at $85. So, one way to look at that is you’re buying the stock at a 15% discount and if it doesn’t achieve that downside volatility, then the investor is getting a $5 yield, 5 into 85, so approximately a 6% return.
So that’s kind of interesting as a one off, but where it really starts to make sense is if you create a diversified portfolio of these assets diversified across time across strike price and across sectors. What kind of attributes does this portfolio have? Number one, it has a built-in hedge, right? Stock is trading at $100, and it can go down by 15% before you have to commit any capital to the name. In fact, the stock can go down all the way to 80 dollars because you’ve taken in that extra $5 from the put, so your principal is protected all the way down 20% to that $80.00 level. So number 1, built-in hedge to these instruments. Number 2 is that it’s providing approximately a 6% yield on an ongoing basis and number 3, is we can get into the probabilities of achieving that yield are much, much higher than achieving a positive return, just by buying that stock itself.
So you ended that with the with the probability of achieving this is you much higher. Could you go into more detail about how that works? I mean you mentioned, obviously the distribution between strike prices and time, but sort of — Could you explain how this gives the investor more of a chance to achieve this goal of the of the better return versus the old classic fixed income investment?
Sure, absolutely. So, I was trained as an equity analyst and what we know about equities is that if the stock that you’re picking goes up a dollar, you make a dollar and if the stock that you’re picking goes down a dollar, you lose a dollar. And if you look overtime, the world’s best equity and analysts have a hit ratio or a success ratio of approximately55%. These are the best analysts in the world, so they have again approximately a 55% chance of being right. If you just look at the distribution of a stock price and the distribution of an average stock has something called about a 20 volatility. And what that means is that if the stock is trading at $100 that 20 volatility means that one standard deviation of the time, or 68% approximately, that stock price will be within $120.00 and $80.00. So it’s price 68% of the time will be somewhere in that distribution.
So, the first thing we’re doing is we’re using that distribution to our benefit. The stock can’t both be at 120 and 80 simultaneously. So, the probability that that stock realizes a price below 80 automatically rises to approximately 84% from 68. So, we’re using what we call single vector analysis and saying I don’t care whether that stock goes up. I don’t care whether that stock goes sideways. I don’t even care whether that stock goes down as long as it doesn’t go down below that strike price. By concentrating on that single vector and that one data point, which is again — What is its intrinsic value? Where will the risks be out of that name? — automatically and structurally improves your hit rate from roughly 50/50 to 84%.
Further to that, you can actually improve those odds by applying fundamental bottom-up research. So, another way to say that is investing in Procter and Gamble is very different than investing inTesla right? They have different trading attributes. They have different volatilities, they have different risks on the downside and by setting that strike price appropriately for each and every underlying company, you again improve your odds and in our work those odds improved from again, mathematically, roughly 84% to roughly the low 90s. And then at Frontier Alpha — we actually we can talk about this later as well — we apply a Pro forma volatility estimate to the market and we have a variable hedge that further immunes the portfolio from Black Swan events or big downside risk. And again, that hit ratio has improved from the low 90s to the mid to high 90s. So, you can either look at this from an equity perspective and you can pick stocks and you have a 50/50 chance of being correct or you can create through put sales these volatility instruments or these volatility yield instruments, and your hit ratio can be as high as the mid to high 90s.
So, that’s really what we’re attempting to do is widen out those goal posts. Again, if you’re just picking a stock, your goal posts are basically $0.00 wide. If the stock goes up you make money, if the stock goes down, you lose money. In in this approach, in using volatility as an asset class, no matter how much the stock goes up, you’re going to realize that yield, and in fact the stock can decline. In our prior example, it can go down by 15% and the yield on that instrument doesn’t change at all, and in fact you’re principally protected down 20%. So, the stock can decline by 20% before any principle is at risk. So, in our terminology, those goal posts are extremely wide. The stock can go anywhere from infinity on the upside to down 20% before your investment is at any risk of principal, and because of that your probability of success improves dramatically.
So, through this investment strategy, it’s really allowing the investor the approach to really give a much greater chance of success of creating that value down the road, but I want to kind of touch on something you said earlier. How does Frontier Alpha take this approach a step further in terms of risk management?
Absolutely, that’s a good question. Over the last several years we have developed a proprietary quantum mental approach that combines equity fundamentals, so we’re actually looking at the fundamentals of every given company and then we’re combining that with what we call proximal volatility, and the best metaphor for proximal volatility is weather. So here we are in the middle of winter and when it is, when it is 0 degrees outside. The concept is that it is very unlikely that we’re going to have a sunny day in the high 90s tomorrow. And we use AI and machine learning and a quantum mental approach to develop an estimate for pro forma volatility for the marketplace. And it uses this concept again of proximal volatility or weather to say the status of the market today is very likely to be the status of the market tomorrow or if there is a huge storm on the Doppler radar, it is likely to rain. And so, we use that to size the downside hedge or the size of the Black Swan event hedge so that again, back to that example, if the stock does go below $85, at that point the investor is hedged. And so, it really just takes those black swan events off the table, and again we found that that improves our hit rate from approximately 90% to approximately 95 or 96%. So terminally, not only is this way more consistent than either than long equity or high yield, but it is also further immune from these big black swan events through our process of variable hedges.
It’s really interesting, and it sounds like just from our conversation that due to kind of almost unprecedented market conditions, not as much right now, but over the past 20 years as far as zero interest rates, 2008, the fact that rates are going up again. Everything is kind of coming together here, you have that classic approach, it seems like this kind of a new look on an old classic here where you where you’re getting the outcome. You give yourself a much better chance to get the outcome that that classic approach had done in the past and actually a potentially safer way to do it. I’d like to wrap it up with one last question. How can investors use this technique in their own portfolios?
Sure, I actually think this this technique is very amenable to people doing it in their own portfolios for themselves. Just a couple of comments about that, about what the investors are actually doing and how they can think about this. So again, back to that example, let’s say that we have a stock and it’s trading at $100 and it’s a name that you like and a name that the investor would like to purchase anyway. So, if they take what I term a “deep value approach” and they ask themselves the following question: pretend you are a deep value investor and where would you really like to buy that name because all the risks are out of the name? All the risks on the downside are baked in, all the bad news is baked in. And again, in this example we’re using 85 and so for the life of that investment, whether that be 3 months or 6 months or a year, whatever duration the investor chooses … that $85 level represents where they would be willing to purchase that stock.
What’s interesting about that is by deciding now that you’re willing to commit capital should the stock reach 85. In exchange for that, you receive $6 or yield and what’s interesting about that yield or why that has such a big effect on an asset allocation, is what is that yield? Well, in options terminology can be called Theta or time value or excess volatility that is baked into the call price but what it really is just cash and the investor is going to realize that cash. All $5 of it ratably between now and expiration at any strike price, any stock price above 85. So why is that interesting? And that is because again, at any stock price above $85, there is zero equity exposure in this model, right? You are not actually committing any capital to equity or having any equity exposure to that name at expiration at any stock price equal to or above 85, right? So, what is really contributing to the alpha of this strategy? It’s the excess volatility inside of those put options and you are monetizing that over a really broad range of stock outcomes. And so, this volatility as an asset class … it’s really not equity and it’s not fixed income, but it has attributes, or I should say a return stream that looks very much like equity over time and looks very much like high yield over time. But the volatility of those returns because of the width of those go posts is very low. So that’s really important to think about when investors are doing this inside their portfolio, because it really is a separate asset class, and it has all these positive attributes that we talked about and so they should think about that in terms of sizing. How big do I want my “volatility portfolio” to be? And how can I do this on my own? How can I monetize this inside of my own portfolio? So the first is that decision of how big do we want volatility to be? Again, I would recommend at least 5%. You’ll see positive benefits. It performs better or you get a larger benefit if you up that to 10% or over. And then the second thing just procedurally to do is, again — Can even be names in your existing portfolio that you like that you would like to buy more of. — So again, XYZ stocks trading at $100, you’d like to buy some more, but you’d like to buy some more at 85. Why? Because the risks are out of the name at that level, and so you can go and open up the options information on Interactive Brokers and you can see all of the put schedules that are there over all the durations that are available. And you know your level, which is 85, and so you can just take the value or the bid price of those puts where you could sell them. For each of those durations as you go further out in time, you will actually take in more money, but your annualized rate will be lower and as you come in, you will take in less money, but your annualized rate will be higher. I usually find the sweet spot is somewhere around between three and six months. You take the bid price of that put you divide that very simply into the strike price and that is your corresponding yield. And so, you can do this just begin very simply and instead of buying an additional 1% or 2% of the equities that are in your existing portfolio, again on names that you already like, look to sell puts against them and create a yield stream against them. And build up to a 5% weighting of these volatility assets in your portfolio and you should see an improvement in risk adjusted returns.
No, that’s great. Todd, thank you so much for coming by. Just to remind our listeners, you can find previous podcasts with Todd Hawthorne on Interactive Brokers website under Education and scroll down to podcast or on the IBKR podcast channel and services such as Spotify, Podbean, Amazon Music at Apple Music. Todd can be reached at LinkedIn at TGH 28 or at firstname.lastname@example.org. Thank you for listening until next time, I’m Jeff Praissman with Interactive Brokers.
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