Stock Investors Fear an AI Bubble. Bond Investors Fear Inflation. How Can You Diversify Without Selling Them?

Adam Butler · ReSolve Asset Management Global

Liquid funding on both sides of a stacked portfolio lets rebalancing offset equity drawdowns.

In a return-stacked portfolio, the managed futures sleeve and the equity sleeve are both liquid. When equities fall, the risk budget of the futures sleeve can be lowered to fund more equity exposure, and when equities rise and futures fall, equities can be sold to fund futures. Because both sides are structurally uncorrelated, the futures position is much less likely to force selling of equities during an equity drawdown. The managed futures side acts as ballast, so the investor can sell one side at a higher level to buy the other at a lower level and let rebalancing work. This addresses the 2008 failure, where illiquid hedge fund stakes blocked rebalancing.

“we're able to take advantage of that diversification because both sides of the trade are liquid. And structurally, both sides of the trade are uncorrelated.”at 37:53

Corey Hoffstein · Newfound Research

Gated hedge-fund portable alpha in 2008 left investors unable to rebalance; turnkey structures fix this.

In the pre-2008 portable alpha structure, hedge funds were fully funded, so an investor who wanted equity beta had to get it synthetically. A 80/20 split (80 in the hedge fund, 20 as collateral) means a 20% equity drawdown wipes out the collateral. If the investor cannot rebalance out of the hedge fund because of redemption periods or gated redemptions, they lose their equity exposure with no way to rebalance. The turnkey structure fixes this: a cash-plus strategy such as managed futures holds T-bills as collateral, so the T-bill collateral can be repurposed into stocks while keeping enough collateral for futures. The stock and futures sides can then be rebalanced together, avoiding the 2008 problem.

“a 20% drawdown in equities before your collateral is fully wiped out. And if you can't rebalance out of the hedge fund because of redemption periods or gated redemptions, you've completely lost exposure to your equity beta with no ability to rebalance.”at 39:39

Corey Hoffstein · Newfound Research

Managed futures trend is a useful third pillar and crisis/inflation diversifier for stock-bond portfolios.

Managed futures is a cash-plus strategy. Futures are capital efficient (about $5 of margin controls $100 of S&P 500 futures), so most of the cash can sit in stocks, bonds, international equities or gold. That lets an investor keep a 60/40 core and add a managed futures overlay by swapping into stock or bond plus managed futures funds. Trend-following has a long empirical record of positive excess returns, is uncorrelated with stocks and bonds, and has delivered crisis alpha in both economic stress and inflationary stress. Advisors find it the easiest alternative to underwrite, and it has a long track record and is well known.

“managed futures has this history empirically of generating positive excess returns, being uncorrelated from stocks and bonds. It's historically delivered crisis alpha in both periods of significant economic stress as well as inflationary stress.”at 43:38

Adam Butler · ReSolve Asset Management Global

Trend-following has been a strong, if not fully reliable, equity diversifier in long bear markets.

Trend managed futures has live returns going back decades, so the record is not purely theoretical. Its rule of buying recent winners and shorting recent losers is intuitive for advisors and investors. It gives access to markets that are hard to reach cheaply otherwise, including oil, currencies, gasoline, silver and obscure international markets. In the 2000-02 and 2008 bear markets, which lasted more than a quarter or two, trend strategies had time to adapt and posted strong positive returns. In many investors' portfolios that was the only thing delivering positive returns in those periods. He notes this is not guaranteed, but the design is built to adapt.

“historically has act as a really strong, if not 100% reliable diversifier to equities during crisis periods, and especially during the really intense bear markets that most investors find most traumatizing.”at 46:32

Adam Butler · ReSolve Asset Management Global

Inflation can push stocks and bonds down together, as in 2022, so stock-bond ballast can fail.

Bonds are usually held to hedge deflation and growth slowdowns, when falling yields lift bond prices and stocks fall on weaker earnings. Inflation breaks that pattern. Higher inflation pushes up bond yields and discount rates, so bond prices fall. Investors may also shift from stocks to higher-yielding bonds, which pressures equities. Stock earnings should in theory keep up with inflation, but in the 1970s stocks did not keep pace with inflation. The 1970s are the only high-inflation precedent, since modern data has few episodes above 5% to 6%, and 2022 is still fresh in investors' minds. So there is reason to be cautious that stocks and bonds can both suffer under a higher-inflation regime, which is why advisers are looking for diversifiers that can hold up in that setting.

“when stocks and bonds get antsy, they sometimes get antsy for the same reason. They're both concerned about inflation.”at 15:07

Adam Butler · ReSolve Asset Management Global

Wars and fiscal strain may trigger inflation; outcome range widens over five to ten years.

He argues that AI's effects are impossible to see beyond the next year or two, and that the political environment is fractious. Potentially escalating wars may trigger major inflationary consequences, and many developed countries, including the US, have a more precarious fiscal position. Together these widen the cone of possible outcomes over the next five to ten years more than at past periods. That case favors spreading bets across more strategies, and he likes managed futures because it can adapt if a major regime change occurs in almost any direction.

“We have fractious political environment. We've got potentially escalating wars that may trigger major inflationary consequences.”at 52:39

Corey Hoffstein · Newfound Research

Stacking more credit on a stock-bond portfolio adds equity-correlated risk, not real diversification.

When building diversifying return streams, Corey argues investors should avoid adding more stocks, bonds or credit. Credit risk is so highly correlated with equity risk that adding it might earn small extra returns, but the portfolio would pay for that in coincident drawdowns when credit and equities fall together. The better approach is to look for return streams that are economically or structurally different from stocks and bonds.

“Frankly, don't probably wanna stack more credit as an example because credit risk is so highly correlated to your equity risk that, yeah, you might eke out some marginal returns, but you're really gonna pay for it in those coincidental drawdowns between credit and equity.”at 24:19

Adam Butler · ReSolve Asset Management Global

Illiquid hedge funds and private credit proved highly correlated to stocks and bonds in 2008 and gated, blocking rebalancing.

Institutions paired liquid futures with illiquid hedge funds, private credit and private equity, often borrowing to buy them. When 2008 hit, the liquid holdings fell, and institutions needed collateral. They wanted to sell the liquid assets that had held up better, but the illiquid funds could only be redeemed monthly, and many gated. Those funds had been described as uncorrelated to core stocks and bonds, but in the crisis they turned out to be highly correlated. Because the investor could not raise cash from the hedge funds, it could not rebalance and had to force-sell whatever was liquid. The lesson is that illiquid alternatives can fail to diversify exactly when investors need liquidity.

“while many of those hedge funds said that they were uncorrelated to their core equity and bond allocations. When the crisis hit, we learned that they were actually highly correlated to them.”at 35:31