We are excited to introduce a new addition to our suite of investment strategies – The Defense Strategy.
It combines Mutiny Fund’s Volatility Strategy and Commodity Trend Strategy. 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).
In combining these two exposures, the Defense Strategy seeks to achieve flat to slightly positive returns during positive periods for stock and bond portfolios while providing its most significant returns in periods of equity market drawdowns or high inflation.
The Defense Strategy is part of the holistic Cockroach Strategy and is intended as a diversifier to be combined with offensive assets in an investor’s portfolio such as stocks, bonds, and private equity.
In this episode, Jason Buck (Mutiny CIO) and Taylor Pearson (Mutiny CEO) talk through how and why we developed the Defense Strategy and the role we believe it can serve in investors’ portfolios.
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Have comments about the show, or ideas for things you’d like Taylor and Jason to discuss in future episodes? We’d love to hear from you at firstname.lastname@example.org.
Transcript Episode 55:
Hello and welcome. This is the Mutiny Investing Podcast. This podcast features long-form conversations on topics related to investing, markets, risk, volatility, and complex systems.
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All right. So we have a unique podcast today. This is Jason Buck, the CIO at Mutiny Funds, and I’m sitting here with my co-founder, Taylor Pearson, the CEO at Mutiny Funds. And we would like to talk a little bit about our new Defense Strategy, why we thought it was a good idea to launch the Defense Strategy, what’s entailed in the Defense Strategy, and how it can be useful for everybody out there. So Taylor, let’s just start with why defense? And I think the most interesting way to start is always through stories. And one of your favorite stories that I think that we originally found Taleb, where maybe it comes from previous to that, is how you can drown in a river that’s two feet deep.
Yeah, this is a Talebism, right? So the idea is you have a river that is two feet deep on average, but if it’s very flat and shallow along the sides, and it has a deep channel, you can still drown in it, right? So 95% of the river is one foot deep, and 5% of the river is a 20-foot deep, fast moving channel, right? So you can wade in through the sides and it’s fine, but you step in the middle, and it’s dangerous. So I guess it’s a more relatable analogy, but sort of the investing analog is the average returns over time saying, “Oh, over this 30-year period, this asset returned 8%, 10%, or whatever isn’t necessarily useful to the individual, right, because it depends on the order in which those returns come.”
So the Dow Jones Industrial Average from 1966 to 1997 returned about 715%, roughly 8% per year. But the order of those returns was very skewed. So up until about 1982, ’66 to ’82, the returns were roughly flat. There are basically no returns. The returns from 1982 to 1997 were something like 15, 16% a year, right? So over that 30-year period, you had an 8% average annual return, give or take. But the order of those returns was very different, and that matters.
So an example that the folks over at ReSolve Asset Management use that we really like is you take a couple that’s retiring, say they’re 63 years old, they’ve saved $3 million in their retirement account, the order in which those returns come is very consequential. If they get the bad return period first, they get that period of flat returns from ’66 to ’82, and they’re spending their five, 6% a year or whatever it is, they can draw down to zero. If they get the period of good returns first, the 1982, 1990, ’97 period, their 3 million appreciates considerably to, I think I want to say 10 million even as they’re drawing it down and then they can live to 120 and still have plenty of money.
So from the individual’s perspective, it’s not very helpful to say “This has 8% returns on average,” and this is equally applicable to the 35-year-old that if you go through a period… And it’s interesting, we ran this internally just because I was curious, but if you have a period of very strong returns relatively early in your career, say twenties, thirties, forties, and then a period of very flat returns later, it’s a lot more challenging than the inverse, right?
So when your income is relatively low and your saving’s relatively low, you have very good returns. But then as your saving start to accumulate, you go through this period of a challenging returns. So doing the same sort of Dow Jones example. You take a 31-year-old, if they get the period of strong returns first, so they start with a $100,000, they’re adding $1,000 per month into their retirement account, they finish with about $1 million. If you get the inverse, right, you get the flat period first, you’re able to accumulate some savings and then it starts to compound. You get the strong returns later, you finish with $3 million, right? So the average return over that period is 8%, but the ending point for both of those investors is very different, right? Retiring with $1 million versus retiring with $3 million, yeah, there’s a huge difference in like what then implies lifestyle-wise.
And I think you’ve even brought up like, you have three or 4% rule rights, the difference between 30 to 40,000 or 120 to 150,000 a year. And we all know that can be very different lifestyles. It really matters at that specific amounts. Like that’s a pretty large delta for what you cost rent, food-wise, everything too. That’s quite a dramatic difference.
One of the other unique peccadillos that I usually like to harp on is like how we really don’t know that we’re just in kind of the first innings or the first iteration of this experiment with like 401(k)s and target date funds and everything. And because we like to harp on this fancy word like ergodicity or what you’re really talking about is sequencing risk or timing risk, is that we are not the average. Everybody looks at a stock market chart and goes, “It’s up into the right,” but they’re not looking in those underwater periods.
So as you were referencing, is like if you have one of those underwater periods in stocks or 60/40 portfolios during your peak earning years or in your retirement years, when you have to take those forced distributions, those can be unbelievably negative to your compounding rate and to your lifestyle changes. And so I don’t think people really think about that too much. And that’s one of the things we try to primarily focus on. And one of those things is obviously 60/40 is what everybody’s accustomed to are these target date funds that are now creeping up into like that 70/30 range these days. But why 60/40 has worked for 40 years, why can’t it work for the next 40 years? What do we know?
Yeah, I think our friend Cory Hochstein likes rebalance timing luck. This is like birth timing luck as well, right? It’s like you’re working really hard, but it’s when you’re born can matter a lot. And where you’re born can matter a lot.
To the point about 60/40, I think has very strong returns sort of in most people’s investing lifetimes sort of post 1980 period, people have probably heard these examples. But you go back further, you look at other markets and that’s not always the case. In real terms, 60/40 was down 45% from peak and was basically flat from 1968 to 1987, right? So roughly 21 years looking at S&P index and 10-year government bonds.
So I think it’s interesting. Like obviously, the GFC was very painful for many people, the .com crash, COVID, but we haven’t really, in most people’s lifetimes, had something that prolonged, right? I think in real terms, the S&P recovered to its all time highs in 2013 or something from the bottom in 29, right? It was relatively short-lived compared to historical drawdowns, but it’s not unprecedented that you have these 10, 15, 20 year periods where basically things go nowhere. And then obviously, you start to look at global markets outside the US. There’s the super dramatic examples, Russian Civil War, China World War II, but then even the UK in the early 1900s had almost a 50% drawdown in sort of a classic 60/40. And so these things aren’t totally unprecedented.
Yeah, I was listening to an interview with Howard Marks the other day and he was saying what money manager really came into the game in the 1970s? He’s like, “None.” Like besides him and like a few others, like nobody has that experience anymore. And even me, I’m pushing into that deep into middle age here, and I graduated high school in the late ’90s, you know? So we haven’t had the experience of like what a… that I almost can’t even imagine what it’s like to go through multi-decade periods of being underwater, or getting nothing out of your investment returns.
And so that could be incredibly frustrating, incredibly new experience for a lot of people. And I think I talk about Jason Zweig said it best, is like, “I could show you a picture of snake or I could throw a snake in your lap,” right? And those lived experiences are much harder to deal with than we realize. And that’s what I was saying about looking at 100-year chart of the S&P and you’re like, “Oh, it’s up into the right.” But then when you get that granularity of those drawdowns and then what’s that lived experience like, it’s always much more difficult than we realize.
So we’re talking about 60/40s, really just two asset classes, stocks and bonds. We’d like to call those offensive asset classes, but let’s try to broaden our scope, our horizon a little bit. We always love Permanent Portfolio. More modern versions are all weather, Dragons, Cockroaches, awesome portfolios, those sorts of things. But let’s go back to why do we think the Permanent Portfolio is cool? If you want to give a recap on Harry Browne?
Yeah, I think people that are listening may know we’re big fans of Harry Browne, but he was a financial advisor in the ’70s and ’80s, maybe started in the ’60s and obviously had a very different perspective. There’s all these newspaper articles from the late ’70s, early ’80s calling bonds certificates of confiscation, right? And of course the post sort of 1980 experience is they were this magical thing with extremely low volatility that had fantastic returns.
But Harry lived through that period of stocks and bonds and that led him to develop what he called the Permanent Portfolio, which is simple and elegant. It is equal parts stocks, bonds, gold and cash. And I think the main lesson we sort of drew from that is this idea, as you said, of offense and defense. So you have your stocks and bonds, your offensive, that’s slated for this sort of deflationary growth environment that we’ve been in for a lot of the last 30 years. But then you also have your defensive assets that are more prepared for sort of a recessionary or inflationary period, like what Harry was living through, and that he called it the Permanent Portfolio because by rebalancing between these different aspects, you were trying to have something that was always helping do well.
You had gold performing very well in the 1970s inflation, cash to help offset some of those drawdowns in stocks and recessions. And also, I mean, cash T-bills were one of the better performing assets of the 1970s, right? The real rates were slightly positive. So as you have stocks and bonds going down, cash actually wasn’t a bad thing to be holding.
And so we took that impetus from the Harry Browne’s Permanent Portfolio. We were like, what if Harry was alive these days? What changes could he potentially make? And so if you have stocks for growth and bonds for a disinflation or a deflationary environment, maybe instead of cash for a recession or liquidity event, we think it’s much better to maybe use long volatility and tail risk so you have much more like a convex-like cash position to really offset that stock exposure. And then instead of gold like Harry Browne had, and obviously coming off the gold standard was a unique time for gold in the 1970s and we’ll maybe touch on that in a little bit later. But we feel like commodity trend following where you have the broad exposure to commodity markets, or the trend following overlay seems to give a much higher beta historically. Whether that happens in the future or not remains to be seen to an inflationary environment, which that position helps offset hopefully the bonds a little bit better than just gold would.
It gives you a much more different strategies and overlays and different commodity markets to attenuate for that sort of environment. So that’s like the modern version of the way we view Harry Browne’s Permanent Portfolio, and kind of putting those all together in a unique way like we’ve done with our Cockroach Strategy. But let’s dive into on the defensive side, like we said, we look at it, the world, as just offense and defense. Sometimes, it’s called short volatility versus long volatility.
On the offensive side, we look at stocks and bonds, they’re very offensive assets, right? When GDPs up into the right, when liquidity is awash, when credit is abundant, those sorts of things tend to do well. But we also, along with stocks and bonds, we also tend to pair in there in the offensive assets. We view PE, VC, real estate, all those things are still offensive assets or long liquidity.
That’s what we consider our offense. On the defensive side of the portfolio that we look to kind of offset those linear, offensive assets, we try to find convex instruments that we used in long volatility, tail risk and commodity trend following. And we view those are the defensive side of the portfolio, and this is why we think it’s going to be interesting to launch a product that really combines those defensive assets for our clients. So let’s kind of break down the defensive side of the portfolio and talk about commodity trend following first. Why trend following? Why is trend following interesting to us?
You and I think we sort of connected initially when we started working on Mutiny over long volatility, and you introduced me to trend following. And I guess compared to crystal veterans, I’m more naive to it. I think it’s interesting we were talking before we hit record, why isn’t trend following more popular? Because there’s so many things that are interesting about it. I think one thing, as you said, that is I think doesn’t get as much discussion as it deserves is just using gold as sort of an inflation hedge. Worked very well in the 1970s. You had the US come off the gold standard, I want to say it was like a 2400% gain for gold or something around 1970s. You had this sort of period of price discovery and this huge run-up.
But sort of the research we’ve looked at over the longer history is it’s gold’s reliability and sort of mild to moderate inflation, call it mid-single into 10 something percent inflationary periods where you’re not having runaway hyperinflation, but you’re having really significant periods of inflation that’s impacting your performance. Hasn’t been as great, right? So I think the first obvious place is like, “Well, what if we did a basket of commodities instead of just gold?” And there’s a number of people that do that approach. The data we’ve seen seems to say that does seem to do better. A basket of commodities in inflationary periods, there’s, we’re looking at one paper, something like 14%. In certain periods, they categorized 14% returns in periods they categorize as high inflation. So that’s very nice. The challenges in sort of commodities and growth also do tend to go together, right, when you have these periods of strong growth and people are building stuff, they need to build stuff with commodities, right? They need lumber and steel and all this kind of stuff.
So the sort of taking a trend following approach to commodities is really interesting because when you have these inflationary shocks, because the trend followers are basically buying what goes up and selling what goes down, they can be long the commodities as they’re going up, as you have these big growth shocks. But then also short the commodities in these deflationary periods like 2008 or much further back, the 1930s.
So the idea of trend following and particularly trend following sort of our implementation of it is more focused on commodities than I think a lot of other trend following approaches are these days, is trying to capture those inflationary moves in commodity markets to help protect against inflationary periods, but then also to offer some of that deflationary sort of prolonged recession risk that you can see in sort of a 2008 or again like a 1930 situation.
Yeah. The interesting part why, like you brought up, why isn’t it more popular? The way I always think about it is that I think in finance or investing, people usually come up one of two ways. Most people come up like reading Buffett and value investing and that’s usually where their entree is into this whole entire world. And then I think there’s a bunch of weirdos like me that their first books were like the Market Wizards.
And so you come up with trend following. And like those are again the two different worlds, and they’re almost like diametrically opposed to each other, right? Like I think a lot of people, we intuitively understand value investing, right? I want to buy cigar butts, I want to buy things for pennies on the dollar. If we go to a flea market, we’re all going to understand that’s what we’re trying to do. And then you flip that around and say, “When a commodity, like when weed is breaking out higher, I want to buy high and sell even higher.”
And you’re like, “Wait, value investment taught me to buy low, sell high. And so it’s counterintuitive.” And then vice versa, like you were saying, is you can also short these markets relatively easy compared to the stock market or individual equities is you want to sell low and buy even lower. And so you’re just following these trends.
But what’s always interesting to me is then they’re agnostic to their fundamental views or their macro views of the world. Hopefully, they’ll stay out of their investment strategies. So for example, in late 2020 when you had oil go negative, this is why I love trend following, they were following that trend even lower. Everybody else in the world is saying “Oil can’t go negative, it’s going to bounce zero off zero and everything.” Trend followers just followed that down to like -30, -$40 at one point during the day there, and I think it was September of 2020.
And so it’s always fascinating to me how hard it is sometimes for people to wrap their heads around trend following. But I think like as you and I have talked over the years, I think we’re much more philosophically aligned with trend followers, right? Having lots of bets. You could trade 60 to 80 commodity markets depending on liquidity issues or the size of your fund. And that’s not even getting into the alternatives or synthetic forms of commodity markets and trend following.
You can also trade the financials, the FX. All of these sorts of different things you can do with commodity trend following. And you’re agnostic necessarily to the directions of markets, right? You’re just following those trends up or down and you’re trading a multitude of markets and you’re waiting for trends to break out, and it creates this unique uncorrelated kind of like absolute returns type strategy that’s very complimentary to portfolios.
But like you’re saying, it hasn’t been more popular even though every time somebody shows a back test for adding trend following to a portfolio, it usually suggests anywhere from like 30 to 60% should be the portfolio size for trend following, and yet nobody will ever do it. And very few people hold more than like five to 10% of trend following, if they hold any at all.
So it’s one of those things like, why isn’t it more popular? I still have no idea, but this is kind of the world we live in. But I think it’s been interesting, a lot of our private conversations of like how once you start learning more and more about it, you start really coming around to the philosophy and ideas. And I think it makes a lot of sense for people like us. And I think part of the other part is it’s we come up understanding stocks and bonds and 60/40 portfolios and hitting those buy buttons where there’s a little bit of learning curve I think with the futures industry, and you start… We’re all usually typically taught to be afraid of leverage, but it’s much more capital-efficient in the futures market, where you only have to put up a small margin or a performance bond to get exposure to larger contract sizes.
And I think that’s scary for people too, right, and thinking that market to market on a daily basis and seeing how your P&L moves around. So that can prohibit some people from doing it. But as I’ve been studying these commodity trend followers forever, one of the things you start to notice about the space and in these strategies is there’s a huge dispersion of returns kind of across different managers. And what we find is that dispersion is really based on time cycles. Once again, getting back to Cory Hochstein, rebalancing timing luck, the way we think about building a trend following ensemble of managers and strategies is on the lookback periods, short, medium, long-term lookbacks. That’s also given their trading styles. They have fast, medium, slow kind of trading styles.
And what that does is that starts to harness kind of the dispersion between returns you see in the space, you know? Like if you have a sharp liquidity event like a March 2020, sometimes those short-term managers can catch it. Medium-term might get whipsawed and the long-term managers might not be in it at all, just depends on what side of the trend they’re on. And then if you have a 2008 or a 2022 event, they’re much more slow and protracted. Maybe the medium to longer term is going to do better and the short term won’t do as well. They might get whipsawed a lot.
So that’s kind of the downside to trend following strategies, is you can get whipsawed as you look for those breakouts, so those trends to happen and they mean-revert. So that’s the trade-offs you have.
Now I think within one of the studies we’re going to show on this white paper that we’ll have links to in the show notes, is that historically if you look at trending across all assets, most people tend to jump into that. Why wouldn’t I just use it on all asset classes? Well, as I said, it’s an uncorrelated strategy. So for it to be uncorrelated, you want to actually pair it with things like buy and hold equities or buy and hold bonds, because that’s going to give you that differentiation or that diversification you’re actually looking for, instead of doing trend following across the entire portfolio.
So I think it’s an interesting diversification you get from that uncorrelated trade that you get out of the commodity trend following. Is there anything else you want to add to that before we move on to long volatility and tail risk?
Yeah, I think that covered all the main points. I’ve been calling this Herschel Walker Syndrome. There was this sort of famous trade actually circa 1990 Herschel Walker was playing for the Cowboys and the Vikings wanted him. They thought this was the final piece they needed for the Super Bowl. And I think it’s called like the Great Highway Robbery. It’s got some great nickname in sort of sports lore. And basically the Vikings just gave up the farm to get Herschel Walker, they gave up all these great draft picks, and sort of all that laid the foundation for the Cowboys sort of dominant early to mid 1990s, three Super Bowl runs.
Those teams were sort of the product of that trade. And I think it’s this line item myopia, “We have to have Herschel Walker, we like this one thing.” And I think trend is sort of the opposite of that in many ways, right? It’s as you said, what’s the most interesting it’s not its standalone performance, it’s how it can be additive to a broader portfolio. And it gives, like you said, what’s interesting about trend as having some more commodities in there is it might actually make it worse on a standalone basis, right, if you just look at it in that way. But if you’re looking at it from a broader portfolio where you have bonds and you want some sort of inflationary hedge, inflationary protection in there, having more commodities in there is important. And I think that is just counterintuitive on some level.
And then the way I put it more colloquially is every time I… As you know I live in Northern California. Every time we see those gas prices just going up and up and up over the years, my girlfriend looks at me and then we go, “That’s why we have trend following in our commodity trend following.” The returns hopefully paired in an inflation environment helps. So for me at least, I always think about it helps offset hopefully the cost of the gas prices rising at the pump. So it’s nice to have something in your portfolio that’s zigging with others or zagging so that way, you can hopefully time well or be a part or participate in the rising cost of your commodities that you have to put into like your gas tank or food or however we look at it.
So let’s move on to the next one. And that is our long volatility and tail risk. Like we said, Harry Browne used cash for that bucket. We tend to long volatility and tail risk. Why do we like using those maybe instead of cash like the Permanent Portfolio did?
So the way I sort of understand the role of cash in the Permanent Portfolio was it was this sort of recessionary protection, right, that if you have a liquidity event, keep giving a Cory Hochstein here, a liquidity cascade, whatever you want to call it, where you have this off across markets. And I think like March 2020, I remember I went to the Finviz dashboard one day and it shows like all the sort of daily price movements, and it’s just all dark red. The whole dashboard, commodities, all the major bond indices, stock indices, everything’s just red, right? And you had this rush for cash that everyone had to have cash and they were selling whatever they could in their portfolio.
And so that was the role of cash in the Permanent Portfolio. When you had those sort of liquidity events, all the correlations go to one. You had something to help rebalance that in March 2020 if you were sitting on a significant cash position, that was a pretty nice place to be in, that you could redeploy that into things that had sold off pretty substantially.
So the logic behind a long volatility and tail risk component is the same, right? Instead of just trying to sort of have something that is staying flat in those periods, you’re hoping to have something that’s sort of providing its most substantial gains from that period. So you’re able to rebalance even more aggressively, right? That you have profits from that long volatility and tail risk and you’re able to use those to purchase stocks, bonds, some of the other offensive assets that are in that sell-off period.
So again, the defensive strategy here in general, like trend following, as a standalone, it doesn’t necessarily make much sense. Putting their whole portfolio in a long volatility and tail risk investment strategy would not be prudent and I don’t think that makes sense. But using it again as part of a sort of complimenting these offensive assets is really interesting. And then do you want to talk a little bit about our sort of particular approach to long volatility and tail risk? How do you think about constructing a long volatility portfolio?
Sure. And part of that, this whole goes back to our discussions in 2018 when we were looking at forming our business and what we really wanted to do for ourselves and eventually for clients, is we talked about you have stocks and bonds and all these other offensive asset classes, and then what I brought up before is that trend following is uncorrelated. So they pair well together, but then you can get that structural negative correlation that you can get from tail risk and long volatility.
And I remember in 2018, we’d have these long discussions about you could have stocks and bonds trending higher, so therefore trend following managers may not have a lot of trends in commodities and then they’re riding this trend of stocks and bonds higher. And then you could have a liquidity cascade, TM Cory Hochstein, and then what would you do in that scenario where none of your strategies would potentially work out?
And we used to talk about that prior to March 2020. And that’s exactly what happened in March 2020. Like you said, everybody’s throwing out the baby with the bathwater. And that’s why Harry Browne wanted cash. And we prefer to have that Comvax-like instruments with tail risk and long volatility so that way, we can buy maybe some of those offensive assets at that lower NAB point.
So the way we think about constructing our long volatility ensemble, once again, we think about everything in ensembles because there’s a lot of path dependencies to these strategies. And more importantly, both in the long volatility and in the commodity trend advisor side is these are very niche type strategies because these are typically built for institutional investors. And the way institutional investors work, is they like to construct their own portfolios. So they like very narrow niche type managers that do very specific things.
It’s quite different than I think we typically think about constructing portfolio at the retail level. But we like that because what it allows us to do is find all these niche managers trading very specific strategies and put them together into ensembles. And so in our long volatility book, we’re buying options that classical tail risk that’s very much like car insurance or house insurance, where you have a little bit of that insurance premium, then your deductible and then you get that payout to cover your risks.
That’s what classical tail risk is the best analogy for it. So we like classical tail risk. The problem is just like most insurance is you’re paying that premium bleed every year. And a lot of people, they don’t mind it on their house, car or life insurance or health insurance, but they tend to mind it on their portfolio insurance.
So the way we thought about that is let’s pair that tail risk options with what we call long volatility managers or long optionality. And these are managers that trade opportunistically those options on both the puts and calls side. And what they’re trying to do is maybe lower the cost of that insurance premium over time, but really capture that move when it does happen. So the analogy we always use is a forest fire, right? They’re looking for winds. Winds start to pick up. What’s the humidity levels? What’s been the dryness or drought conditions in that environment? Is this a particular forest that’s susceptible to lightning strikes?
All of those things kind of add up to then opportunistically buy that insurance instead of having that permanent tail risk kind of always rolling and always paying that premium. So we combine kind of those two long optionality strategies, but like we said, once again, you have that premium cost of it.
So we look to cover that premium cost a little bit with what we call our relative value volatility managers. And those managers are trading a lot of spread trades on both the VIX, the S&P, and other potential option markets. And the idea there is if with a stereotypical pairs trade, is you’re trying to offset those pairs to give you a little bit of income. And so as long as you’re trading those fairly market neutral and you may buy the tails as extra protection, we view that those kind of implicitly mean-reversion type strategies should hopefully provide a little bit of income that helps offset that premium bleed that we’re getting on that long optionality side.
The other thing that we’d like to layer in there is after that March 2020 scenario, if you go to roll those options forward, the implied volatility in those options can be higher. It just means they’re more expensive. The premium has gone up, because we have a recency bias of the most recent event. And so we use like intraday trend following that can short those market indices around the world using futures, where they don’t have to pay up for the implied volatility. It’s just a directional kind of bet.
And so by having kind of those three to four different markets and multiple strategies within each, we’re up to 14 managers or 14 and actually more strategies than just the 14 because a lot of our managers have even sub strategies inside of there, is we’re trying to build out that ensemble approach to capture all those path dependencies to a sell off. And so we think about the paths of moneyness from at the money, to out of the money, to deep out of the money, and we try to overlay and overlay those paths with our optionality as well.
But the general idea is we’re trying to keep the carry over the longer term, carry the cost of that premium insurance as low as we can, as close to zero as possible over the long term, but still trying to capture those major selloffs that they happen every one to five, 10 years, that sort of thing. And the idea is we try to think about anything less than a -10% drawdown is kind of a noise to us. It would cost too much to cover that. We look to start really seeing that convexity start to kick into like that -20% drawdown in the S&P markets.
So that’s the kind of the way we think about kind of building out that long volatility piece. So we have our long volatility ensemble, our commodity trend ensemble. And so with this new Defense Strategy, what we really want to do is we want to pair those together.
Now why do we want to pair those together? Hopefully, it’s becoming clear that that long volatility and tail risk tends to do really well in these liquidity crunches or these liquidity crises, like when we brought up March 2020 where all your other strategies in your portfolio, like Taylor said, can be thrown out baby with the bathwater. Like even March 2020, people are selling off gold and crypto. They did not want to sell them. They really did not want to sell them, but everybody had to go to cash.
And so these are what happens in those liquidity crunches or those liquidity cascades, and that’s what long volatility and tail risk is great about. And once again, it’s that convexity that you can get from optionality that we really like that has those kind of exponential returns that you can’t get elsewhere. And then what happens in a more protracted recession or a inflationary environment, like 2008 or 2022, those are when you’re going to have your commodity trend followers. Hopefully they have a higher beta to those types of environment and are hopefully going to do well in those environments.
So if we’re trying to think about your defense is like where does all your offensive assets get hurt? They get hurt in liquidity cascades, protracted recessions, inflationary environments. And so if we can pair those two strategies together, we’re hoping to cover more of those paths for our clients. And so that’s the idea around kind of pairing those together and offering that in a package deal. And then by offering that package, hopefully we’re increasing the diversification and… I’m sorry, increasing the diversification, increasing that ensemble exposure, which we hope helps bring a more positive carry or a better carry with a maybe reduced volatility and reduced drawdown over time and then still trying to maintain that pop you would get when you really need that defense to jump out from behind the curtain and really help you. I’m sure I said some things in there you might want to correct or expand on. So go ahead, please.
No, that was great. I think the other just practical thing, sort of the core of our investment philosophy and how we think about things is sort of this idea of the Cockroach, which is our sort of modern version of the Permanent Portfolio. So that same four quadrant model just looking at, we call it fractal diversification. How can we diversify even within each of these buckets? So you talked about within trend following, looking across those different timing, or short versus long-term trends. And I think it’s easy to look at, oh, trend following, quote unquote, “Does well in this or doesn’t do well in this.” But once you’ve been following these managers for a long time as you have, you see this big dispersion, right, that you can have short-term trend followers doing very well and longer term trend followers struggling and vice versa. And so putting those all in an ensemble really makes a lot of sense, right, for trying to capture sort of wherever those trends are showing up.
And again, the same true at the Cockroach level. I think one of the things we’ve learned is just you have to meet people where they’re at to some extent. And there’s also a factor outside of just your investment strategy. There’s whatever your tax situation is. There’s if you own a bunch of real estate that’s illiquid, right?
And so we found that there are a lot of people that maybe are in the position of, “Well, I would like to add some more defense to my portfolio, but I have all these offensive assets that either, “A, maybe there’s some tax reasons I don’t want to get rid of them. Maybe they’re illiquid. Maybe I really like them. I think I’m a real estate investor, I’m a private equity investor, in a VC, whatever, and I think I can do some things here that’s better than just sort of a stock/bond index or 60/40 portfolio. How can I sort of combine defense into my portfolio?”
So that was the genesis we started talking about, “Okay, can we find some way to structure something?” Unless people say, “All right, I want to manage for whatever reason, more of the offensive stuff, but I do think I need to combine some defense with that and what’s a way to do that?”
No, the other thing you’re touching on there that will have more information in the white paper and more information on as we put out more on this strategy is the idea is we really love the futures and options spaces because we’re able to implement a lot of capital efficiency. And so by combining these kind of strategies together in a very capital efficient way, it allows our clients to get access to like these defensive strategies in a way that really works for them, that they can pair with their offensive strategies, especially if they’re like you said, in more illiquid real estate or private equity or venture capital.
This is why we love this space, because it allows us to build capital efficient portfolios for ourselves and our clients that are much more useful than traditional style of investing that can have like kind of like a dead cash problem where you’re not getting the best usage of your capital when you’re pairing these kind of strategies together.
So the other question would be that we started touching on the beginning, but there’s other ways to look at is like why now? Why should people add defense to their portfolio now? Like if I look at a back test, 60/40 has been great and it’s been fairly… stocks and bonds have been fairly negatively correlated till recently. Like why now? Why is defense interesting?
Well, I think to some extent, we would answer that question and be like, “Well, you should do it anytime, right? Like it’s not that now’s particularly good or particularly bad necessarily,” but I do think 2022 was a bit of a wake-up call for some people, maybe not as much as sort of expected, that these periods of stock bond correlation, I think we were looking at this internally a week or so ago, right? Like the five-year moving average of stock bond correlation has turned positive I think in like the last… in 2023 for the first time since pre .com bubble, that that correlation when you’ve had these stock selloffs, 2008, typically you’ve had this rally and bonds. And so that 60/40 portfolio has worked really well.
As we’ve been in an inflationary period to trying to see that, well, that’s not always the case, right? You can have periods where stocks and bonds are very correlating, and I think that’s been challenging people like, “Oh, they de-risk and they went heavier into bonds and less into stocks as they were retiring two years ago or something.” And like that’s been a difficult position to be in, as you’ve seen this bonds really take a major hit and the drawdowns go together.
So I think there’s some awareness sort of the role of defense in the portfolio that maybe wasn’t there as much a couple years ago. And then I think generally in our experience, the inclination is investors’ portfolios are always fully prepared to fight the previous war, right? Is we’ve looked at everything bad that happened over the last 10 years and we’re prepared for all that bad stuff to happen in the future, but generally, the market takes the path of most pain, right? It takes the path that people are least prepared for. And so I think over the last 30 years, these sorts of more defensive strategies have been relatively out of favor. And so now’s an interesting time to start thinking about working them back into a portfolio.
Yeah. And so the things we always look at in portfolios and we try to share with clients and for people to take a look at is like, what can you have in your portfolio that does well during like the .com bust of 2000 to 2002, the great financial crisis of ’08, ’09, or even ’07 if you’re in real estate, the COVID crisis of 2020, the inflationary effects or 2022, whatever we’re going to call 2022 in the future, is what can you have in your portfolio that will hopefully do well during that? And that is why we build things like this defensive strategy that can hopefully do well in whatever that future war is without necessarily attenuating to the past wars.
And so that’s the way we try to think about it. And we can try to show what it could potentially do in a hypothetical scenario like in the past, but also with an eye towards the future of things we can’t imagine. Part of that though is what we’ve been talking about. It’s like we love ensembles, we love diversification. We talked about rebalancing timing luck, but we haven’t necessarily talked about rebalancing specifically. And this is what we think about with our Cockroach Portfolio or with this Defense Strategy or Cockroach Strategy versus our Defense Strategy and other strategies is you have to rebalance these portfolios. So maybe you could talk about that a little bit.
Yeah, I think, again, we’ve talked about, go back to our March 2020 example, the advantage there of having some sort of defensive assets, right, long volatility, cash, whatever that’s performing well is it’s only useful if you’re deploying that at that point, right? You want to use it to buy sort of the things that have sold off rapidly and rebalance. The flip side is equally true, which is I think the famous story was, I believe CalPERS basically had a tail risk manager they were using for five or six years, and they gave up on that manager in January of 2020 because they said, “Oh, this is a waste. We just lose 3% a year or whatever on our tail risk position. Let’s let it go,” right?
They stopped rebalancing the tail risk position, and then you had the massive sell off in March and they were unprepared. So the defensive strategies really only make sense if you’re going to be rebalancing them with the rest of your portfolio, which means both taking money out of them when they’ve done exceptionally good over the last period, and also putting money back in. So whether that’s monthly, quarterly, yearly, a lot of people use rebalancing bands. They say, “I want to keep this between 20 and 30% and I’ll rebalance the portfolio at that point.” There’s a bunch of different approaches, but some sort of rebalancing is basically a prerequisite for this to make any sense.
The other part of our industry when we’re going back to why isn’t trend following more popular, I think that’s part of it is unfortunately the finance or investing industry talks about stocks and bonds and then everything else falls into this bucket of alts. Like we even go to at the end of January, we go down to South Florida for Alternative Hedge Fund Week. But like what does alts mean to you? Like does that have any meaning to you? How do you think about when people say alts, or alternatives?
We were talking about this before we turned on the podcast. I think everyone has, whatever you’re an expert in, right? Like you see all the nuance and you see all the details and you hear other people that aren’t involved in the details talk about this at a very high level. That just makes no sense. But then you see it happen somewhere else and you’re like, “It’s that kind of thing.” So I think like alternatives or like hedge funds, “Oh, hedge funds did good or hedge funds did bad,” I think is a weird thing from our perspective to say, because the difference between a value-oriented long/short equity hedge fund and a trend follower are completely different things, right? It doesn’t make any sense to talk… It’s like the food is good, the food is bad, and there’s 250 things on the menu. Like what’s good? What’s bad? Like they’re all totally different things.
It’s hard to talk about it in those broad terms. Yeah, I think that’s one of the… We like these terms offense and defense, because a lot of what falls under alternatives, we would consider alternative forms of offense, which can be great, right? Real estate, private equity, venture capital, angel investing, private credit, all this kind of stuff that are sort of considered alternatives, those things can be great and they can have an important role in the portfolio. But in terms of looking at how they fit in overall, we think of them as those are offensive things that you still want to offset by defense. So rather than using sort of stocks, bonds, alts nomenclature, I think it’s more useful to talk about offense and defense and then how you get exposure to each of those things. You can be strategic within that context.
Yeah, I think a lot of times, the Alternative Hedge Fund Week, I’m using quotes, is that like private credit and those sorts of things that are in there. And like you just said, stocks, bonds, and alts, it makes me laugh because the way we think about it a lot of times, they’re good diversifiers and they can have different liquidity premiums, but at the end of the day, they’re still offense. And most of them are highly levered equity or debt. And so they would still be in the same bucket. So calling those things alts that are just leveraged versions or high-powered versions of equity or debt are still in the same offensive bucket or category that we look at. So it usually throws us off a little bit.
And then I was telling you, there’s a great story just recently that David Rubenstein did a interview with Howard Marks and they were talking about in the last kind of year or two, some of Howard Marks’ letters. And at the end, David asked one of his usual questions, “What do you do at a cocktail party if somebody comes up to you and says, ‘Hey, I have 100 grand. How should I invest it? Should I invest it in your funds?’ That sort of a thing.” And he said, “That’s like coming up to a doctor and asking, ‘Hey, do you have any good drugs?'”
And so he’s like, “Well, what’s your malady? What is your family history? What are you trying to accomplish?” There’s a lot more questions to be involved there than just the category of drugs or alts is another one that we always like hate when people similarly hate on like hedge funds. Like hedge funds can be anything. That’s like saying, “I hate LLCs.” Like it can be any kind of business in that LLC. So it’s just an interesting category. When we try to simplify things too much, we lose a lot of context and nuance that are very important. Then the last thing kind of want to touch on or talked about is before the fall, after the fall. So I’ll let you kind of riff on that.
Yeah. No, I thought of this, we were talking about… My background was running small businesses and working with small business owners. I know a lot of people in that space and there’s sort of a… what the famous Mike Tyson quote like, “Everyone’s got a plan until you get punched in the face” kind of thing. And so I think there’s people that have been punched in the face and there’s people that haven’t been punched in the face. There’s some lucky people that haven’t been punched in the face, but have seen other people that got punched in the face and go, “That doesn’t look very fun. I’d like to not get punched in the face.”
But I think in practice, this sort of defensive approach is probably going to appeal to the people that have been punched in the face or seen someone else get punched in the face and are thinking, “Well, getting punched in the face isn’t so nice, right? When things are going good and everything’s great, maybe it isn’t so good, but I’d really like to not get punched in the face too much over the course of my lifetime.”
And so I think just from the investors we’ve talked to and sort of psychologically, I think there’s a bit of that mindset of have you been through a situation where things have been rough and things have gone bad? And I think there’s also, we can talk… Again, we talked a bunch about the, even if you’re not in that scenario, you’re the relatively young investor and you’re just trying to reduce that path risk or that timing risk that maybe goes… I think there’s a lot of other uses for defense, but I think you do have to wrap your head around that to some extent, right, that this is something that can happen. There is path risk, and it may not happen, I don’t know. But being prepared for that scenario is sort of the prudent thing to do.
Yeah, I was envisioning cartoons versions of you and I being like punch-drunk boxers and like Mike Tyson’s punch out. That was great, with the Tweety birds around their heads or something. But like you said, we talk about this all the time, we build portfolios exactly for what we want it, right? And because we realized we want to ride the good times like everybody else, but we realize bad stuff does happen, right? And so we’re just kind of agnostic about it, but we prepare for it.
And just like everybody, we think that a lot of people take a lot of concentrated risks to get wealthy and then to stay wealthy, you’re going to need that diversification. But it also applies to like the young person investing. You want that diversification to reduce the variance of your path. That way, you can compound more efficiently and effectively over time.
And just betting on one asset class like stocks has a lot of variance to it. And like we pointed out, you can go through multi-decade periods of being underwater. So we try to diversify and kind of pair up offense and defense. So no matter what, that was the idea of Harry Browne, that you can muddle along in kind of whatever global macro environment we’re in. And all you really want is your savings to kind of like outpace inflation over time and be there when you need it most. And that’s the way we think about constructing portfolios.
We’ll put links in the show notes of about the audio and video, where you can find out more information about the Defense Strategy that we’ll be launching in the near future here. Also, you’ll be able to find it on our new and improved website. It’s quite beautiful, I must say myself. Taylor and everybody else has done an amazing job on it. But you can find that at mutinyfund.com. Taylor, anything else at the end?
Good talking to you. We’ll do it again, hopefully not too distant in the future.
All right. Thanks everybody.
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If you’d like more information about Mutiny Fund, you can go to mutinyfund.com. For any thoughts on how we can improve the show or questions about anything we’ve talked about here on the podcast today, drop us a message via email. I’m email@example.com. And Jason is firstname.lastname@example.org, or you can reach us on Twitter. I’m @TaylorPearsonMe and Jason is @JasonMutiny. To hear about new episodes or get our monthly newsletter with reading recommendations, sign up at mutinyfund.com/newsletter.