Cockroach Strategy

Many approaches to diversification, such as the 60/40 stock/bond approach, rely on historical statistical correlations. We believe that historical correlations can be informative, they should not be solely relied upon as they are often subject to change as the economy moves through different regimes.

Instead of starting with historical correlations, we start with the four quadrant model of different macroeconomic regimes: growth, decline, inflation and deflation. All periods of financial history can be categorized as one, or a combination, of these four regimes.

For each of those quadrants, we sought to identify asset classes and investment strategies with return drivers that we feel will benefit from each of these macroeconomic regimes.

A return driver is the primary underlying condition that drives the price of a market. As opposed to using shorter term historical correlations, return drivers seek to identify fundamental relationships between an asset or strategy and the different macroeconomic environments.

The four return drivers we believe will do well in these different environments are:

• Stocks tend to do well in Growth
• Income Strategies tend to do well in Deflation
• Volatility strategies tend to do well in Decline
• Trend Strategies tend to do well in Inflation

We view each of these strategies as having one core environment where it should do the best, but also able to “overlap” and augment the other strategies. For instance, income strategies can do well in growth environments as can trend strategies. Volatility can do well in an inflationary environment and Trend can do well in Decline.

This seeks to provide more robustness and resilience to the overall portfolio and maximize the chance number of periods in which the overall return is positive which should increase the long-term returns.

We call this approach fractal diversification. Diversification across the four macro quadrants is a good starting point, but even better is diversification within each of those quadrants.

By including not just US markets, but global stocks and global bonds, different income strategies, three different volatility strategies and three different trend approaches, the Cockroach Strategy diversifies within each of the quadrants, seeking to further reduce the risk and increase the returns of the portfolio.

Ultimately, we believe this approach will help investors improve their risk-adjusted returns, both more efficiently compound their while better mitigating drawdowns in the interim.

Stocks

We see stocks as fundamentally correlated to economic growth. When GDP is increasing, corporate profits tend to increase as well which is the long-term driver of equity prices (though there can be plenty of fluctuations in the short to medium term).

Within the equities strategy, the Cockroach Strategy intends to have 60% allocated to a broad basket of US stock index futures (S&P 500, Nasdaq, and Russell 2000) and 40% to International stock index futures (developed and emerging markets) to achieve broad diversification across equity markets.

Specifically, the stock sub-strategy includes:

• U.S. Stock Market Exposures include S&P 500, Nasdaq, and Russell 2000
• Developed Market Exposures include: MSCI EAFE (Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the UK)
• Emerging Markets Exposures include: MSCI Emerging Markets (Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Pakistan, Peru, Philippines, Poland, Qatar, Russia, Saudi Arabia, South Africa, Taiwan, Thailand, Turkey, and the United Arab Emirates)

Income

The Income sub-strategy is designed to replicate the consistent source of income historically provided by bond investments and consequently perform well in a deflationary environment.

Where stocks can struggle in deflationary periods (or periods of declining inflation known as disinflation) because of the increased debt service, the bond holders which are providing that debt can benefit.

While bonds are the most common and easily accessible return driver for a deflationary environment, we believe that other assets which provide a yield such as carry trades also serve the same core function of providing income to the portfolio while offering diversification benefits beyond just bonds.

The Cockroach Strategy has a diversified income strategy that includes exposure to:

• US Treasury Bond Futures – A blend of US Treasury Note and Bond Futures ranging from 2 years to 30 years. The bonds are position sized in such a way that each has a target duration of 15 years, allowing for diversification across the yield curve.
• Global Bond Futures – A blend of German, UK, Canadian, Japanese and Australian Bonds sized in such a way that each has a target duration of 15 years.
• An Ensemble of Carry Strategies – The ReSolve Ensemble Carry strategy we are using seeks to harness carry returns from over 70 global futures markets across equity indices, bonds, currencies and commodities. The strategy seeks to maximize long exposure to assets with positive carry and maximize short exposure to markets with negative carry, while minimizing the overall risk of the portfolio. Learn more about Carry Strategies here.

Trend

The Commodity Trend sub-strategy seeks to do well in prolonged declines in equity markets, as well as Inflationary environments due to their substantial exposure to commodity markets. We believe that commodities are the most fundamental return driver linked to inflation, since inflation is (typically) measured against a basket of commodities or products made using commodities.

That’s not to say an inflationary environment will just affect commodity prices. Currencies, interest rates, and stock markets would likely move as well. The Trend sub-strategy includes exposure to all of them (going both long and short) as part of our Trend bucket.

We believe the Trend bucket should help augment our volatility bucket in the case of a prolonged recession while leading the charge in a sustained period of high inflation.

We believe that this makes it superior to buy and hold commodities approaches as it is able to benefit from both rising and falling commodity markets as well as trends in other markets.

We include managers with short-term, medium-term, and longer-term look back periods (ranging from a few days to many months) trading across 100+ futures markets. We believe this maximizes our chance of capturing the bulk of a sustained trend move.

For more detailed information on the managers and strategies we employ, please see our Commodity Trend Strategy DDQ.

Long Volatility

Volatility is known to expand, sometimes dramatically, in both sharp and extended stock market declines. Volatility then is the return driver which appears most fundamentally linked to such declines.

We do not believe that the most common equity hedge, U.S. government bonds, will necessarily do well if stock prices decline sharply. Rather, our research indicates that this is a historical correlation which has come and gone over history. We see no such structural reason that traditional safe haven assets like government bonds will fare well whereas a put option on the S&P, for example, will pay out if the S&P declines past its strike price.

There is a cost to buying such put options, of course, which is why they are a piece of a larger strategy.

To achieve its long volatility exposure, The Cockroach Strategy will invest into the same sub-managers as those used in Mutiny Funds’ Volatility Strategy.

It is intended as an efficient vehicle for investors seeking diversification, long volatility exposure, and tail risk protection, and combines four types of long volatility strategies across a basket of managers.

This ensemble approach is designed to have minimal carry costs in good years for the market, while maximizing the certainty of providing large, convex returns in volatile market crashes (e.g. 2001-2003, 2008-2011, Q1 2020).

For more detailed information on the managers and strategies used, please see our Volatility Strategy.

Gold and Crypto Assets

Since the four core strategies (stocks, volatility, trend, and income) are predominantly denominated in U.S. dollars, we include gold as a hedge against fiat risk from a prolonged period of high inflation.

Additionally, gold provides another uncorrelated return stream which, when rebalanced with the rest of the portfolio, should improve the risk-adjusted returns during “normal” periods with low to moderate levels of inflation.

Many of the same fiat protection logic exists for owning crypto currencies such as Bitcoin and Ethereum. In addition, crypto assets such as Bitcoin are historically uncorrelated to traditional asset classes and offer the potential for asymmetric risk/return profiles. The Strategy will seek limited Bitcoin exposure via CME Group Bitcoin and Ethereum futures contracts. In the future, if the regulatory landscape for these assets becomes more clear, we may add other crypto assets, and likely apply our ensemble approach to combine niche active managers implementing different trading strategies across the crypto landscape.

A portion of our gold exposure is held in physical gold, resulting in about 5% of the Cockroach Strategy currently sitting in physical gold bars. The remainder of the exposure is via Futures contracts.

Due to our structure, we are not able to customize the exposures inside of the Cockroach Strategy based on individual investors preferences.

Our Defense Strategy, Volatility Strategy, and Commodity Trend Strategy are available as standalones to give investors the ability to construct their portfolio as they see fit.

The Volatility Strategy is designed to act as a so-called ‘black swan’ investment, achieving asymmetric gains in times of high volatility or tail risk (e.g. March 2020). The Commodity Trend Strategy is designed to profit during inflationary periods (e.g. 2022) as well as during extended ‘crisis periods’ for stocks and bonds (e.g. 2008).

The Defense Strategy combines Mutiny Fund’s Volatility Strategy and Commodity Trend Strategy. It is intended for investors who wish to add a Defensive component to their own offensive assets such as stocks, bonds, and private equity.

Having said that, our view is that having a truly diversified portfolio means that you will almost always hate at least one thing in the portfolio. It’s not uncommon that the most hated asset will go on to perform the best: in the wake of the 1970s, many investors in the early 1980s didn’t want to include bonds in their portfolios. The media sometimes referred to bonds as “certificates of confiscation” in 1980. Then, the 1980s and 1990s ended up being a huge bull market in bonds.

We take no view on where interest rates or bond prices (or any other asset prices for that matter) will go, but rather focus on diversifying our income sub-strategy (as we do all other strategies) such that we do not feel overly exposed to any single asset or strategy.

In a sense, the Cockroach Strategy is designed to be the “least bad” portfolio rather than the “best” over any short term period. It is designed to have some asset which performs well in any macroeconomic environment, seeking to minimize drawdowns and maximize risk-adjusted returns without needing to predict macroeconomic regime changes. It is our belief that the key to being the best in the long run is more about trying to make sure you are never the worst over any short period.

The Cockroach Strategy will rebalance between its sub-strategies on a monthly basis.

We believe the main limiter to the scale and strategy capacity will be the capacity of the volatility strategy. We believe capacity constraints wouldn’t be experienced until around $1-2 Billion in assets under management in the Cockroach Strategy.

Of course, the question of how much you should invest is unique to your situation and nothing we say here is a substitute for speaking with a financial advisor or the use of your own judgment. Having said that, we can offer a few ways of how we personally think about it.

We personally view the Cockroach Strategy as a core liquid portfolio that can be effectively paired with illiquid alternatives such as Real Estate, Venture, or Private Equity.

For instance, an investor with a 50%/50% split between liquid/illiquid assets could allocate 50% of their assets to the Cockroach Strategy or similar total portfolio approaches and then use the remaining portion to diversify into illiquid alternatives and rebalance as those investments became liquid.

Investors that wanted to retain some of their liquid assets at another custodian could also do that and utilize whatever liquid strategy they deemed appropriate there.

One barbell-like approach would be to allocate 50% to the Cockroach Strategy of the Cockroach Fund, 25% to a diversified portfolio of liquid assets at a custodian (e.g. Schwab, Fidelity, TD Ameritrade) and 25% into illiquid alternatives such as Real Estate, Venture Capital, or Private Equity.

Of course, this is our personal view and investors should carefully consider the risks and use their own good judgment to make whatever allocation they deem appropriate.

There are a number of other products with philosophically similar approaches to our Cockroach Strategy using a variety of structures. In particular, some investors prefer ETF structures for their simplicity and ability to hold them in existing brokerage accounts.

We have done a substantial amount of research on ETFs and other structures. Our research has indicated to us that the limitations which are inherent in an ETF substantially reduce the risk-adjusted performance of the strategy.

In particular, ETFs restrict the use of active managers. It is not possible, to our knowledge, to include active managers in an ETF structure. About half the Cockroach portfolio relies on actively managed long volatility and trend strategies.

As a result, substitutions or alternate approaches need to be taken for half of the portfolio. Our research and belief suggests that this significantly impairs the effectiveness and performance of the strategy. We believe that a structure which allows the use of active managers is ultimately better for investors. Additionally, because we primarily utilize commodity futures, we are able to be more capital efficient.

Though we are all about making it as easy as possible for investors and will continue to look at different vehicles, ultimately our goal is to build the most effective product and we believe our current structure best facilitates that.

We have also done a lot of work to streamline our onboarding and redemption process and generally find that it takes most investors about 20-30 minutes to go through the onboarding and 5 minutes to redeem.

The portfolio will have a target nominal exposure of 220%. This means that for a $100k investment that the investor will get $220k of nominal exposure to the different return drivers.

Approximate weightings exposure across the strategies in this example would be:

• $50k Stocks
• $50k Income
• $50k Volatility
• $50k Trend
• $15k Gold
• $5k Crypto Assets

How is the exposure greater than 100%?

We overlay the exposures on top of each other via the built in leverage of commodity futures,^*1
which results in our exposure being roughly ~2.2x the assets of the strategy. We offer this level of exposure for two reasons.

For one, we believe that the use of modest leverage such as this across a well-diversified portfolio such as the Cockroach Total Portfolio Strategy is a better way to achieve return targets – as contrasted with taking more risks in an unlevered portfolio.

The whole idea of a well diversified portfolio is to achieve better risk adjusted returns which means either

1. Provide the same return with lower risk, or
2. Provide higher returns with the same risk.

If your diversification results in both lower return and lower risk, we believe the prudent approach is to add a modest amount of leverage to increase the return while remaining well within acceptable risk limits.^*2

We believe this level of exposure will mostly “keep up” with more traditional portfolios (such as the 60% stock/40% bond portfolio) in good markets and significantly outperform these traditional portfolios in bear markets.

Consider a period where stocks and bonds are performing well but where the volatility and trend buckets are flat. In this scenario, the portfolio would perform roughly as well as a stock/bond only portfolio, while still carrying protection against a recession or inflationary period.

Further, there are cost savings to this approach for the investor. As the Fund’s fees are based on the cash invested, not the nominal exposure amount. That means that for the $225,000 of exposure gained through a $100,000 investment, the 1% annual management fee is just $1,000 instead of $2,250. This allows for investors to pay less fees in order to get the same level of exposure.

In sum, our research indicates that for a portfolio that is as highly diversified as the Cockroach strategy, this use of leverage keeps our risk within acceptable limits while allowing a more capital efficient and fee efficient solution for our investors.

^{*1 Because the bulk of the assets in the strategy are done using the futures markets, we just have to post margin to control the positions. What this looks like in practice is generally needing to post around 5% to 20% of the nominal size of the exposure as a “performance bond” in the account to put on and maintain those positions.}

^{So, for example, you could get $1 million worth of futures exposure with just $200,000 in the account. Because of this natural leverage built into futures markets and the cash efficiency it affords – there is sufficient capital to put on exposures greater than the cash amount invested.}

^{If you are unfamiliar with how futures contracts work, we recommend this presentation from Dr. Kathryn Kaminski beginning at 4:10 as a short introduction.}

^{*2 See AQR’s explanation of leverage used in their risk parity strategy here for a more robust explanation of this logic.}

Hypothetical performance for the Cockroach strategy going back to 1990 is available in our presentation for QEP investors.^*3 The data sources and methodologies used are listed in the disclaimer at the end of the presentation. Generally speaking the results use actual sub-advisor returns from 2006-onwards, and index performance (such as Barclay Aggregate Bond Index) prior to that for each asset class.

We did NOT include bitcoin or other crypto assets in the results as we did not feel that its historical performance was realistic on a walk-forward basis. Instead gold is substituted for the bitcoin allocation in the backtest.

We chose to extend the back test to 1990 because we felt it was a long enough time period to show the robustness of the portfolio but generally a period where acceptable data sources are available.

For instance, options did not exist until the 1970s and so the estimated returns of an option strategy prior to that time involves hypothetically calculating what option prices would have been, had they been tradable. Similar challenges exist for our carry strategy, as well as parts of the trend strategy. We view that any backtest using hypothetical data (including our own) should be viewed as a useful toy model or “intuition pump” for thinking about portfolio construction rather than a reliable estimate of performance going forward.

The broad conclusion that we draw from our research and others is that investors are likely to improve their risk-adjusted returns from diversifying their portfolios from a more typical stock/bond focused portfolio to include substantial allocations to commodity and volatility strategies. We do not feel we nor anyone else has the ability to draw much more specific conclusions than that, nor do we believe that we are able to forecast returns or risk metrics.

^{3* These presentations are intended only for investors that qualify as “QEP.” If you aren’t sure if you qualify as QEP, you can see what that means here. Please note that the investment itself is available to all accredited investors. The QEP requirement is only required to view the hypothetical composite performance of our sub-advisors prior to Mutiny’s launch. Any accredited investor may invest.}

The Cockroach Strategy is designed to be the best liquid portfolio we can construct. It seeks to perform well in any macroeconomic environment. However, many investors benchmark performance to equities and we expect there will be periods where the Cockroach Strategy substantially lags equity performance and will outright lose money.

In the interest of helping set clear expectations, we’ve identified a few environments where we would expect Cockroach to struggle on both an absolute and relative basis.

Irrational Exuberance

A period of exuberance in equity markets with volatility, trend, gold and commodities all experiencing overlapping drawdown/flat periods is likely to result in underperformance of the Cockroach strategy relative to equities.

For example, the period from January 1999 to October 2000 where equities rose rapidly into the height of the dotcom boom would likely result in significant equity outperformance while we would expect the Cockroach strategy to be roughly flat or even slightly down.

In our view, these periods tend to set the stage and something will eventually have to give. To use the dotcom boom as an example, we would still expect the Cockroach portfolio to do well on a longer term horizon (say 5 years from January 1999 through 2004), while equities would have declined following the bust.

Though we believe that the Cockroach strategy will outperform over the long run, we fully expect that there will be multi-quarter if not multi-year periods of underperformance relative to certain common benchmarks such as the S&P or a 60/40 portfolio such as this one.

Mild Sell Offs

Another environment where we would expect the Cockroach strategy to struggle is a mild to moderate sell off across offensive assets. In general, the volatility component of the strategy is not intended to perform well in a move of less than -10% down in equity markets and not really accelerate until a -20% down move.

This means that it is very possible that you could see a -10% move in equities accompanied by similar drawdowns in bonds with the commodity and volatility strategies flat or even negative resulting in a meaningful drawdown for the Cockroach strategy.

One such historical example would be February 1994 to March 1995. In that instance, a surprise interest rate hike from the Federal Reserve sent stocks, bonds, gold, and volatility heading down. We anticipate that the trend portion could help in that type of environment but likely wouldn’t do enough to buoy the rest of the portfolio.

The Cockroach strategy is intended as a longer term investment and we expect that it would ultimately recover and do well over the subsequent five years. In our view, the assets we are using are fundamentally uncorrelated so eventually something will have to give and one will perform well.

Ultimately, we feel that the only lesson we can take from these scenarios is that even uncorrelated strategies such as the ones we use will sometimes go through periods where they become correlated and the portfolio suffers. This is to be expected and we fully expect such periods of underperformance and losses to occur in the future.

Though it is impossible to forecast, our expectation would be that these periods should be fairly short-lived compared to less diversified portfolios such as the more common 60/40 stock/bond portfolio.