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The Queen’s Gambit Declined


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By: Rick RiederRussell Brownback

Playing The Long Game….

The Queen’s Gambit miniseries helped propel Netflix to a winning earnings report last quarter, but in fact the chess strategy it is named after has helped propel chess players to winning games for decades. The player controlling the white pieces, which always moves first, attempts to entice the black piece player into an inferior position by using a pawn sacrifice as a lure – the “gambit” – an offer that unwitting opponents often find irresistible. Yet, while black would then be up on material early in the game (by capturing the offered pawn) any attempt to defend this lead would almost certainly result in defeat as the center of the board would be lost, and along with it the positional advantage for the rest of the game. Black’s best chance of winning against the powerful Queen’s Gambit is to decline to take the small lead, in favor of developing other pieces in the center of the board, resulting in better opportunities to capture opponents’ pieces later. That decision to ignore the early pawn is so influential on the game’s outcome that it is one of those rare instances in which the act of not making a critical move has been given its own title: The Queen’s Gambit Declined.

​Similarly, a cash allocation in portfolios can be thought of as dollars not being used to secure an available investable asset. And at first, having any cash allocation at all can seem a bit naive today. With interest rates at 0%, cash offers no return, and could even be considered a liability with a negative return if assessed either against the opportunity cost of owning an asset with positive return potential (FOMO in urban speak), or relative to inflation (via a negative real return).

Yet the game of chess shows us that there are reasons why declining to take a particular position today may actually offer better long-term prospects for portfolios, and a higher probability of winning the long game. Some opportunities, whether in very low yielding high quality fixed income, or in structurally challenged industries, offer simply too small of a return to warrant the risk, and could result in constrained overall portfolio positions down the line that preclude new risk from being taken. Against such slim opportunities, it may be better to hold cash instead and focus on developing other parts of the portfolio (for more details on the role of cash in portfolio construction today, see our recent note: More Cash, Fewer Treasury Bonds).

An Evolving Risk/Return Landscape

A fully invested portfolio of investment grade fixed income (IG), using the Bloomberg-Barclays Investment Grade Corporate Index for example, offers roughly a 1.9% yield while realizing a 4.5% volatility over the last six months, as of January 31, 2021 (deliberately excluding the exceptionally volatile first half of 2020). To put that in context, two years ago, IG bond yields were about 1% higher than their volatility at that time (at 4% versus 3%). Many parts of high-quality fixed income exhibit similar characteristics today: in a one standard deviation negative shock, they would lose a multiple of the yield they would stand to earn should nothing happen. Measured against these assets, cash may be the equivalent of The Queen’s Gambit Declined for portfolios: giving up a pawn on offer, given today’s record low fixed income yields, in order to be well positioned to take advantage of better opportunities that may come along down the line (such as when some crowded positions are forced to unwind as we have seen in recent weeks).​

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​There is no magic formula for how much cash a portfolio should hold. As a defensive strategy, the answer to that question would be largely dependent on what the rest of the portfolio is made up of. The higher the return potential of other assets in the portfolio, the more a portfolio can afford a cash allocation (keeping in mind that while cash has a 0% return, it also has 0% volatility). Portfolio math today does favor holding some cash and building out other, higher-yielding allocations, while waiting for an opportunity to deploy that cash later. A portfolio invested 50-50 in cash and high yield bonds today offers a yield of roughly 2.1% and a volatility of 2.5% (using the Bloomberg-Barclays High Yield Index as a proxy, as of January 31, 2021), surpassing the 1.9% yield of a 100% IG portfolio, while also realizing a lower level of volatility. Likewise, one only needs a 15% equity allocation (to the S&P 500 Index, as of January 31, 2021) to generate the equivalent yield of a portfolio that was fully invested in 5-Year U.S. Treasury bonds.​

Global Currencies and Creative Cash Proxies

For more flexible global portfolios, the nature of cash itself may require an allocation decision, and hence present a return-generation opportunity. While the U.S. dollar is a common safe haven during times of stress and could act as a hedge against risk, the Japanese yen and sometimes the euro have displayed such characteristics in the past too. Arguably, alternative currencies, like gold (and even the B-word) could creatively be worked into a broad and diverse measure of cash. Like a chess game, depending on how the opportunity set in the market evolves, cash can be deployed accordingly, even if it is to purchase a previously underweight asset at a later time.​

The Queen’s Gambit miniseries, with 62million views in its first month, might be the perfect microcosm for the frictionless “CC: All economy” of tomorrow (as we have previously described). In fact, the show can be thought of as a cash-generating intangible asset, marketed by “word of mouth” (through consumer reviews and social media), with an almost perfectly elastic supply curve (there are no significant capacity constraints or incremental costs restricting the marginal subscriber from viewing the series). But asset allocators would do well not to forget its defensive counterpart in the chess world, The Queen’s Gambit Declined, when thinking about cash as an asset class in portfolios today.

Originally Posted on February 25, 2021 – The Queen’s Gambit Declined

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