Why do we invest? How do we protect our wealth and our family’s future amidst an unknown and chaotic world?

For the past decade, we’ve been researching and working on answers to those seemingly simple questions.

The journey for us began in the depths of the 2008 global financial crisis. It was a formative year for a lot of people. While it is one thing to read about a major recession in a textbook, it is another to have lived it. It was the year many retirees or near-retirees had to rethink their futures, families downsized, and plans for the future changed in big ways.

In the wake of 2008, one thing in particular became clear: traditional approaches to diversification were not working. It became clear to us that we had to reimagine the way our financial models view the world in a fundamental way.

We seek to diversify our savings and investments because they are more than just numbers on a screen, they represent the fruits of hard work in the past and the promise of being able to do things in the future, whether that’s providing for children, a sick loved one, or enjoying retirement.

The promise of diversification has always been that to improve your risk-adjusted returns – either by realizing less risk for a similar return or a higher return for the same risk.

Said a bit more straightforward, true diversification seeks to accomplish the two things most investors care about in their portfolios:

  • Having a lot of assets in the future: That is, maximizing the long-term compounding, or expected terminal wealth of a portfolio.
  • Having enough assets in the interim: That is, making sure that if we need to use our assets for a family emergency, illness or other unexpected life event (dare I say a global pandemic?) in the near term, that it will be there when we need it.

However, 2008 and subsequent events suggested to us that the commonly touted forms of diversification were not as effective as advertised.

In 2008, a seemingly “diversified” portfolio of U.S. stocks, international stocks, real estate, commodities, hedge funds, and corporate bonds turned out not to be so diversified.

Source: Why Alternatives

Our search for better answers led us to studying many portfolios and asset allocation strategies.

The one that stuck out was the work of a little known financial advisor from the 1970s, Mr Harry Browne.

From his Franklin, TN office, Browne had a key insight about portfolio construction and effective diversification.

He saw that there were four possible macroeconomic environments: Growth, Recession, Inflation, and Deflation.

Any period of recorded economic history in any country in the world can be fit into one or a combination of these four environments.

While many investors believe they have diversified portfolios, the reality for nearly all investors is that almost everything in their portfolio is designed to do well in only two of these quadrants.

The most common portfolio construction is a stock and bond focused approach such as the 60% stock /40% bond portfolio. However, stock and bond focused portfolios only do well in two of the four quadrants. Stocks tend to do well in periods of growth and bonds tend to do well in periods of growth with low inflation or deflation. The stock/bond focused portfolio is like a sports team that is all offense.

It can go through periods such as 1980-1999 or 2010-2019 where it puts up a lot of points. However, when the offense has a couple of off days, the championship hopes go out the window.

Most investors alive today, particularly U.S. focused investors, have invested overwhelmingly in periods where stocks and bonds performed exceedingly well and so there is a strong bias towards those offensive assets.

We have a different philosophy, inspired by Browne’s work: Offense wins games, but defense wins championships. Offense can work great in the short term for a single game, but you need defense to win in the long run. In the same way, a portfolio requires both offensive assets like stocks and bonds, but also defensive assets.

Browne’s historical perspective from the 1970s and early 1980s was very different. Adjusting for inflation, the S&P peaked at 810 in November, 1968, fell 63% to 300 by 1982. The S&P didn’t return to its inflation-adjusted 1968 level for 25 years, until 1993.1 Bonds did poorly too over the 1970s which had repeated bouts of high inflation.

He saw the need for offensive and defensive assets and looked at the tools he had available to be able to build a portfolio that could handle all four environments.

It included the traditional offensive assets:

  • 25% in Stocks which do well in Growth
  • 25% in Bonds which do well in Deflation

But, it also included equal allocations to defensive assets:

  • 25% in Cash which does well in a Recession
  • 25% in Gold which does well in Inflation

By directly addressing all four possible macro-economic environments, Browne made a large improvement to the traditional 60% stock/40% bond portfolio, calling his alternative the Permanent Portfolio. Permanent, because it is designed to last forever – handling each of the market environments no matter if they show up 10 years from now or 100. It does not require predicting future macroeconomic environments, but is prepared for whatever may come.

Proponents of the approach like to say that the Permanent Portfolio has produced “stock like returns with bond like risk” and this is a roughly accurate statement.

In a study from Resolve Asset Management2utilizing daily long-term data from 1970 to 2012 for each of the four asset classes (stocks, bonds, cash and gold), the permanent portfolio had an annual growth rate of 8.55% with a maximum drawdown of about 18%. And, the research showed, 93% of rolling 12-month periods delivering positive nominal returns.

Though the Permanent Portfolio had slightly lower returns than an all-stock portfolio (8.55% vs. 9.61%), this portfolio had substantially lower risk than a stock focused portfolio. The maximum drawdown was reduced by 66% (the worst daily drawdown was -18% for the Permanent Portfolio vs. -53% for stocks). This period includes 1980-1999 which was the best two-decade run for stocks in the last century!3

Browne’s Permanent Portfolio approach was a step in the right direction towards our objective of maximizing long-term wealth while letting us be confident that ourselves and our families will have the financial resources to deal with what life throws at us.

This is what we would expect true diversification to look like: over a 40 year period which included periods of growth, recession, inflation, and some deflation, the Permanent Portfolio chugged along providing solid returns with much more manageable levels of risk.

As the chart below shows, it has a fairly “smooth” curve compared to any single asset, helping to better achieve the dual goals of both maximizing long-term wealth while having the smoothest possible path.

Stability Through Volatility

The key lesson from the Permanent Portfolio is that by taking assets which do well in each of the core macro environments and rebalancing between them, you can create stability through volatility.

In our opinion, investors tend to focus too specifically on the risk characteristics of a single investment, as opposed to the overall portfolio. The Permanent Portfolio includes a couple assets that can be pretty volatile: stocks and gold, but shows that the combination of volatile, but uncorrelated assets can be a stable portfolio.

Source: Rowland, Craig; Lawson, J. M.. The Permanent Portfolio (p. 64). Wiley. Kindle Edition.

In the research, you can see that as the world has moved through various economic cycles and stock market and bond market shocks, different asset classes took their turn in delivering returns. The gains were rebalanced and transferred to another (more out of favour) asset or assets that will be fully primed and ready to support the portfolio for when it’s time for that asset to shine. Since it covers each of the four macro-environments, something is almost always working, and the profits are harvested and redistributed.

Browne’s approach showed the world that to be truly diversified, investors need something that reacts positively to defensive environments including recessions and risk events like 2008 and periods of sustained inflation like the 1970s.

At Mutiny Funds, we started experimenting with different permanent portfolio approaches in the wake of 2008 and looking for ways in which we could build upon Browne’s approach using modern tools that had not been available when Browne came up with his system in the 1970s.

The Dragon Portfolio and Other Similar Approaches

A number of other practitioners have utilized a similar four quadrant model: Ray Dalio of Bridgewater and his all weather portfolio is probably the most popular example. Meb Faber’s Trinity Portfolio included more diversification within each of the buckets and incorporated factors such as momentum and value.

Most recently and similarly to the Cockroach, Artemis Capital developed the Dragon Portfolio. The Dragon Portfolio is based on historical research stretching back to the 1920s that sought to identify the most effective portfolio not just over the last few decades, but the long run of history.

A Modern Permanent Portfolio: The Cockroach

Building on these approaches, Mutiny Funds saw three key areas where we felt Browne’s approach could be improved and set out to build our own approach, the Cockroach portfolio.

The biggest hole we saw in the traditional Permanent Portfolio was a sharp sell-off leading into a recession. At the time he created his portfolio, using cash to help dampen the losses in other parts of the portfolio was the best option Browne had.

However, with the advent and increasing accessibility of volatility trading strategies in the 2010s, we came to believe that utilizing a long volatility strategy instead of just cash could better offset losses elsewhere in the portfolio, improving the risk-adjusted returns.

Holding cash dampens the drawdowns in the rest of the portfolio, but long volatility strategies seek to not just dampen but overcome it so that the drawdown is much lower and gains can be rebalanced into the other buckets at the opportune moment.

The challenge for us and our families was that these strategies were not readily accessible to non-institutional investors. In 2018, we set out to solve that problem. We identified and spoke with dozens of long volatility managers and figured out a structure that would allow us to invest in a diversified ensemble of long volatility managers.

As we spoke with more and more people, we realized that we were not the only people looking to solve this problem and decided to launch our long volatility strategy to the investing public in 2020.

The second hole we saw in Browne’s approach was the strong reliance on gold for protection against inflation or an extended depression. Volatility strategies can do well in the first leg down in markets where you have a sharp sell off and volatility spikes. But, they don’t tend to do as well in an extended recession.

In general, we feel that gold is an excellent hedge against hyperinflation but doesn’t always do well with bouts of high, but not runaway inflation (say 5-15% annually). While gold performed exceedingly well in the 1970s inflationary environment, its longer history is more checkered. We saw that incorporating trend strategies on commodity, stock and bond markets would help to cover these possibilities.

By focusing on a broad basket of commodities instead of just gold, commodity trend strategies can capture inflation wherever it shows up. By utilizing trend strategies on financials such as stocks and bonds, they can do well in an extended recession or bear market.

Finally, and most importantly, we believed that investors would benefit from layered diversification. Diversification across the four macro quadrants is a good starting point, but even better is diversification within each of those quadrants.

By including global stocks, global bonds, four different volatility strategies and three different trend approaches, The Cockroach approach diversifies within each of the quadrants, further “robustifying” the portfolio.

Ultimately, we believe this should result in better risk-adjusted returns and our ultimate goal of both compounding capital so we have lots of assets in the future while reducing drawdowns in the interim.

We set out to find the best balance between two goals:

  • Having a lot of assets in the future: maximizing the long-term compounding, or expected terminal wealth of our portfolios.
  • Having enough assets in the interim: making sure that if we need to use our assets for a family emergency, illness or other unexpected life event (dare I say global pandemic?) in the near term, that it will be there when we need it.

Having spent over a decade thinking about and working on this problem, we believe that the Cockroach approach is the best way to achieve this.

Traditional portfolio diversification is overwhelmingly focused on offensive assets: stocks, bonds, REITs, private equity, and venture capital.

While these all have their role in a portfolio, to effectively compound wealth over the long run while minimizing drawdowns, these offensive assets must be paired with defensive assets such as long volatility, tail risk, trend, and gold.

We map different return drivers for these assets to each of Browne’s four macro environments.

  • Stocks do well in Growth – Equities benefit from increasing growth environments. When GDP is increasing, corporate profits tend to increase as well which seems to be the long-term driver of equity prices (though there can be plenty of fluctuations in the short to medium term).
  • Income does well in Deflation – While stocks can struggle in deflationary periods because of the increased debt service, the bond holders which are providing that debt benefit. While bonds are the most common and easily accessible return driver for a deflationary environment, other assets which provide a yield such as Real Estate and carry trades would also serve the same function. If you own a rental property which is paying 4% yield and you have deflation, then the real yield increases similarly to bonds.
  • Volatility does well in Decline – the asset class which seems most fundamentally linked to a decline is volatility. A put option on the S&P is guaranteed to pay out if the S&P declines below the strike price before expiry whereas there is no guarantee that traditional safe-haven assets like government bonds will fare well in the case of an equity market sell-off. There is a cost to just holding put options which is why they are a piece of a larger strategy. We believe holding long volatility as part of a broader portfolio should improve the portfolio’s risk-adjusted returns.
  • Trend does well in Inflation – commodities are a fundamental return driver. In the same way that a put option on the S&P is fundamentally linked to a decline in stock prices, commodities are fundamentally linked to increases in inflation since inflation is measured against a basket of commodities. That’s not to say an inflationary environment will just affect commodity prices, currencies, interest rates, and stock markets are likely to move as well. We include exposure to all of them (going both long and short) as part of our trend bucket. The Trend bucket then should help augment our volatility bucket in the case of a prolonged recession while leading the charge in a sustained period of high inflation.

Towards the Cockroach

We began working on this portfolio in 2018, originally under the name Ataraxia, a greek word meaning “calmness untroubled by mental or emotional disquiet.” (We gave up on the name when no one could spell it and few could pronounce it, though we never gave up on the sentiment.) Our goal has always been to construct a portfolio where we could hold our savings without constantly worrying about the next crash – while still compounding capital efficiently.

We launched our Long Volatility Strategy in April of 2020 because we felt it was an important component of a well-diversified portfolio that could effectively compound wealth, and, from our own experience, it was very difficult for non-institutional investors to access active long volatility managers.

However, our core belief has always been that long volatility is only a part of a broader portfolio. We launched our Long Volatility and Stocks Strategy in July 2020 to offer a more balanced and diversified approach that included both long volatility and stocks in a single product.

The Cockroach Strategy was the next step in building a truly diversified and robust portfolio that incorporates income strategies as well as commodity exposure.

Cockroaches aren’t cuddly, but they do two things well that we also want out of our portfolios: they’re really hard to kill and they compound fast.

The Cockroach Strategy is intended to be a total portfolio solution that includes long volatility as well as stocks, income producing assets, commodities, gold and bitcoin with the ultimate goal of making an investment strategy that produces ataraxia.

Though stock and bond focused portfolios have performed well over the past four decades, investors using that approach are betting on the greatest bull market in history repeating itself again with minimal volatility or inflation. While this is certainly possible, we do not feel it is prudent and certainly doesn’t qualify as a well-diversified portfolio.

Though there are no guarantees in investing, our research suggest that the cockroach portfolio has historically provided better returns with less drawdowns than other approaches and we believe that it is likely to do so going forward.

For the investor, this means it has provided and seeks to continue provide strong compounded growth so investors have the assets they want to fund their retirement, take care of their families, or to use in whatever ways that they feel are important; and, lower drawdowns meaning that investors can feel more confident that if something pops up along the way, that they can afford to deal with it.

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  1. Source: https://www.macrotrends.net/2324/sp-500-historical-chart-data
  2. https://www.gestaltu.com/2012/08/permanent-portfolio-shakedown-part-ii.html/
  3. Note that this study was an academic exercise and not representative of actual trading