Building A Recession-Proof Portfolio

The fact that most investment advice is based on just the last 40 years of financial history has always concerned me.

Even today, financial advisors around the world are running around with their hair on fire trying to rationalize to their clients that, while today was technically worse than the worst of 1929, it’s not as bad yet.

Still, as we should know, it’s not about being afraid; it’s about being prepared. 

We are potentially (and likely) at the start of a complex and painful market cycle. 

I know. That’s probably the last sentence we want to hear after it was looking like I maybe we’d see the crypto market hit new highs this year . . . but we need to play the hand we’re dealt. 

So, let’s focus this week on addressing and combating this situation we’re in. 

Today, we’ll focus on recession-proof portfolios as your first line of defense. 

There are a ton of low cost, passively managed, index-tracking model portfolios that allocate a certain percent to gold.

I’d suggest looking at the Permanent, Golden Butterfly and Pinwheel Portfolios on this portfoliocharts page: https://portfoliocharts.com/portfolios/

Backtesting shows that these portfolios have had much lower volatility without too much sacrifice of long term returns. The problem is that part the reason gold has had a negative correlation to the other assets is that when markets have plummeted there has been an irrational flight to gold — the “store of value” narrative only comes into effect after the initial shock and awe, as we saw in 2008. 

But will that always be the case? 

If someone chooses to invest in one of these portfolios it is as if they are betting that decades from now investors will still have the same irrational reaction.

So, I looked for a better “recession-proof” portfolio. My search came across this video about the Dragon Portfolio published by Real Vision Finance a few days ago:

So, unless you want to watch the whole thing, there’s a nice accompanying article that sums up their positions nicely and was a really excellent read: https://taylorpearson.me/thedragon/

Here’s some of their thesis:

“Beginning in the early 1980s, a self-reinforcing serpent of favorable demographics (the baby boomers) and declining interest rates (falling from 19% in 1981 to nearly 0% today) drove asset prices higher and higher.

Baby boomers saving for retirement meant more money flowed into stocks, bonds, and real estate, driving up prices. At the same time, interest rates were decreasing, causing individuals and companies to take on more debt, some of which were used to buy those same assets, further increasing prices.

Today, the situation looks quite different. The first wave of boomers began retiring in 2017. Over the next decade, more boomers will sell their serpent assets (stocks, bonds and real estate) to fund their retirement. On the interest rate side, it’s anyone’s guess where rates will go from here. We do know that they are at historic lows already.

No one knows how this will all end. The essential point is that you don’t need to know what will happen to build a portfolio that will outperform over the next century, you just need to build a diversified portfolio that can thrive in all market regimes.

The classic 60/40 Equity/Bond portfolio is highly reliant on assumptions based on a once-in-a-century bull market in Stocks and Bonds from 1984 to 2020. 

Such risky, serpent portfolios perform well during secular booms (1947-1963, 1984-2007, 2010-2019). However, they are based heavily on the belief that stocks and bonds will remain uncorrelated — that bonds will go up when stocks go down. This has been true since 1984, but not over the last 100 years.

In fact, stocks and bonds have been moderately or highly correlated in 89% of months going back to 1883.”

They go on to describe their “Dragon” portfolio:

“Assets like long volatility, gold, and commodity trend following, which most investors have no or very limited exposure to, should be core portfolio holdings. 

According to Artemis’s research, the optimal portfolio from 1929 to 2019 was:

Domestic Equity (24%)

Fixed Income/Bonds (18%)

Active Long Volatility (21%)

Commodity Trend Following (18%)

Physical Gold (19%)

This allocation is highly unorthodox compared to a traditional pension portfolio dominated by Equity-Linked assets (73%) and Fixed Income (21%), or a 60% stock/40% bond portfolio that is frequently recommended to individual investors.”

While a lot of the ideas they discuss are novel and interesting, the Dragon Portfolio is compared to a risk parity portfolio and shows far better performance, which is highly misleading in my opinion. While it isn’t stated anywhere explicitly, it seems the risk parity portfolio model in the paper’s charts lacks any gold, which probably would make the Dragon Portfolio much worse in comparison.

The truth is, that the dragon portfolio isn’t really anything else than a risk parity portfolio is.

The risk parity approach attempts to avoid the risks and skews of traditional portfolio diversification, allowing an optimal portfolio considering the volatility of the assets included in the portfolio.

Risk parity is primarily coined by Ray Dalio and applied in his all-weather portfolio (which in fact does contain a chunk of gold).

Dalio’s philosophy on the world is one of risk. If you read his book “Principles” it becomes clear that being blindsided by risk early in his career led him to drastically rethink his approach, and ultimately come up with strategies like the All Weather Portfolio.

The strategy is pretty basic. It’s designed to do well in times of growth and in times of economic stress. This portfolio allocation performs well over history, and significantly better over most financial crises than both traditionally weighted portfolios, and any attempt I’d be able to achieve to try and time market swings.

The way the Dragon Portfolio differentiates itself is by using commodity trend instead of commodities and volatility as an additional asset.

“Commodity trend” basically is the same as “commodity momentum”: If commodities are trending up, you go long and if they are trending down, you go short. Commodity trend roughly correlates with commodities (so it doesn’t really differ from a typical risk parity portfolio), but the paper claims it has a far better performance.

“Long Volatility” bets on volatility in the market by purchasing out-of-the money put and call options. It’s basically a bet on big swings in the market, which acts as an insurance when the rest of the portfolio is hit by those swings. It seems to me like a clever idea to have this kind of asset as a negatively correlated asset.

The traditional method for investors to access Long Volatility and Commodity Trend is through a private hedge fund, but the minimum investment amounts on those can reach into the millions.

Alternatively, there are some publicly traded funds that do different versions of Commodity Trend:

 

Rational/ReSolve Adaptive Asset Allocation Fund Class I (RDMIX)

PIMCO TRENDS Managed Futures Strategy Fund Institutional Class (PQTIX)

Natixis ASG Managed Futures Strategy Fund Class Y (ASFYX)

LoCorr Market Trend Fund Class I (LOTIX)

Goldman Sachs Managed Futures Strategy Fund Institutional Class (GMSSX)

 

There are a few publicly tradable vehicles for long volatility:

 

Quadratic Interest Rate Volatility and Inflation Hedge ETF New (IVOL)

Cambria Tail Risk ETF (TAIL)

 

In each of these buckets, it is likely a better approach to combine several different assets in a mosaic approach. This helps protect against any individual asset not performing as expected.

While commodity trend and long volatility strategies seem like a great addition to a more traditional risk parity portfolio, they are insanely hard to implement, if you don’t have a solid knowledge about derivative trading + a lot of time for implementing those strategies — or access to private equity. 

Essentially, the Dragon Portolfio is basically the same as All-Weather by Ray Dalio. 

It has some nice ideas which are virtually impossible to implement for mere mortals. Further, it compares itself to a risk parity benchmark, which seems misleading to me. The paper is still worth reading, if only for it bashing the “buy and hold stocks, because of long term outperformance”-mentality.

So, as always, there’s no perfect answer because your risk tolerance, time horizon, and many other factors influence your decisions. Hopefully, this has given you some ideas about how to restructure or at least build a portfolio going forward that will better weather the storm.