An Uncorrelated Portfolio.

Thoughts for the Passive Investor.

Recently, I opened my investment advisory firm, different from a hedge fund to be clear which I’ll explain in a few for new readers here, and part of the job is ensuring clients understand what it is we do and do not do. It’s my view that investors (and traders alike) believe that there is one approach/strategy to everything - for investors that may be the 60/40 portfolio for the traders reading this it may be the idea that directional options trading with technicals is the only approach.

Both views, in my view, are incorrect - so I want to take the time here to review the rationale behind holding uncorrelated assets in portfolios as well as various strategies, again, all within one portfolio.

Essentially, the argument is that most would be better of passively investing into the markets and that this approach may be the best. There’s a Wharton piece here that discusses some of this and the arguments against active are pretty standard points that have been discussed time and time again. One of them being transaction costs which is just not valid anymore given the fees to transact. Two, is capital gains realization which there’s an argument for depending on where you are in life, income and tax bracket so that becomes subjective investor-to-investor.

But since when is the idea that passive investing is the only way to generate a return from capital markets? Sure, it’s been relatively simple with QE and Central Banks globally doing what they do but there are many issues that come with it in my view that I’ll do my best to share here. One, is that many tend to have correlated market-positions in they’re all tied to the broad markets. Two, it’s that investors must sit through peaks and troughs and then tie themselves to the idea that the “market” and gauging returns for “beating the market” are tied to the SP500 - and before the comments come in I understand fully the papers/arguments for pro passive and for pro indexing but if I agreed with them I wouldn’t be writing this nor would we have our firms long/short approach go against this idea.

So, what’s the solution for an overly correlated portfolio and second is it for everyone? I’ll do my best to explain our view as it relates to how we run portfolios in our accredited long/short strategy then as well for the AST Portfolio we run at The LongVol - I suppose it’s in you to decide if it fits you best based on your needs but I think everyone can benefit : ).

Let’s try the above logic about the idea of passive investing or indexing for instance. If I were to note, as many have for many years, that the average active stock picker underperforms the capitalization-weighted market index after fees and trading costs, does that then mean that you shouldn’t be interested exploring uncorrelated assets or other strategies? I certainly wouldn’t and I’d argue that most that try to do that are attempting to actually day trade and not pick stocks and build a portfolio, which, there is a big difference that should be noted. But, this is what I do 24/7 so my views on this may be skewed, however, the LongVol Report and the AST Portfolio would argue my point that not-indexing and using an active approach at times works.

So take the idea that there is a different approach than just buying the same names or the indices as the only way to do this and I think you might be pleasantly surprised.

Let me try to persuade you as I did many years ago when I sold the education co. I created a training for the new firm called “WealthAbilities” and one of the topics I discussed was a 3-bucket approach - that might sound like some Dave Ramsey nonsense but I assure you it’s not. It took the view that if you were someone (as described above) with wealth to manage, a career with a larger salary and other income producing interests that you could then afford to run the portfolio with a mixed approach.

The portfolio of would consist of passive investments ( SPY 0.00%↑ QQQ 0.00%↑ etc), some active-investments and some speculative - think a long-shot growth stock or even a bio-tech stock that may or may not pass regulation. In fact, earlier this year I had a LEAPs call position on RIVN 0.00%↑ which was discussed in Q1 in The LongVol Report literally as a “speculative” portfolio position.

The reality is that anyone can passively index into a market and anyone (and they do to be clear) can buy the “well known” names in the markets to build a portfolio but then you have a correlated portfolio of holdings. To give you an analogy, when one domino falls they all do in perfect order. You saw the worse day in markets since 2022 last month and saw tech and other names all sold off in conjunction.

Now, is that just a one-off situation or is their data to back up the analogy of the domino effect? You can go back and see the correlations on your own time, and should, and you’ll find that this is not just a one-off occurrence.

So, how does one find a solution to that, if that’s what they want? In my view and as listed above, through a portfolio approach that houses uncorrelated positions. My approach when we manage portfolios for clients is similar to the 3-bucket approach above in that:

One, I am not opposed to buying heavily weighted index stocks, provided they are priced to a point where there is upside. Two, active trading through select event-driven situations, index long/short etc. to generate portfolio gains. And three, through finding potential 2-3 baggers with smaller capital allocated.

So, put simply, running a portfolio from this view allows me to buy companies we want to own but also companies that are not correlated to what the broad-market does. It also allows me to actively trade situations as needed to generate returns to the overall portfolio and that in itself is contrarian to what most correlated portfolios do.

And let’s be clear - it’s worked to index the last 5 or so years (arguably longer) but then one has to sit through the peaks and troughs to get a return to which you never really realize until you actually sell.

I just simply reject that idea.

In other words, and in a perfect world, the portfolio would be beta-balanced, attempting to be uncorrelated with major markets and that’s what we aim for when running portfolios.

I’ll give you a few examples to chew on using the AST Portfolio (Swing Trading - which is not what most think so please read carefully). There is a portfolio strategy we publish that is long/short (mostly long) but one that utilizes a variety of analysis models to capture short-term price changes in not just stocks but select ETFs and commodities - we take the commodity idea and find a correlated ETF to express the idea. These stocks/ideas also don’t need to be an idea that has to have some industry-leading idea either - that’s a misconception that most think when they “pick stocks”. And yes, there are things that can be just trades -which I get that may be hard to rationalize if you’re new to this view I’m sharing. That portfolio is not designed to be the driving force for one’s entire portfolio (though maybe it could with significant adjustments). For starters, the risk sizing is relatively small, and it uses deep-in-the-money calls and puts to express the views. Two, the idea is to take a smaller portion of a portfolio and put that money to work with risk that cannot hurt the portfolio significantly and to have non-correlated positions: just this last month we had short positions that were only designed to profit on the market going down - again, another idea that the passive crowd really tends to avoid because they are sitting through the peaks and troughs.

That portfolio has performed and beat the market all year, not important, but I realize some of you may still think in terms of beating the market. The point is, that approach, like many, can be used within a larger portfolio to generate returns while the other part can be passively indexed and/or correlated to the market.

Let’s do a thought experiment. Assume you had $250,000 worth of capital and you divided it as follows:

Passive/Correlated Stocks: 60% or $150,000

Active-Management: 30% or $75,000

Speculative/Growth Stocks: 10% or $25,000

Taking the side of the passive investing groups - you get your passive indexing/investing out of the way and can add on dips (though not sure now is the time for that but that’s another conversation 😎). Then taking the idea that you could actively manage part of that using either a) Uncorrelated stocks to trade and/or b) Use The Long Vol AST Portfolio to generate portfolio returns - would that be something you might be interested in?

The rest you could trade/speculate as you see fit with the idea that the portfolio is now uncorrelated to the major markets and diversified in a way that is actual diversification and not just buying more beta - which, buying AAPL 0.00%↑ AM 0.00%↑ AMZN 0.00%↑ META 0.00%↑ SMCI 0.00%↑ is at the end of that day no matter how you slice it : ).

In sum, we believe that running a portfolio with both uncorrelated holdings and active-management is a better approach for most who are in the wealth-building phase but, also to be clear, those who are after capital appreciation without having to sit through the peaks/troughs of the market only to cash out in 10 years or so.

There was a book I suggested to many friends by a fellow hedge funder, Bill Perkins, called Die With Zero - it’s a bid redundant but his messaging in there was clear. You have a finite amount of time, so you allocate your life experiences into windows to which they fit and use your money to spend to achieve those experiences. I think it’s a good read to get people to think about how they use their money v. the idea that you are just using it to live on at retirement.

Making a long story short:

So why might you want a standalone portfolio of AMZN 0.00%↑, AAPL 0.00%↑ TSLA 0.00%↑ and PLTR 0.00%↑ you’re then left to the market forces, momentum, Warren Buffet (with his Apple sale) and Central Bank policy to guide you higher. And just as many TSLA 0.00%↑ bulls love the stock, cars and Elon the current cycle of rate hikes did not spare that name or many others that were correlated to broad market. From last July to the 2024 lows that stock alone was down over -50% and YTD it’s still down - BUT, trading that stock OR trading around the holding would paint a different picture, something to think about.

This may be fine for those who are “in it for the long haul” but I’d challenge you the reader to decide and define what it is you want from the market. We do the same when we meet with clients for the firm by discussing their portfolio, goals, expectations and then are able to give an objective solution to fit that - in some cases, that solution for them is in-fact indexing and basic bonds to which is not what we do, but that is a solution for some…but the key is as I see it is deciding what you’re really after first and then deciding on the best solution for that because the markets are NOT one dimensional.

Conclusion

You definitely shouldn’t have a portfolio of only uncorrelated stocks and only a portfolio that is speculative. And, again, you shouldn’t just chase the idea that all stock pickers fail meaning you shouldn’t try either. But, you might consider this approach if you want a truly diverse portfolio that allows you to house multiple strategies under one umbrella while being able to go long/short as needed to generate returns.

If you decide that this is the case The LongVol Report that we publish each Sunday along with the AST Alert Portfolio is an approach to help you to do that.

Thanks for reading,

Dan

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This article is presented for informational purposes only, is an opinion, and is not intended to recommend any investment, and is not an offer to sell or the solicitation of an offer to purchase an interest in any current or future investments. Any such solicitation of an offer to purchase interest will be made by a definitive private placement memorandum or other offering documents.