Mostly Voices [0:00]

A foolish consistency is the hobgoblin of little minds, adored by little statesmen and philosophers and divines. If a man does not keep pace with his companions, perhaps it is because he hears a different drummer. A different drummer.

Mostly Mary [0:19]

And now, coming to you from dead center on your dial, welcome to Risk Parity Radio, where we explore alternatives and asset allocations for the do-it-yourself investor. Broadcasting to you now from the comfort of his easy chair, here is your host, Frank Vasquez.

Mostly Uncle Frank [0:38]

Thank you, Mary, and welcome to episode 53 of Risk Parity Radio. Today on Risk Parity Radio, it is time for our monthly rant. I think I have a good one this time. And then we are going to talk about something called the Dragon Portfolio. which is on the cutting edge of risk parity-ness or constructing portfolios based on balancing out volatilities. But let's start with that rant. First, I need to find the music. I can just push this button here. We're ready to go. And here we are. Now, of course, today's rant has to be about GameStop since everybody else is talking about GameStop, but I have a very different perspective from most people and my perspective could be summarized as a pox on both your houses in one respect, but it's really dedicated to the memory of George Santayana. George Santayana was a Spanish-American philosopher who lived from about the 1860s to around 1950. And he is most known for a phrase that was popularized by Winston Churchill. And the phrase is, those who cannot remember the past are condemned to repeat it. Those who cannot remember the past are condemned to repeat it. And we're going to apply that to risks, risks in investing. Because if you don't know the history of the risks in the kind of investing that you are doing, you are condemned to repeat it and to fall into that risk and be subject to it. And then the predictable result is that you will whine about it. Now let's talk about the risks that some people took and the risks that they are whining about. First, let's talk about the hedge funds who were leveraging up and selling these shares and going mega short on them. Now, selling shares short is a big risk in itself. If you take leverage on it, it's an even bigger risk because all that borrowed money goes into that. The reason why shorting shares is so risky is that your losses are potentially unlimited. And in addition, you are going against the idea that these companies who have shares are trying to make money, are trying to run a business. They may not be running it very well and they may not be able to run it very long, but that's the reason that taking the long side owning shares is generally the safer course. You don't have as big a risk because you know at least that the people who are running these companies that you're buying shares in are trying to make money. And so you're fighting against that. But what happened to them in this circumstance is called a short squeeze. And if there are lots of people shorting the same things, it is possible for buyers to come in and start buying it up. And then those people who have borrowed these shares and are shorting them and have taken out all the leverage all of a sudden get called by their lenders. and get called by their brokers who have loaned them the shares to either put more money up or to buy the shares back and get out of it. And naturally, that intends to increase the price even more. And so the squeeze is on and the price accelerates to heights that have nothing to do with the company itself, but have to do with the price action of what's going on in the marketplace. And then it attracts more momentum, More people buy in and you see a huge spike in the price of those shares. Now, one would think, given all the brouhaha about this, that this is something new. In fact, this is one of the oldest phenomena in trading markets. It is one of the oldest phenomena. If you go back to the 1860s, and this was what went on all the time in the 19th century in the stock market. If you go back to the 1860s, this is how Cornelius Vanderbilt took over the railroads in New York through a process of a short squeeze, where he squeezed some people out and then bought majority of the shares and ran off and had himself a railroad empire out of that. So why are people complaining about it? Because they forgot, they think that nothing can happen that happened before just because it was a different era. that that can't happen again. Of course it can happen again. The fact that it's happened before tells you it can happen again and it is a risk that you need to account for if you are going to engage in that behavior. Because if you don't account for that risk, we got no sympathy for you. We got no sympathy for you. You took the risk, you lost. I assume that you thought you knew what you were doing, but you didn't. Now, where could you learn about this? One of the things I like to do when I get involved in any kind of investment or just any kind of thing is to read the history of something. The history of investing, the history of these kind of ideas. So it's very easy for anyone to go to the library or go on the internet and read a few books about what's happened in the past. What is the history of the stock market? What happened before? Why do we have the stock market regulations we do now? Where did they come from? They didn't come magically because somebody was conspiring to regulate some market. They came out of behaviors that people didn't want to see, usually based in fraud or concealing of information. Now, where can you learn about this? The best place, single place you can learn about this is go read a book called 50 Years in Wall Street. It's by a man named Henry Clews and it was published in 1908. 1908 was the year after the great 1907 crash. And if you don't know what that is, then you don't know what the stock market is. You need to know what these things are if you're going to participate in these markets in any meaningful capacity, and if you're going to take on risks that involve leverages and squeezes. Now, that book is a fascinating book because it goes back and it talks about all of these characters on Wall Street. And what went on in Wall Street in those days, it was all about the trading. There wasn't buy and hold. That wasn't the point of it. The point of it was to screw the other people that were in the market in any way you could, either by concealing information, forming pools, forming monopolies. Every kind of chicanery that you can think of was conducted at that time. There is a history of all of this stuff. and short squeezes were very common. They happened all the time. They were the big news of the day. Who's got a squeeze on? And then who's trying to corner the market? That was the other thing. And this went on with railroads and steel and every kind of industrial thing that was being built in the late 19th century in the United States. And so I would commend to you to go read that book if you're interested in what happened with GameStop, because it was not new. It was the oldest trick in the book. Now another thing I would commend you to read so that you can remember the past and not repeat it is a biography of Hetty Howland Green. Now, who is Hetty Howland Green? Hetty Howland Green was the best individual investor in this period of time from the American Civil War into the 20th century. She was the Warren Buffett of her time. But she was not very popular for two reasons. First, she was known to be extremely frugal to the point of being miserly. But second, she was a woman and she dressed in black and they called her the witch of Wall Street. And she saw these short squeezes, she would participate in them, she would laugh at people who were getting involved in these sorts of things. She made her first fortune buying up US treasury bonds after the Civil War. At that time, that was a speculative thing to do. but she bought them up and she got paid off handsomely. Now how did that occur? It occurred with the passage of the 14th Amendment. You may have learned about the 14th Amendment in school and you may have thought that it was all about applying the Bill of Rights to the states. And that was a major portion of it, but there was a minor portion of it. that is still the law today. And it says that the government will pay the debt of the government. It's not a choice. It is in the law, in the 14th Amendment, in the Constitution. Why was that important then? Because there was a debate that was going on as to whether and how the Union debt would be repaid and then what to do about the Confederate debt. And so what was decided is that the Union debt would all be repaid and none of the Confederate debt would be repaid. So if you were holding bonds in the Confederacy, you lost it all. That was a big risk. If you were holding bonds in the Union, all of a sudden your bonds doubled in value overnight. And then what else happened? That was around 1868. In 1873, the United States went back on the gold standard, which made the dollar worth even more and tradable with European currencies like the pound, which was the reserve currency of the world at the time. And so if you were still holding that debt, it became even more valuable. And Hetty Howland Green made a fortune just on buying US government bonds, just like those US government treasuries we talk about buying today, which I think is amazing. Again, You got to know some history or you're just going to repeat it. The bad part of it. Now let's talk about the other side of this. The Robin Hood traders in the Wall Street Bets crowd. Now what did they get upset about? Well, they got upset when trading was shut down while this was going on. Should they get upset about that? Well, it's happened before, people. It's happened before, in fact, it happens all the time whenever there's some dislocation or disruption in the trading of shares, whether they be one issuance or the whole market has been shut down at various times. You go back to 1987, you go to wartime, you go to 9/11, you go to any number of times in history and that is a risk you are taking that if you are investing in something that is going to be highly volatile, there is a risk that trading is going to be restricted. Now, if you were using Robinhood, you even failed to understand recent history. What's the recent history of Robinhood? They shut down Last spring, in the middle of that sell-off financial crisis, you couldn't trade there. They've been fined by the SEC in the past year. They've had problems with hacking in the past year. All of that is recent history. And if you didn't know it, and if you didn't understand it, you were taking a risk. You're taking a risk by using that particular platform. that you don't need to take. Use something else. Stop taking risks and then whining about it when they blow up in your face because that's going to happen to you again. It's going to happen to you again if you take risks and you don't understand, you don't know the history, they are going to blow up in your face and don't expect people to come bail you out. I don't expect anybody to be bailed out. I didn't like it when people get bailed out. But the idea is not we need to bail out some people and not bail out other people and then make up for not bailing them out by bailing these other people out. Let's just stop the bailing and make people take responsibility for what they've done. The other thing you need to know about Robinhood is that it is not in the business of treating its traders as its customers. Its customers are the people that sells the order or deal flow to. This is why that every time somebody opens up an account at Robinhood, it's not a normal account, it's a margin account. The reason it's a margin account is they want to encourage as much trading as possible, which generates as much data as possible, which they can sell on to their real customers who are often these hedge funds. And if you didn't know that, I'm sorry, but you should have known that. You should have said, Why can I do this for free? Why are they willing to hand me out money? It seems like a golden goose. It seems like a free lunch. Well, guess what? There's no golden goose. There's no free lunch. So, if you went off and participated in this short squeeze, you made a lot of money, great. I'm happy you won the lottery. You could ask yourself a question.

Mostly Voices [15:31]

Do I feel lucky? Well, do you punk?

Mostly Uncle Frank [15:36]

But I know some people lost a lot of money. And they're not going to be the ones that are talking, but there are small investors who were buying GameStop at hundreds of dollars a share because somebody else was saying, oh, it's got to go to a thousand. And now it's back down under a hundred. Probably lost half or more of their money. It's really sad. But that is why George Santayana's quote is so famous and remains so famous. Those who cannot remember the past are condemned to repeat it. Don't be one of those people. Understand your risks. Know the history of the risks in whatever you are doing with respect to investing, and then you won't get caught. And now for something completely different. That was enough ranting, and now it's time to talk about the Dragon Portfolio. I'm not going to do a full 10 questions on this right now, but we will be talking about the Dragon Portfolio and its components in some future episodes. Now, what is the Dragon Portfolio? The Dragon Portfolio is a creation of a man named Chris Cole, who's a hedge fund manager. He's not a short seller, as far as I know, but he runs a firm called Artemis Capital, and they create funds that are patterned along the idea of a dragon portfolio. What is the point of this dragon portfolio? It is basically trying to extend the ideas we talk about in risk parity style portfolios to their maximum, to the limits. The ideas we're talking about are using uncorrelated assets to create a portfolio that is likely to do well in all kinds of markets. Now, what is unusual or different about this Dragon portfolio? It has two additional asset classes that we've only talked about a little bit. One is an investment in volatility, and the other one is an investment in managed futures or commodities. And Chris Cole did a study, and he's written a number of papers. I'll link to some in the show notes, and I'll link to an interview in the show notes where he describes this. But basically he's trying to take these two asset classes and then combine them with stocks, gold, and bonds to create a balanced risk portfolio that he calls the Dragon Portfolio. Now, what is in this Dragon portfolio? It is roughly 1/5 equity, a little bit more 24%, roughly 1/5 gold, 1/5 fixed income, and then it's got these two other components, which are the managed futures and the long volatility. Now, let's talk about what those are. Long volatility is an attempt to capture the idea that when things are going crazy in the markets, whether it's the stock market or bond market, things typically increase in what is known as volatility, or how much it's going up and down. Now, there are some products that try to capture this volatility, and we have one of them in our Risk Parity Ultimate Sample Portfolio. It's called VXX, and it is a ETF that invests in options on what's called the volatility index, which measures the volatility of the stock market. There are actually volatility indexes for every kind of market. There's one for the bond market, there's one for the gold market. You don't see or hear about these that much, but they do exist. Although there aren't funds that track them. Now, the problem with trying to invest in long volatility and what Artemis Capital is trying to solve is how exactly do you do that? Because as we've seen, these ETFs that invest in volatility like VXX, they really don't do a very good job because of the way options decay and decline. and if you were going to put on one of these kind of strategies, you probably want to have something that's more sophisticated. And that's what part of what he's offering, or part of what Artemis Capital is offering, is a more sophisticated way of approaching this. Generally, these do use options. Now, one of the problems we have with that and why this is sort of on the outer limits of stuff is there are no good funds for the do-it-yourself investor. This would require another level of knowledge to be able to trade options in volatility in a way that makes sense and also in a way that is balanced with the rest of the portfolio. Now, he claims to be able to do this. This fund has not been operating that long, so we don't know what his long-term track record is going to be with this, but it is there and it makes you do wonder in the future, whether somebody will come up with an ETF that captures long volatility in a way that makes sense to make it a larger portion of a risk parity style portfolio. So like we saw in the evolution of do-it-yourself investing, going back to the 1990s is when risk parity style investing was invented. by Ray Dalio at Bridgewater, and then others have built upon that over the past 25 or 30 years. What Chris Cole is recommending is an extension of that idea. Well, let's look at even broader measures of asset classes, come up with things that are less correlated or not correlated with any of the things we have and try to add those in. So that is an attempt to do that. Now, what is the other thing that he's got in here? is what is called managed futures. Now, the idea of having managed futures has been around a long time. What managed futures is usually is futures and options contracts often on currencies, commodities, and other things. And usually these strategies are what is called trend following. So they have some kind of mechanical way of adding contracts as for instance something goes up in price or down in price. Now this kind of investing is also sophisticated and it's also difficult to do. The reason why it's difficult to do for the average person is that most of the trades actually lose money and only a few of the trades make money. So maybe only a third of the trades are making any money at all. and the profit from the strategy actually comes from a very small number of trades. It's difficult for anyone to manage that, seeing the losses mount up as things just fluctuate back and forth and they're not trending. So these strategies have been difficult to implement, and there are funds out there that try to implement them. We will be talking about one in a future episode that's relatively new. But so far, there has not been a good ETF for managed futures. The ones that have tried this have pretty much failed miserably and gone out of existence. But it is true, if you could get something like this or follow this kind of strategy with one part of your portfolio, that would be another uncorrelated way of investing in these sorts of things. So just some points of interest from this paper that I'm going to link to. On page 11 of the paper, it describes the risk-weighted combinations of this Dragon Portfolio, and it's designed to be 24% equities, domestic equities is what he's got, 18% fixed income or bonds, 21% in this long volatility strategy, 18% in trend following commodity strategy or managed futures, and then 19% in physical gold. Now exactly how he's implementing those things is not really described that well in this paper, and I'm sure it's part of the secret sauce that he would like you to buy into if you're going to become an investor in Artemis Capital, which is running this hedge fund, you do need to be an accredited investor to do that. And I have no idea whether that is actually a very good investment these days or not. Another interesting thing that he's got there, if you look on pages 20 and 21 of this paper, and the paper has the very lyrical sounding title The allegory of the hawk and the serpent, how to grow and protect wealth for a hundred years. His idea that a dragon is a combination between a hawk and a serpent and covers all the bases. But you can look at this mega correlation matrix that he's got here. There are strategy performance tables, and then I should have given you the right page for this. the correlation matrix of the key assets and portfolios is on page 22 of this paper. But it's got the same kind of correlation matrix that we are using constantly in our risk parity style portfolios when we're putting things together and seeing whether they're correlated or not. And since this is goes from 1928 to 2018, I think that's what makes it particularly valuable for us because it's got those long-term correlations and we can rely a little bit more on this if we're thinking about two assets that we don't have very much data for. But if we can put them in the classes that are presented in this table, then we can have an idea of what their long-term correlation is likely to be like. But what you do see from this table is what you would expect that Treasury bonds are negatively correlated with the stock market. A lot of these other things have zero correlation or close to zero correlation, like gold with bonds or gold with stocks. But he's got all kinds of different strategies in here that are listed, for instance, in long volatility he has what's called portfolio insurance. He's got left tail portfolio insurance and right tail portfolio insurance. We may be talking about this more in a future episode, but I just wanted to give a kind of preview as to what he's all talking about with respect to these different kinds of asset classes. But I do view this as a potential future for risk parity style portfolios. You have to say potential because there are a lot of hedge funds out there that are experimenting with a lot of things, and we don't know how well they will perform until you see a number of funds and a number of people adopting the same kinds of strategies and writing more papers about them. And once you have more of a consensus that this is a valuable or a workable strategy, then it's something that we can think about as do-it-yourself investors as to should we implement that or how we might implement that. But right now, this is sort of on the horizon, and it's just a good thing, I think. to be aware of and we will be talking about it more in the future. But now I see our signal is beginning to fade. I wanted to thank you for tuning in today. If you have questions or comments, you can send them by email to frank@riskparityradio.com that's frank@riskparityradio.com or you can go to the website www.riskparityradio.com .com and put your message into the contact form and I will get it from you that way. We will be picking up again this weekend with our weekly portfolio review. We are not adding any meme stocks to our portfolios in case you were wondering. I don't think you were wondering that. But if you have not had a chance and you would go to the iTunes or the Stitcher or wherever you pick up this podcast and leave it a five star review, I would appreciate it because it gets the word out to more people. I fortunately did entitle this podcast with Risk Parity in it and I think it's the only podcast in existence that has those words in it. So you go right there if you search for it. But thank you again for tuning in. This is Frank Vasquez with Risk Parity Radio. Signing off.

Mostly Mary [29:37]

The Risk Parity Radio show is hosted by Frank Vasquez. The content provided is for entertainment and informational purposes only and does not constitute financial, investment, tax, or legal advice. Please consult with your own advisors before taking any actions based on any information you have heard here. Making sure to take into account your own personal circumstances.