Portfolio Air Cover: The Case for True Diversifiers

Kristian Kerr [0:14] Welcome to the LPL Research Market Signals podcast. I'm your host, Kristian Kerr, and this week I'm very excited to have Mark Raskopf join us on the show. Mark is a senior research analyst and portfolio manager at Russell Investments on the hedge fund team. And in this role, he heads their coverage of tactical trading strategies like discretionary and quantitative macro, managed futures, commodities, and quantitative equity. Mark's been with Russell since 2011 and has over 25 years experience in research and alternatives portfolio management and is just one of the smartest people I know in the hedge fund space. Mark, how are you? Welcome to Market Signals.

Mark Raskopf [0:49] Thanks, Kristian. Appreciate that. Very kind of you to say. Great to be here. Happy to have a conversation.

Kristian Kerr [0:54] Yeah, thanks for being here. You know, I have been looking forward to having you on. You know, I think you and I have kind of very similar views on asset allocation, particularly when it comes to the role of hedge fund diversifying strategy and portfolios and how they're frankly probably being underutilized in most portfolios. So, you know, to kick things off, let's start off with why we're even having this conversation today.

You know, for decades, investors have been taught that bonds are really the only shock absorber that you really need in a portfolio. Is that no longer the case? And if so, what has changed in your view?

Mark Raskopf [1:29] Great question. Well, I think if you take a step back, what I try to do is go down to the foundation. Sort of the job anyone managing money is trying to get right, which is to compound wealth when stuff goes up, but also do all you can to help your clients maintain purchasing power when risk assets are under pressure. And getting that right is all about good asset allocation. And I think the reason we're having this conversation today is really what happened in 22.

I think when both bonds and stocks sold off, that was a pretty painful wake-up call for everybody that bonds won't really kick in all the time when risk assets sell off. So if inflation rises and interest rates move higher, you know, bonds and stocks can lose at the same time. And you know, that really introduces this question about using active strategies, hedge funds, other things to sort of fill that gap in portfolios.

Kristian Kerr [2:26] I completely agree. I mean, let's pull this thread a little bit more. You know, kind of we see this dynamic where, you know, there's a higher correlation between stocks and bonds, particularly in the kind of the post 2020 environment. You know, why does that matter so much from a portfolio construction standpoint? Like, you know, I guess I'm getting at what happens when the assets that, you know, an investor's using to rely on for diversification starts moving in the same direction as, as you say, you know, the assets in the portfolio that are meant to compound, grow wealth. Like when they both start moving together, that has some connotations. Can you just walk the listeners a little bit, you know, why that's so important and why we need to kind of find things that help address that potential issue?

Mark Raskopf [3:10] Yeah, absolutely. Yeah, it's obviously not a good thing when everything moves in the same direction. But, you know, bonds have done such a great job for so long, you know, really decades. You haven't had to worry about them. Literally, anytime growth slowed, you know, stocks would struggle, the Fed would come in and cut rates, and bonds were your shock absorber. And that really made the 60/40 portfolio feel kind of self-evident.

You know, so for a long time in a regime of low inflation, you know, inflation, bonds just worked really well as your main or only diversifier. You know, but in hindsight, I think this major event going back even before 22 was early in the COVID shock, I think when the 10-year hit roughly, you know, half a percent yield of, you know, literally 0.5 on the 10-year.

Mark Raskopf [4:01] That was probably the right time to literally start rethinking the role of bonds in a portfolio as your primary shock absorber, you know, since at 0.5, the downside's clearly like greater than the upside. But I remember that period pretty well. It's pretty obviously scary for everybody. I think that's why most people ignored the math. But, you know, walking forward from then to ignore the math can be a mistake. And sort of in hindsight here for the past five years, the U.S. Agg has underperformed inflation by about 3%. I think that's what we're talking about.

So maybe we can talk just about inflation in more detail for a second since it's been a big factor. I wouldn't personally be at all surprised to see more inflation volatility going forward for a bunch of reasons, including, you know, this obvious ongoing deglobalization.

Mark Raskopf [4:54] Maybe, you know, if we have these higher diesel prices persist for a year or two, I mean, looking at the futures curve, December 27 crude has already rallied a lot. You know, that can be a signal that the energy component of the economy will continue to push up consumer prices. And looking over sort of more academic stuff, research going back decades, and a lot of people have replicated this work, the evidence is really that around two and a half to 3% inflation is sort of this threshold above which, you know, and obviously the trajectory of rates has a big impact too, but above that threshold, interest rates often pressure bonds and stocks at the same time, and that's really what made 22 so tough.

So I guess the portfolio construction lesson, in my view, isn't to abandon bonds, but having just one diversifier probably won't cover you for all bad environments for your core assets.

Kristian Kerr [5:46] Yeah. Yeah, exactly. So I, you know, I think that's a great kind of lead in to what gets us in the real meat of this conversation, why, you know, what we're really here to talk about today. And it's, you know, if bonds aren't providing that same level of protection that they once did or that we got so used to, you know, what other tools can you use to build that more resilient all weather portfolio? You know, I got a feeling it's going to be hedge fund strategies, but let's talk about which ones. [laughs]

Mark Raskopf [6:13] Okay. Yeah, I mean, there's lots of alternatives with different sources of return. In the recent past, you know, for better or for worse, it feels to me like the whole world's gotten addicted to private assets for diversification. I see that kind of as a, as hiding from mark-to-market. In my view, the low reported correlation that private assets has shown compared to stocks, I think dramatically overstates how much they diversify the underlying economic risk in a client portfolio. It's a lot of pro-cyclical risk, but I'm going to leave that rabbit hole for someone else to go down.

I also think that real assets are pretty good diversifiers, and particularly, you know, in inflationary regimes. Obviously gold has done well for some time, although it's under pressure right now. And the broader commodities benchmark, like the BCOM has been up, you know, about 10% annually for the past five years, which is really nice, obviously.

Mark Raskopf [7:03] But in our research, two liquid and active alternatives really stood out as potential diversifiers. One is trend following, the other is active long volatility. And, you know, I think a lot of investors are familiar with trend following these days, that it can be long or short equity indices, you know, bonds, currencies, commodities, you know, it doesn't have any bias to being long or short. And your listeners are also probably familiar with the VIX index. It's a measure, you know, technically of what the market expects the S&P 500 volatility to be over the next month. Typically when the VIX spikes, it isn't great for risk assets.

So active long volatility strategies hold, you know, these various option structures that may appreciate as investor fear increases and things like the VIX goes up. So those two I think are really interesting.

Kristian Kerr [7:51] Yeah, no, I, you know, I think that's a really important point you make, by the way, that a lot of people get confused on. And, you know, the industry kind of lumps everything all together and calls anything that's not a stock or a bond an alt or an alternative, right? But, you know, the alternative universe is really more intentional than that in my mind. You know, some strategies are intentionally meant to amplify risk, others are meant to help reduce risk or overall risk in a portfolio. And that's, you know, what we're really talking about today, you know, what I think you and I both like to call kind of alternative diversifiers, and, you know, kind of just these strategies that have an explicit intention of diversifying a portfolio or helping, you know, reduce that overall risk.

So with that in mind, you know, I've heard you use the phrase air cover before when referencing kind of these types of strategies. Can you explain, you know, to the audience what you mean by that and how exactly that applies to a portfolio?

Mark Raskopf [8:43] Yeah, sure. Happy to. I mean, I haven't spent any time in the military and I'm probably not using the term properly, so apologies. Okay. But I believe that air cover describes, you know, aircraft or long-range ordinance that provides effective but not perfect protection for the main ground forces. And basically, I just like the sound of that.

You know, at work you have — you know, I have, I have friends at work that give me air cover, you know, and for portfolios, I'm always looking for strategies that psychologically and structurally help, you know, investors and me stay the course in core positions in some of my more volatile, you know, growth ideas. So if I own a lot of stocks, you know, technology, biotech, energy, or other growth assets, then I want to know my entire portfolio is not dependent on continuous uninterrupted economic support for those investments.

Mark Raskopf [9:39] So to me, to qualify as true air cover, a strategy has to show genuinely different return drivers where the response function is different or potentially more rapid, you know, if the core portfolio comes under steady pressure, even, you know, one of these fast punishing attacks. But I think it's important to acknowledge that air cover isn't a guarantee or even a one for one hedge. It's just, you know, a useful term for potential support to help stay committed to the long-term plan.

Kristian Kerr [10:10] And I think that's a great, that's a great way to describe it. And, yeah, and completely, completely agree there. You know, I do want to make this as practical and as useful as possible for advisors. You kind of touched on it, but can you just walk us through a bit more in detail exactly, you know, what trend following and active long volatility really is? Like, like how do these strategies work, you know, for a 30,000 foot view and how they fit into this idea of, you know, providing the air cover during periods of market stress specifically?

Mark Raskopf [10:42] Yeah. Yeah, there's really two different response speeds here. On the one hand, trend following for a move that builds over time, and on the other hand, active long volatility may react more quickly when markets suddenly reprice. And I'll try to paint a picture first of how trend following works.

I thought about this a lot, and I hope this lands with your listeners, but imagine for a second, you have five interns all watching the same market, and you ask, you know, one intern to count back five days, one counts back 10 days, 20 days, 40 days, 60 days. And so your five interns, then each analyst uses a formula to calculate the slope of the price path that market took over their lookback period. So those five days, 10 days, whatever. If the market these interns are analyzing has been choppy but recently rising, the interns using the most recent lookbacks of say five or 10 days of data, you know, probably have positive slopes, you know, up to the right, while those using the longer lookbacks, 20, 40, 60 days, you know, during that choppy period, probably have a flat slope, maybe even a negative slope.

Mark Raskopf [11:53] So if that's the case, you'd score each slope, you know, the steeper it gets a higher score, add them up, and the fund probably has, in that case, no position, or maybe a small long or short because it's been choppy. But once a story emerges, a stronger story emerges, and the uptrend or downtrend and price continues, then sticking with this analogy for a second, when you do your lookbacks and calculate those slopes, over time, more of those slopes and position signals align, and that combines to create a bigger long or a short in specific markets. And I think that's... I hope that makes sense to people.

A good example, I think, is this, you know, inflation surge we had in 21, 22. We had elevated inflation data in the back of, you know, this COVID response. I remember that. Companies raised prices, the Fed eventually stopped, you know, saying inflation was transitory, you know, finally began hiking rates, you know, bonds weakened, investors, you know, eventually sold out of some equities.

Mark Raskopf [12:48] And the shorter lookback models responded first, so shorting bonds and going long commodities, and a few weeks later, the longer lookback models, you know, kicked in and followed the inflation story as it picked up steam. That's exactly what trend following is designed to capture. Not the first alarming headline, but a market that's gradually changing direction and then building momentum, you know, either up or down. You know, a bad market for trend followers, you know, obviously is when a story emerges, but then it goes away, you know, creating this chop that ends up generating, you know, trading costs without the follow-through from profitable trend.

Should I move on quickly to long vol?

Kristian Kerr [13:26] Well, yeah, I think you can. I mean, I was going to ask, like, you know, like, trend sounds so good, right? So, you know, do you need two strategies in a portfolio if, you know, if over the course of, you know, a full market cycle, I'm just worried about kind of bigger picture drawdowns. Like, tell us why you think you need active long vol in there paired alongside with trend. I think, you know, just that understanding of why you think those two work so well together.

Mark Raskopf [13:52] Yeah, okay. Well, I think first, let me just sort of quickly paint a little picture about what long vol strategies, active long vol is. Yeah. So your listeners kind of, you know, know more of the nuts and bolts, I guess. In practice, you know, these strategies use very modern quant tools. Basically, they look to identify these, you know, almost insurance-like long vol exposure at what the managers believe are reasonable prices, you know? And to cover more bases, you know, and I like to diversify, to be where the action is, these exposures are often taken not just in equities, but in rates and currencies and sometimes in commodities.

And so once you've constructed a portfolio of these long vol structures, then if uncertainty rises or markets move really sharply, these positions may gain value potentially faster, and that's the whole point, than a medium term trend strategy, than trend followers, you know, because options prices can reprice very quickly as investors reassess market risk.

Mark Raskopf [14:56] So March 2020 is a great example of this dynamic, a bad market being, you know, I guess just generally calm markets, you know, that don't experience big moves because there's a cost to owning these kinds of structures, regardless of whether profit opportunities materialize. So I guess, you know, why combine them?

So we combine them in our institutional portfolios because they offer very different sources of diversification. Yeah. The trend following for new themes that lead to sustained market moves, you know, an active vol for when an investor, you know, demands, you know, protection. One is for a slow-moving regime change, and the other is for a fast shock, you know? One looks at historical data, you know, this whole thing we talked about, about, you know, this lookback and those interns, you know, counting back five days, the historical data, and the other uses options that are really forward-looking pricing, you know, and I think together, they offer a much broader range of potential responses.

Mark Raskopf [15:55] I think that either trend or active long vol can stand on their own. Yeah,

Kristian Kerr [15:59] I think that's exactly it, right? You're trying to cover, you know, as many potential scenarios as you can. And listen, March 2020 COVID was very, very different than the GFC, right? And, you know, one, you know, these strategies can perform very differently, you know, depending on what's causing the shaking of the tree in the market. So I think that's one reason why you want to have these is you're kind of, you're kind of increasing your chances of having kind of that protection that you kind of need in these portfolios, right?

All right, so, you know, I do know that you guys are launching a mutual fund next year that combines these strategies in a single solution. You know, the concept seems intuitive to me.

Kristian Kerr [16:48] You know, so my question is why hasn't someone built a product like this before? And before you answer, you know, I think our listeners would love to hear you first read, as they are, you know, the most popular part of the show. And we are talking about a specific product, so go ahead with that and then, yeah, you know, tell us more about the mutual fund.

Mark Raskopf [17:08] I appreciate it, thanks, Kristian. Yeah, I love this part, but it's important. So, I'm just going to read the... Investing involves risk, including possible loss of principal. The Russell Alternative Diversifier Fund is a new fund with no operating history, no guarantee that the fund will achieve its investment objective. The fund uses complex alternative investment strategies that involve risk, different from traditional mutual funds and may not perform as expected. These strategies can increase trading costs and introduce implementation, liquidity, and operating risks. Diversification and hedging may not prevent losses, and different strategies may lose money at the same time. Allocation decisions may adversely affect returns. There's no guarantee the strategies will reduce volatility or achieve their intended results. Trend following and managed future strategies may lose money when markets lack sustained trends or reverse suddenly and may increase trading costs. Volatility strategies may experience substantial losses when volatility and market relationships change unexpectedly.

Mark Raskopf [17:57] Long volatility positions involve ongoing costs that can reduce returns over time. Derivatives can magnify losses, including losses exceeding the amount initially invested, and involve liquidity, valuation and counterparty risks. And finally, fund objectives, risks, charges, and expenses should be carefully considered before investing. A summary prospectus, if available, or a prospectus containing this and other important information can be obtained by calling 1-800-787-7354. Please read the prospectus carefully before investing. Okay, with that out of the way —

Kristian Kerr [18:28] Mouthful.

Mark Raskopf [18:29] Yeah. Okay. So the... Technically, the combination isn't new itself. We've used this combination of trend and active long vol for institutional clients for years as a way to complement their risk assets. But what is new and I think really exciting is that we've brought the pieces together in a daily liquid mutual fund, a structure that I think is understandable and practical for advisors and individual investors. So trend following is already available in mutual funds and some ETFs, but to my knowledge, the combination of trend with active long vol in a mutual fund is unique.

So I think the active long volatility piece is really the unique differentiator here, and what's probably not obvious is that to get access to these strategies on your own, you'd probably need over 10 million and you'd be investing in the hedge funds that managers return.

Mark Raskopf [19:24] So that's a significant barrier to entry that we're now able to overcome. And one more quick point, and another reason why I haven't seen this combination before, I think specifically with active long vol managers, it's the fact that it requires an absolutely Herculean effort in terms of the build out of operational infrastructure. And then this extremely detailed risk management process, really a lot of innovation. I think it's important to say that. So to me, the appeal isn't that we've invented a new concept, but we've taken a page from the institutional playbook and made it available to a much broader group of investors.

Kristian Kerr [19:57] Yeah, just an easier wrapper, right, for people to get exposure.

Mark Raskopf [20:01] Yeah, exactly.

Kristian Kerr [20:02] All right, so, you know, a couple things I want to touch on, just, you know, every investment comes with trade-offs, right? So what are some of the potential drawbacks or challenges advisors should be aware of when it comes to incorporating alternative diversified strategies, like this in a portfolio?

Mark Raskopf [20:22] Yeah, sure, absolutely. Well, I mean, one of them is, you know, how do you think about it strategically, you know, tactically? I think people have tried over time to time these things, but usually by the time everyone feels certain that this stuff makes sense, you know, markets usually have moved or maybe protection's more expensive. So I think the trend and active long vol make more sense as a strategic allocation, you know, not something an investor, you know, kind of gets into only after getting worried, I think.

But I do think it does make sense to rebalance this kind of investment either regularly or opportunistically. But overall, I think these — I think of these things as long-term and typically worth holding through different environments, including when they may lag. And really quickly, sort of, I think the main potential challenges is that diversification sometimes does lag, right?

Mark Raskopf [21:22] You know, we talked a little bit about it earlier, in strong, calm, bull markets, you know, volatility can lose money because market fear is low.

Kristian Kerr [21:33] Yeah.

Mark Raskopf [21:33] Even using these, you know, super sophisticated models to pick good entry points, you know, the strategies, you know, will just hold their positions, and when volatility's down, they don't, you know, generate strong returns. And for trend, the Achilles heel is a choppy, directionless, you know, market. So that really makes sizing important. I think the alternative diversifiers are best sized, you know, as a portfolio complement, you know, obviously at a level an investor can remain comfortable holding through periods of underperformance.

Kristian Kerr [22:01] Yeah. You know, I think from an advisor standpoint, that's, you know, what I would add there is that returns can be lumpy, right? So you might, you know, there might be a period where, you know, you go through, like, a March 2020 or something like that, and you get really good returns from long vol, and then you might go through a few years where you don't really get great returns. So you've got to be aware of that. You know, you're really investing, you know, as you said, in a more of a strategic time horizon, you know, full market cycle.

And, you know, from an advisor standpoint, there are going to be times where you're going to need to, you know, justify it to clients, because you're in a regime where markets just... Equity markets are just grinding up, and you're wondering why you have that.

Kristian Kerr [22:38] But, you know, where these things, I think, can add value is over the course of a full market cycle, where you will, you know, get the eventual, you know, shaking of the tree in the market and you'll be... And, you know, you should be happy to have things like this in a portfolio. All right, so to wrap things up, you know, if advisors remember only one thing from today's conversation, what would you want that takeaway to be?

Mark Raskopf [23:01] Okay, by the way, and I do agree with everything you said about, sizing and holding through volatility. I think just... I always go back to sort of the foundation, you know, I think because, you know, the point is to invest with conviction, you know, and, at the same time, diversify how you get there. I think what we've been talking about using alternatives that respond differently to changing markets is, is really the, you know, great solution. I think maybe the last thing I'll say is sort of a... To simplify that is to say, you know, the future is clearly worth investing in, and the path for more, for most people is worth diversifying. And I think we've talked about some good solutions to diversify portfolios.

Kristian Kerr [23:51] Yeah, I think that's a great place to wrap things up. Great, great point. Mark, thank you again for joining us today and sharing all of these insights. It was a great conversation. I look forward to having you back on, and thank you again to all our listeners for tuning in. Please be sure to join us next week for another episode of Market Signals. Until then, take care. Bye for now.