The stock market just suffered its worst year since June... of 2020, with the S&P plunging 4.3% and the Nasdaq a spectacular 5.5%.
Nothing was spared on September 14th, not bonds, stocks, or even low volatility aristocrats or utilities. Even JNJ, one of the lowest volatility blue-chips on earth, fell 2.6%.
The Consumer Price Index or CPI report measures inflation came in hotter than expected.
The actual results were worse than expected across the board.
But aren't these pretty close to what was expected? Why on earth would inflation coming in 0.2% higher than expected cause the market to crash 4.3% in a day?
The answer is that core inflation, which is 42% driven by housing costs, is still rising, and helping to make core inflation sticky.
Here's why that matters to the Fed, investors, and the economy.
Housing costs aren't expected to peak until January, at the earliest.
Some economists think housing costs might keep climbing until mid or even late 2023 and peak at closer to 10%.
That means that core inflation from housing alone might be as high as 4.2% well into next year.
The Cleveland Fed's inflation model forecasts that core PCE, the Fed's official inflation metric will rise next month to 4.8%.
Why does this matter? Because since 1954, no Fed hiking cycle has ever ended without the Fed Funds Rate or FFR, going above core PCE.
If core PCE keeps rising, even for a few more months, then the Fed will have to keep hiking much higher than the stock and bond markets had previously expected.
Bond Market Fed Futures
The bond market is now pricing in a 100% chance of the Fed hiking at least 75% on September 21st and a 36% chance of a 1% hike.
In November, the bond market is pricing in a 78% chance of a 75% hike and expects the Fed will pause and hold at 4.5%.
But won't the Fed hiking another 2.25% (double the current rate) cause a recession?
That's been true historically. We've never had 5+% inflation without a recession curing the problem within a year or two.
|Date||3 Month Yield||10 Year Yield||3m-10Yr Curve|| |
13-Month Recession Risk
(Source: DK S&P 500 Valuation And Total Return Potential Tool, New York Federal Reserve, CNBC)
The bond market is currently pricing in an 81% chance of a recession beginning by October 2023.
But wait a second? If the stock market is crashing because rates are rising, and rates are rising due to inflation, and recessions cure recessions, then isn't recession a good thing for stocks?
According to Bloomberg, Goldman Sachs, one of the most accurate blue-chip economists in the world, is now forecasting an 11% EPS decline in 2023, should we get a recession next year.
That's actually mild by historical standards, courtesy to the mild recession that Goldman, Deutsche Bank, and Bank of America all expect (all blue-chip economists).
What does an 11% EPS decline next year mean for stocks? According to Goldman, the S&P 500 will likely bottom at -35% from its record high.
OK, so that might be very painful for stocks, BUT if inflation comes down and we get a recession doesn't that mean that bonds should do well?
The blue-chip economist consensus is that 10-year Treasury yields will peak at 3.5% to 3.6%, not much higher than they are today.
What does the consensus expect if we get a recession?
OK then, what's the problem? If you want to hedge against a potential 21% to 25% further market decline, then just some long bond ETFs and ride out the bear market in comfort and style, right?
Except that Pimco, the world's leading bond manager, thinks that inflation could remain high for the next few years, causing bonds to suffer and not act like hedges at all.
If the world's best economists and bond experts can't agree, what's a prudent investor trying to hedge against stagflation and this bear market to do?
Here is a deep dive intro to the Dynamic Beta Managed Futures (DBMF) ETF, the Vanguard of hedge funds, and my favorite way to beat stagflation and this bear market.
On September 13th, DBMF was up 1.5%, thanks to its potent combination of being long the dollar and short bonds.
During the 3rd worst day in US market history, when the S&P fell 12% in a single day, bonds soared 6% to 8%, and DBMF was flat.
In the 2022 bear market, bonds are being hammered (worst bond bear market in history), and stocks are too.
Managed futures, at least those run by the highest Morningstar-rated firms, are crushing it, up 11% to 40%.
Since 1980 managed futures have acted as a wonderful hedge during both stagflation (the early 80s and 2022) as well as most periods of market turmoil.
Does that mean that managed futures are perfect? There is no such thing as a perfect asset.
Should this be the only thing you own in a bear market? Heck no!
Managed futures usually focus on commodities, currencies, and going long or short the stock market.
Compared to commodities, they are far better performing and less volatile hedges.
Compared to bonds they are more volatile but slightly better performing over time.
DBMF remains my favorite way to gain exposure to managed futures, and here's why.
DBMF only uses the most liquid futures on the 10 or so core positions of the 20 hedge fund blue-chip consensus.
It has the lowest costs (0.95%), and while its 3 years of returns aren't statistically significant, they are in the 85th percentile of its peers.
Hedge funds average 5% fees over time. Managed futures funds that retail investors can buy, can cost as much as 3.24% per year.
An 0.95% expense ratio, 80% lower than the hedge fund industry, is why DBMF has outperformed 85% of its peers by 5% annually so far.
DBMF's strategy, of basically tracking the blue-chips hedge fund consensus, is the most likely to deliver consistent results over time.
In contrast, DBMF, which has been around for just over 3 years, has delivered 15% CAGR returns, 50% more than its peers, putting it in the top 13% of hedge funds.
In 2022 its 28% returns put it in the top 25%.
Over the last three years, DBMF's correlation to the stock market has been -0.01, very bond-like.
Its volatility-adjusted returns (Sharpe ratio) have been 45% better than its peers, thanks to higher returns and slightly lower volatility.
That includes only falling 5% at its peak, half as much as its peers.
But didn't I promise you 3 amazing ways to beat stagflation? Indeed I did.
I've had several Dividend Kings members ask me something:
I'd like to diversify into managed futures, but I'm nervous that DBMF only has a track record of 3 years....
and is run by just 2 people and an algorithm...
isn't there a relatively low-cost alternative you can recommend...
One run by a proven team of experts?
This is where I get to work looking at 3 of Morningstar's top-rated hedge funds (systematic trend following funds).
So let's take a look at all three and why they are a reasonable alternative to DBMF for anyone wanting to diversify beyond stocks and bonds, including how to use them in your portfolio safely.
AlphaSimplex uses a team of 44 quant traders to manage its futures portfolio, which includes 80 holdings over time.
A skilled and well-organized team of researchers at AlphaSimplex Group manages this strategy. CIO Alex Healy, who has been with ASG since 2007, oversees the research team and leads the implementation of the managed-futures program. The firm's research scientists report to Kathryn Kaminski, an experienced industry veteran the firm added in 2018. Five portfolio managers work closely with the researchers, and a strong academic culture underpins their work. - Morningstar
The team at AlphaSimplex includes some truly excellent quant managers with long track records of successfully navigating the complex world of commodities, currencies, and going long/short global stocks and bonds. The quant team reports to Kathryn Kaminski, a former MIT researcher specializing in quantitative trend-following trading strategies.
Because of its well-defined research process, this systematic trading strategy, which aims to deliver gains with a low correlation to traditional markets, should be able to stay ahead of many trend-following peers. It buys long futures contracts across roughly 80 markets with prices that are trending positively and shorts assets that are trending negatively. - Morningstar
Like most managed futures funds, it's a trend-following strategy, so basically, betting that momentum will continue in whatever direction is currently working.
As you'd expect from a $3 billion fund run by a team of 44, it's a lot more complex than DBMF's algorithm, which just tracks the blue-chip hedge fund consensus index.
The research process supports the program's ongoing improvement. The firm's investment committee meets weekly to assess potential new signals or data sets to add to the trading program. It is an iterative process designed to rigorously test new ideas, including extensive peer review and paper trading before a new signal is added to the live portfolio. - Morningstar
AlphaSimplex is like the TROW Price of hedge funds, a rock-star team of experts who make decisions by committee.
The strategy trades more than 80 futures contracts across equities, fixed income, currencies, and commodities. Position sizing depends on the composite score of the underlying signals. When the three distinctive models agree on an asset's trend direction, the greater risk is assigned to that asset. For example, if more models agree on a long position in fixed income, that asset class gets a higher weight subject to various risk constraints like maximum trade size and asset-class exposure limits. Single asset-class risk allocation, which can be a significant performance differentiator, can vary from 0 to 50%; that upper limit is on the high side for a typical systematic trend-follower. - Morningstar
It is a very reasonable (and highly effective over time) approach that balances high conviction ideas with prudent risk management.
AlphaSimplex runs a punchy program. Gross notional exposure varies depending on market volatility and correlations, decreasing when markets are more erratic. Gross exposure was 610% as of Sept. 30, 2021, but has ranged from 284% all the way up 1941%. These levels might seem exceptionally high, but much of the notional exposure comes from short-duration fixed-income rates trades, which have limited volatility. It invested 38% of its risk allocation in commodities, 32% in equities, 13% in fixed income, and 18% in currencies. Top long positions were in natural gas, the S&P 500, and copper futures, while top short positions included Japanese yen and silver futures. - Morningstar
AlphaSimplex isn't afraid to use a lot of leverage with its strategies, with a range of 284% to 1941% gross exposure (most positions cancel out) over the years.
The researchers at AlphaSimplex are about 50% quants and 50% fundamentals-driven experts in economics.
AlphaSimplex has been crushing it in 2022, with an industry-leading 40% gain. That's courtesy of massive concentrated and levered bets on some of the top trades of this year.
But that doesn't mean that AlphaSimplex is always a great hedge.
Its peak decline was 25%, and it badly lagged behind its peers from April 2015 to February 2019.
Alpha's higher tolerance for volatility means that when the market inflects and pivots hard, it can be caught offside (often the case with trend-following strategies).
But over time, especially since July 2010 (one of the oldest managed futures funds), it's performed very well.
Over the last decade, AlphaSimplex delivered 10% CAGR total returns, 75% more than hedge funds, putting it in the top 4% of its peers.
Over the last five years, it delivered 9.8% returns, 50% more than its peers, putting it in the top 13%.
Over the last three years, returns of 16.9% CAGR were 70% better than its peers, putting it in the top 6% of all hedge funds.
Over the last decade, AMFAX has been more volatile than other hedge funds but delivered 67% higher volatility-adjusted returns.
The future doesn't repeat, but it often rhymes. - Mark Twain
Past performance is no guarantee of future results. However, over sufficiently long periods of time, this is the best method we have of estimating the skill of a fund manager or a given investment strategy.
AlphaSimplex is one of the oldest managed futures funds, launched 13 years ago.
AlphaSimplex actually outperformed its peers by a very healthy margin.
The 60/40 is the simplest and lowest cost hedge fund ever devised, and historically has delivered 6.7% returns, exactly what analysts expect from it over the long-term.
Managed futures are NEVER MEANT to rebalance a 60/40 portfolio but to be an alternative diversifying bucket.
AMFAX's big leveraged bets can sometimes result in LONG bear markets when its positions prove incorrect.
The income AMFAX pays out is highly variable and doesn't necessarily grow over time, like a 60/40's.
The income is a mix of futures contract income and short and long-term capital gains; just like DBMF, AMFAX tends to make one or two distributions per year.
GIFMX is one of the lowest-cost managed futures funds on Wall Street.
There is no qualitative information available on GuidePath, not even a website. Thus I have to do a purely quantitative analysis.
Guess who manages GIFMX? AlphaSimplex, including the same rockstar team running AMFAX.
GFIMX has been growing pretty steadily (for a hedge fund in a raging bull market).
That's not surprising given the management team has replicated its 5-star returns, but at a fraction of the cost.
Just like AMFAX, GIFMX is in the top 6% of hedge funds, potentially because it's using an almost identical strategy.
Over the last 3 years, it was in the top 1% of hedge funds with 17% annual returns.
And just like AMFAX and DBMF, variable payouts, once per year in this case.
GIFMX is an industry-leading hedge fund run by some of the smartest managers in the industry. But it's not designed to replace or keep up with a 60/40 portfolio.
GIFMX has delivered very consistent returns on par with the long-term returns of the hedge fund industry (since 2001).
But it does so at about 80% lower cost.
Other than the major bear market created by AlphaSimplex's concentrated positions going wrong from 2015 to 2019, GIFMX tends to experience very small declines.
Remember that managed futures funds tend to pay out all of their gains as distributions once or twice per year.
Like most managed futures hedge funds, PQTAX goes long or short stocks, bonds, currencies, and commodities, depending on the latest trends.
Pimco is the BlackRock of bond managers, and they bring a team of skilled risk managers and quants to PQTAX.
Who are the managers running this? There are two.
Prior to joining PIMCO in 2006, he received his Ph.D. in theoretical particle physics from the California Institute of Technology, where he was a National Science Foundation Graduate Research Fellow. He has 16 years of investment experience and holds undergraduate degrees in mathematics and physics from Ohio State University. - Pimco
A theoretical physicist from CalTech with 16 years of experience in advanced quantitative trading handles the quant trades.
Prior to joining PIMCO in 2011, Mr. Rennison was a director and head of systematic strategies research at Barclays Capital in New York and also spent five years at Lehman Brothers. He has 20 years of investment experience and holds master's and undergraduate degrees in mathematics from Cambridge University, England. - Pimco
The other manager holds a masters in mathematics from Cambridge and has over 20 years of experience with quantitative trading.
Both of the current managers have been there since the start of the fund, with nine years of experience with PQTAX specifically.
PQTAX is mostly focused on currencies, commodities, and betting on interest rates.
Pimco's hedge fund is the most diversified by far, and that means lower returns in a year when concentrated bets are paying off.
Pimco has struggled in recent years, especially with the exit of Bill Gross (arguably the best bond trader in history).
But it still has $344 billion in assets, and you don't have to worry about this being run by a fly-by-night operation no one has heard of.
In 2022 PQTAX is in the bottom 35% of hedge funds, but it's highly diversified approach has put it in the top 28% of powers over the last five years.
PQTAX has very small declines due to owning almost 1,000 futures contracts.
It's correlation to the stock market (beta) has been -0.14 over the last five years.
PQTAX has beaten its peers by 3.25% annually and with a 2% lower annual volatility.
The nice thing about PQTAX is that the distributions are quarterly. They are also 100% income which isn't that great from a tax perspective.
PQTAX has done a fantastic job of nearly matching a 60/40 over the last eight years, and with lower volatility (thanks to PIMCO's risk-management prowess and a super diversified portfolio).
Its volatility-adjusted returns are nearly identical to the 60/40's but with a -0.23 correlation to the stock market.
Notice how PQTAX's average returns are lower than its historical return, though very consistent.
Why is that? Because like most hedge funds it shines brightest when the market is freaking out.
PQTAX doesn't always keep up with a 60/40, but it's had just one down year in its first eight.
Remember how managed futures really struggled through the 2015 to 2019 industry bear market? The 6-year bear market for AMFAX?
Well, Pimco's bear market lasted 2.5 years and it only fell 13% at its peak during that.
Outside of that, extreme bear market declines are very mild, including a 2022 peak decline that's just 4.5%, 1/4th as much as a 60/40's.
I can't stress this enough; HEDGE FUNDS ARE NEVER THE ONLY THING YOU SHOULD OWN.
For most investors, a 5-15% allocation to managed futures may offer a good balance of diversification and volatility. Over the long term, the volatility of most managed futures strategies will be closer to that of equities than that of core bonds, and this size of allocation generally may be enough to "move the needle" positively in most portfolio allocations. - Pimco (emphasis added)
Andrew Beers, cofounder, and co-manager of DBMF, recommends a 5% to 20% allocation to managed futures for most blue-chip portfolios.
Let me show you a concrete example of how managed futures can benefit you by using my Uncle's $1 million ZEUS Income Growth Portfolio.
When I helped my uncle rescue his life savings after losing $1 million in the great 2022 crypto crash, I wasn't aware of DBMF or the diversification benefits of managed futures hedge fund ETFs.
When helping Rose (a family friend) build her $3 million ZEUS High-Yield Ultra-Low-Volatility portfolio, we incorporated DBMF as part of her 33% hedging bucket.
My uncle recently put the rest of his cash to work and hedged aggressively against the likely 2023 bear market (80% probability, according to the bond market).
Most people wouldn't be comfortable with a 25% allocation to hedge funds, but my Uncle is.
But let me show you what his ZEUS portfolio looks like with and without managed futures funds.
This was the original asset allocation of my uncle's ZIG portfolio.
Now let's see what it looks like with half the bonds replaced with AMFAX.
This is a more diversified portfolio with more negatively correlated assets. That means we should expect similar total returns to the non-hedged version.
And due to more negatively correlation, we should get lower volatility in the stagflation crash.
So that's what the theory says; now let's look at the results.
My Uncle's goals with ZIG include:
ZIG without hedge funds (just bonds) delivered solid 10.6% CAGR returns over the last 12 years.
ZIG, with AMFAX hedging, delivered 10.9% CAGR returns, slightly better.
In 2022's bear market, 50% of the unhedged portfolio fell off a cliff.
In the Pandemic crash, it fell 6%, half that of a 60/40.
Now here's ZIG with AMFAX as a hedge.
A peak decline in 2022's bear market of 7%.
So far, the largest decline was a 16% decline in the 2018 bear market versus a 20% decline in the S&P 500.
33% of this portfolio has variable-paying bonds and hedge funds. And yet the annual income is relatively stable.
This portfolio today also yields 4.5% (as it did in 2011), and analysts expect it to keep delivering similar 10% to 11% long-term returns just as it has historically.
3X the yield of a 60/40? Far better long-term returns (3% more per year)? And with lower volatility and smaller declines in bear markets?
In 2022's stagflation bear market, the hedged version of ZIG is doing great:
Zig with hedges has beaten a 60/40 in 8 of the last 13 years.
So AMFAX works well with this portfolio, but what about the others?
Better returns than a 60/40 in both versions of ZIG? Check.
Better returns with Pimco's hedge fund than without? Check.
Lower volatility with Pimco's hedge fund? Check.
Higher negative-volatility-adjusted total returns (Sortino)? Check
Smaller peak declines with Pimco's hedge fund? Just 13% over the past eight years.
During the 2018 bear market, the market fell 20%. Pimco hedged ZIG fell just 13%.
During the Pandemic, it fell 8%, 4% less than a 60/40, and 12% less than the S&P 500.
And its largest decline so far in this bear market is a 10% decline, half that of the S&P 500 and 7% less than a 60/40.
Now let's look at the income over time.
33% of this portfolio was in a historically terrible bear market (BTI, ENB, and MO) by 2016.
And yet even the unhedged version of ZIG delivered solid 7% returns and lower peak declines than a 60/40.
But look at what happens when we put the master hedge fund managers at AlphaSimplex (who run GIFMX) to work for us.
Down 10% less than a 60/40 in 2022's bear market and 13% less than the S&P 500.
Down just 3% in 2022, 5X less than a 60/40 and almost 6X less than the market.
What about annual income growth?
Even without hedging and with 33% of the portfolio in a terrible bear market (ENB, BTI, and MO), ZIG beat a 60/40 in absolute and negative-volatility-adjusted terms.
But with DBMF (my favorite hedge fund) it saw explosive growth in returns that ran circles around a 60/40.
Half the market declines in the Pandemic, and 2% less than a 60/40.
An 8% peak decline in 2022, 12% better than the S&P, and 9% better than a 60/40.
Look at how smooth those returns are! Even during the hedge fund bear market, ZIG with DBMF hedging delivered exceptional returns.
|Year||ZIG (No Hedge Funds)||ZIG (DBMF Hedging)||60/40|
(Source: Portfolio Visualizer Premium)
If you can't stick with a portfolio strategy over time, it's useless to you, no matter how great it might be on paper.
That's exactly why my uncle added DBMF to his portfolio because, long-term, the Vanguard of hedge funds makes ZEUS Income Growth better in all market conditions.
Finally, let's consider the annual income.
This is the power of a diversified blue-chip portfolio that includes one of the top 15% hedge funds in the world.
On paper, as long as you have a 20+ year time horizon, you don't need to hedge your portfolio at all. Why?
Because blue-chip portfolio will go up over time and without hedges, you can, theoretically, maximize both income and total returns.
But are you a robot? Can you personally stomach 30%, 40%, or even 50% bear markets? Can you ignore the crashing market and not look at your portfolio until it's time for annual rebalancing? That's also the optimal strategy, and most people can't.
This is what real people do during bear markets. They try to time the market. They succumb to FOMO (fear of missing out) in the good times, and panic sell in corrections.
And that's why the average retail investor underperformed even a 60/40 by 4% per year...for the last two decades.
The point is that the perfect strategy isn't what you need, but the perfect strategy you can live with for decades. Not just in good times, but bad times as well.
You need an all-weather bunker portfolio to help you ride over the market's potholes with Rolls Royce levels of comfort and zen-like calm.
And that's where hedging assets like cash, bonds, and hedge funds can help.
I remain convinced that DBMF is the best hedge fund the average investor can buy, thanks to its focus on:
But is there potential value in actively managed hedge funds? You bet.
During the Pandemic, here were how these assets performed:
When interest rates are not soaring (92% of recessions), long-duration bonds are the most powerful hedge you can own.
But when inflation is high and rates are rising, bonds stop working and managed futures hedge funds shine.
So if you're interested in adding a 5% to 20% allocation of hedge funds to your portfolio, DBMF, AMFAX, GIFMX, and PQTAX are four of the best options I've found.
You don't need to hedge your portfolio; you don't need to use hedge funds to do it. But if you want to beat stagflation in 2022 and possibly 2023 and own something that goes up when stocks and bonds don't, these are the best world-beater blue-chip options I can recommend.
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This article was written by
Adam Galas is a co-founder of Wide Moat Research ("WMR"), a subscription-based publisher of financial information, serving over 5,000 investors around the world. WMR has a team of experienced multi-disciplined analysts covering all dividend categories, including REITs, MLPs, BDCs, and traditional C-Corps.
The WMR brands include: (1) The Intelligent REIT Investor (newsletter), (2) The Intelligent Dividend Investor (newsletter), (3) iREIT on Alpha (Seeking Alpha), and (4) The Dividend Kings (Seeking Alpha).
I'm a proud Army veteran and have seven years of experience as an analyst/investment writer for Dividend Kings, iREIT, The Intelligent Dividend Investor, The Motley Fool, Simply Safe Dividends, Seeking Alpha, and the Adam Mesh Trading Group. I'm proud to be one of the founders of The Dividend Kings, joining forces with Brad Thomas, Chuck Carnevale, and other leading income writers to offer the best premium service on Seeking Alpha's Market Place.
My goal is to help all people learn how to harness the awesome power of dividend growth investing to achieve their financial dreams and enrich their lives.
With 24 years of investing experience, I've learned what works and more importantly, what doesn't, when it comes to building long-term wealth and safe and dependable income streams in all economic and market conditions.
Disclosure: I/we have a beneficial long position in the shares of DBMF either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Dividend Kings owns DBMF in our portfolios.