Risk Parity Radio

Episode 396: We're Talkin' Futures, Backtesting Considerations, And That Big Mo (Again)

• Frank Vasquez • Season 5 • Episode 396

Share episode

In this episode we answer emails from Lucas, Martijn, and Alexi (a/k/a "the Dude").  We discuss futures contracts and the efforts required to use them, being careful about backtests and interpreting them, and more musings on Big Mo momentum.

Links:

Father McKenna Center Donation Page:  Donate - Father McKenna Center

Martijn's Link:  testfol.io/?s=aoTgPMqhGQA

Portfolio Matrix (Start Date Sensitivity):  Portfolio Matrix – Portfolio Charts

The Dude's First Link:  Asset Correlations

The Dude's Second Link:  testfol.io/?s=aKrdp1uCnEu

The Dude's Third Link:  testfol.io/?s=kUK5djVum0A

Amusing Unedited AI-Bot Summary:

Unlock the secrets of futures trading and leveraged ETFs as we tackle complex investment strategies, inspired by a thought-provoking listener email from Lucas. Discover how you can master the intricacies of futures contracts, from rolling them over to navigating market conditions like backwardation and contango, without getting overwhelmed. Learn why leveraged ETFs were created to simplify leverage acquisition, and get insider recommendations on the best platforms to embark on futures trading. Martain, another keen listener, challenges us with a debate on straightforward 1.5 times equities strategy versus modern portfolio theory, leading to a rich discussion on investment approaches.

Venture further into the world of leveraged risk parity portfolios and how hedge funds are using them to optimize risk-reward profiles during the accumulation phase. Comparing these advanced strategies to more straightforward leveraged S&P portfolios, we emphasize the essential role of historical data in shaping robust investment decisions. Be wary of the allure of short-term gains as we dissect the role of momentum funds in risk parity portfolios and the significance of diversification in securing stable outcomes. Through listener insights and expert analysis, this episode is a treasure trove for anyone seeking to broaden their understanding of strategic investing.

Support the show

Voices:

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.

Mostly Uncle Frank:

A different drummer.

Mary and Voices:

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:

Thank you, Mary, and welcome to Risk Parity Radio. If you are new here and wonder what we are talking about, you may wish to go back and listen to some of the foundational episodes for this program.

Voices:

Yeah, baby, yeah.

Mostly Uncle Frank:

And the basic foundational episodes are episodes 1, 3, 5, 7, and 9. Some of our listeners, including Karen and Chris, have identified additional episodes that you may consider foundational, and those are episodes 12, 14, 16, 19, 21, 56, 82, and 184. Whoa, and you probably should check those out too, because we have the finest podcast audience available.

Mary and Voices:

Top drawer, really top drawer.

Mostly Uncle Frank:

Along with a host named after a hot dog.

Voices:

Lighten up Francis.

Mostly Uncle Frank:

But now onward to episode 396. Today, on Risk Parody Radio, we're just going to do what we do best here, which is attend to your emails, and so, without further ado, here I go once again with the email. First off. First off, we have an email from Lucas. Use the force Luke, and Lucas writes.

Mary and Voices:

Hey, frank and Mary, happy 2025. Any thoughts and experience using futures? I was debating rolling futures for long-term holding instead of using three times or two times leveraged ETFs. I know they have S&P, gold and treasury futures, but not sure how to compare performance. I also use Fidelity, which doesn't have access to futures. Thanks, as always, lucas.

Mostly Uncle Frank:

Well, first off, lucas has used the force to move his email to the front of the line. The force is strong and the way you do that is by donating to our charity. As most of you know, we do not have any sponsors on this podcast. We do have a charity we support. It's called the Father McKenna Center and it supports homeless and hungry people in Washington DC. Full disclosure I am on the board of the charity and am the current treasurer, but if you donate to the charity, you get to go to the front of my email line.

Voices:

Yeah, baby, yeah.

Mostly Uncle Frank:

There are two ways to do that. You can do it through the support page at wwwriskparadisecom and become one of our patrons on Patreon. Or you can go directly to the Father McKenna donation page website and donate there. Either way, make sure you mention it in your email, in the subject line or otherwise, and I will move you to the front of the line. That is the straight stuff. Oh, funk master. But now getting to your email. Well, lucas, a long time ago and in a galaxy far away, I did trade futures. This was back in the 1990s, pre-internet. He did this on the phone, 1990s, pre-internet. He did this on the phone, never his mind on where he was, hmm, what he was doing. But the thing about futures contracts is they have a tendency to expire.

Voices:

That is how they are arranged by date, and so they either need to be closed out or rolled over or some combination thereof, and you also need to learn fun terms like backwardization and contango.

Mostly Uncle Frank:

Which, despite the way it sounds, is actually not a dance, but is the description of a time series of contracts on a curve, so you could use futures contracts to do all kinds of things. But it would be a lot of work and I'm not sure you want that job.

Voices:

I don't think I'd like another job.

Mostly Uncle Frank:

Because it actually takes a lot of time and effort to do. Well, and it's funny. One of the reasons these leveraged ETFs exist was to make it easier for people to get leverage without having to trade futures contracts and options contracts.

Voices:

That's the fact, Jack. That's the fact, Jack.

Mostly Uncle Frank:

Because all of those are methods of achieving leverage. You are also correct that it's very difficult to compare performance because you have to assume some kind of trading pattern and then it's not easy to do a backtest on some personal trading pattern that you've come up with. So that's even more complications Inconceivable. If you do want to do this, I suggest you not do it at Fidelity. They're really not set up for that. You really need a place where people trade a lot, and interactive brokers is probably your best bet, because it's otherwise also a very good platform. But if you're really interested in it, I would take some money and put it in an account and start trying to do it to see if you really want to do it, because it's a big pain it really is, unless you are really into the day-to-day monitoring of these things. Anyway, good luck with it. If you try it, alright.

Voices:

I'll give it a try, no try, not Do or do not.

Mary and Voices:

There is no try.

Mostly Uncle Frank:

And thank you for your email. I'm not afraid.

Voices:

Yeah, you will be.

Mostly Uncle Frank:

You will be. You will be second off, second off. We have an email from Martain, and Martain writes hi.

Mary and Voices:

Today you suggested in reply to my question to simply take 1.5 times equities. Why not apply modern portfolio theory? Here's what I have in mind, myself in the meantime.

Mostly Uncle Frank:

So this is referring back to episode 377. I'm sure you all had that on the tip of your tongues and memories. Surely you can't be serious.

Voices:

I am serious, and don't call me Shirley.

Mostly Uncle Frank:

But Martain had written in about essentially using a leveraged kind of risk parity portfolio in an accumulation phase, and my answer is yes, you can certainly do something like that. That is what hedge funds do, but for most people, you'd probably be better off just taking some small amount of leverage on the S&P. So you are technically correct. You are correct, sir. Yes, that the very best strategy would be what hedge funds try to do with risk parity portfolio switches Create them and then add leverage to them to make them perform better, to achieve the best risk-reward on an efficient frontier, and so this is all part of the same kinds of analysis whether you're going straight back to modern portfolio theory, how that leads to the efficient frontier, and then why people have come up with strategies like risk parity to get yourself on the efficient frontier somewhere. The devil is always in the details, though, because in order to apply modern portfolio theory, you have to assume performances of the assets involved, and you can literally just assume them, put in numbers you get from somewhere, or you can use historical data, and then you can use that in the way that it presented historically, or you can mix it up and do other things. So there are infinite variations, but it's really the data itself that determines the outcome. This link in the show notes and what you see is some sample portfolios from 1995 until now showing how a risk parity style portfolio outperforms a lot of other suggestions, levered portfolios or traditional portfolios or things that are just 100% stocks and part of that is, yes, these are good portfolios to hold for a variety of reasons, but the other part is the time period that you're actually using here and the shorter it gets when it incorporates that first decade of the early 2000s, the more these diversified portfolios are going to look better than simple portfolios, at least on an overall performance basis, and you can see that by changing the dates of the analysis. If you go right after the financial crisis and put in the same things, you'll see that your levered risk parity style portfolio actually greatly underperforms some of these other simplistic S&P 500 levered portfolios.

Mostly Uncle Frank:

But all that is really showing you is that the less data you have, the less confidence you should have in the overall conclusions and you should dampen down your expectations. And that's kind of a paradox or a truth about having a more diversified portfolio with more types of assets than just a heavy stock, concentration assets than just a heavy stock concentration, and that is most years. The heavy stock concentration portfolio is going to outperform the more diversified portfolio, at least on a nominal basis, and that's because the stock market goes up about 70% of the time. So, in 70% of the years, the more diversified portfolio is going to underperform the less diversified and stock-heavy portfolio. What you are really getting, though, is when you get to those bad years that 30% of the time, or that one in three decades, which seem to come about every 30 years or so then you do see the more diversified portfolio greatly outperforming the less diversified, more stock heavy portfolio, and that is, in particular, why, in the data you're looking at with this back test, which has an early concentration in one of these bad decades, makes the more diversified portfolio look even better than it is, because, essentially, what's going on in that time series is there's zero or negative performance of the stock-based portfolio in that entire decade, and since that is a great proportion of the entire time series, that dominates the overall performance.

Mostly Uncle Frank:

Conclusion conclusion this is also why you want to use multiple calculators and multiple time series for your analyses, particularly comparative analyses, where you're comparing one portfolio to another, because the more different calculators you can use with the more varied time series and the more different kinds of Monte Carlo applications that you apply to this. If you are getting the same answer over and over again, that portfolio A always seems to outperform portfolio B, or the vast majority of the time, that is really what you're looking for, that kind of answer, but you do need to be mindful of what those particular periods or that particular data that is in your analysis set is like and what kind of portfolios performed well in that kind of economic environment at that particular time. What really happens in popular personal finance is that people look at the last decade or so as indicative of all future performance.

Voices:

Are you stupid or something?

Mostly Uncle Frank:

And that's where people tend to get in trouble.

Voices:

Fat, drunk and stupid is no way to go through life, son.

Mostly Uncle Frank:

So they get greedy chasing on whatever's performed the best in the short term and then they get their head handed to them subsequently after that because markets change. But what is popular today in a lot of personal finance circles is what I would call a fear and greed portfolio. The greed part is a large concentration on large cap tech stocks, since they've greatly outperformed for 15 years now and some people have convinced themselves that it's going to be like that forever. The fear part of that is this kind of all or nothing approach to this. So the only other thing that they will hold in their portfolio with their high concentration of large cap tech stocks is cash or something that's highly correlated with the tech stocks, like cryptocurrencies, and so whatever is the popular thing to do tends to persist as long as it works and then, when it stops working after about five years, people start looking around for other things.

Mostly Uncle Frank:

But it's almost like the same process of chasing the hot thing or the most recent hot thing goes over and over again. I think a lot of it has to do with the fact that you get these trackers of funds that show you one, three, five and 10 years of performance data and people use that to pick assets, and that is exactly the wrong thing to do, because 10 years of performance data particularly when it's only fund-based and not asset class-based is just noise, as Ken French would say. So you really do need to be talking about 25 years plus of data before you start getting things that are even meaningful in any respect. One of the least understood metrics for evaluating portfolios is something called start date sensitivity.

Mostly Uncle Frank:

It is actually in the portfolio matrix tool at Portfolio Charts, but basically what that is asking or answering is how often does this thing perform close to its average performance, and how much deviation does it have from that, depending on when you start the time series, and you can check that out on Portfolio Matrix. But what you generally find is that more well-diversified portfolios tend to perform similarly regardless of when you start them, whereas less diversified portfolios tend to be all over the map depending on when you start your analysis. So that's also something to think about. Anyway, I'll let people check these out in your link and thank you for your email.

Mary and Voices:

My mom always said life was like a box of chocolates.

Voices:

You never know what you're going to get. Last, off.

Mostly Uncle Frank:

Last off, we have an email from Alexi.

Voices:

So that's what you call me. You know that, or His dudeness or Duder, or you know, bruce Dickinson, if you're not into the whole brevity thing.

Mostly Uncle Frank:

The dude has been very prolific in December, but always has interesting things to say.

Voices:

What is this Wonka? Some kind of fun house. Why having fun?

Mary and Voices:

And this time the dude writes hey, frank, I really enjoyed your revisiting of the role momentum funds in risk parity portfolios. On this week's episode, some thoughts. I still feel momentum really ought to work, particularly QMOM, based on its fairly low correlations to other equity styles. We can see that QMOM has a correlation to SCV of about 0.7 and a correlation to LCG of about 0.75. Not bad and not too different from LCG to SCV correlation of about 0.64. But at least recently there's no debate. It really doesn't add anything to the mix.

Mostly Uncle Frank:

Forget about it.

Mary and Voices:

Here's a back test that pairs SCV with either a 50-50 mix of AMOM, slash QQQ or an equal weight of the SCV-LCV-AMOMX, lcv, lcv, amomx. I'm using AMOMX as it's the oldest momentum mutual fund I know of. Momentum truly brings nothing to the table in terms of return augmentation or risk reduction. Some thoughts One we only have 12 years of data on momentum funds to backtest. That's a real problem. How did MOMO do in the 70s relative to LCG, I wonder? One can imagine momentum doubling up on the value cowbell and really helping out equity performance in such a regime.

Voices:

I'll be honest, fellas, it was sounding great, but I could have used a little more cowbell.

Mary and Voices:

Two during the time period where we can compare momentum, lcv has been on a run for the ages. Witness this comparison of QQQ, s&p, scv and SCV slash QQQ. Observation One QQQ creams everything else, so, logically, any asset that is substituted for QQQ is going to be a drag on any portfolio in this time frame, at least in terms of compounded annual growth rate. Two check out the length and depth of the QQQ drawdown from 2000 to 2015. Yikes A 100% LCG portfolio would be an absolute nightmare for a portfolio in terms of safe withdrawal rates. Az.

Voices:

Man, I've got certain information, all right, certain things have come to light and, you know, has it ever occurred to you that, instead of, you know, running around blaming me, you know, this could be a lot more complex. I mean, it's not just. It might not be just such a simple. You know, what in God's holy name are you blathering about?

Mostly Uncle Frank:

All right. What the dude is referring to in this email is episode 387, where we did review and talk about momentum, momentum funds and how you may or may not try to incorporate it into a diversified portfolio. I won't revisit all of what we talked about there or in past episodes, but suffice it to say I agree with you that it sounds like momentum ought to work for something, but I find it very difficult to actually incorporate it into too many things. To me, it does go back to the fact that there is no kind of one set definition for momentum. People are generally agreed on what is a growth asset and what is a value asset, but in terms of how they would structure a momentum strategy, things are just all over the map, and especially in terms of what time period you're looking at for assessing momentum. Is it one week momentum? Is it one month momentum? Is it six month momentum? You're going to get different strategies and different outcomes for all of those kinds of approaches, outcomes for all of those kinds of approaches.

Mostly Uncle Frank:

And to me momentum does seem to go mostly with growth, because you tend to see, over a period of years, like we're having now and you saw in the late 1990s, these growth stocks can go on quite a run and you can have these 20% plus performances back to back over a couple of years, or even more than a couple of years. Of course, that's generally followed by a crash at some point, which I think gets to your final observation is that just using large cap growth in a drawdown portfolio is kind of a recipe for disaster due to its inherent volatility. Anyway, I will put all these links for people to check out and consider, and thank you for your email. Take it easy, dude.

Voices:

Oh yeah.

Mostly Uncle Frank:

I know that you will.

Voices:

Yeah well, the dude abides the dude abides.

Mostly Uncle Frank:

But now I see our signal is beginning to fade and I'm afraid I'm off to the dentist today. You get to my age and they have to keep rebuilding your mouth.

Mary and Voices:

Death stalks you at every turn.

Mostly Uncle Frank:

We're on the third time for some of these crowns and fillings and things that hurt?

Mary and Voices:

no, I just think it would should take better care of your teeth. You have a quite a cavity here. Is it safe? Look, I I tell you I can't you think he knows.

Voices:

Of course he knows. He's being very stubborn.

Mostly Uncle Frank:

But if you have comments or questions for me, please send them to frank at riskparityradarcom. That email is frank at riskparityradarcom. Or you can go to the website wwwriskparityradarcom. Or you can go to the website wwwriskparityradarcom. Put your message into the contact form and I'll get it that way. We're currently just over a month behind In our email queue, but we will get to yours eventually. If you haven't heard it yet, and in the meantime, if you haven't had a chance to do it, please go to your favorite podcast provider and like subscribe. Give me some stars, a follow, a review. That would be great, okay, thank you once again for tuning in. This is Frank Vasquez with Risk Clarity Radio.

Mary and Voices:

Signing off 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.

People on this episode

Head Shot

Frank Vasquez

Host