New Funds in the Portfolio

We recently made a few changes to portfolios and wanted to describe conceptually what these new funds are doing. We purchased three ETFs (exchange traded funds):

• Simplify Volatility Premium ETF (SVOL)
• WisdomTree US Efficient Core Fund (NTSX)
• WisdomTree International Efficient Core Fund (NTSI)

We describe the funds below.

SVOL

SVOL can seem complex on the surface because it uses derivatives such as futures and options to execute the strategy. Conceptually, however, the strategy is quite simple. Most of the fund is simply trying to earn a consistent yield above what you can currently get from bonds. It does this by “shorting the VIX” (also known as the Volatility Index) with a small portion of the fund, which is a bet that volatility will remain low or stable. This can be a very high yielding strategy since the VIX tends to be low or stable most of the time. However, it can be dangerous since spikes in the VIX can happen rather quickly and drastically. For that reason, only about a quarter of the fund engages in it. The rest of the assets are in treasuries to smooth out the volatility.

A strategy like this tends to perform very well in normal environments, however occasionally when volatility quickly spikes (like in March 2020), the portion of the fund that “shorts the VIX” will suffer. As a result, there is one more critical piece to this strategy, called a tail hedge.

When you buy insurance, let us say home insurance for example, you pay small, consistent premiums with the expectation that if anything disastrous happens to your house, the insurance company would have to pay for the damages. A tail hedge can be thought of like portfolio insurance. You pay into it consistently, perhaps monthly, and in most environments, you would not see anything in return. However, in those extremely rare events, say in March 2020 or October 2008 when the market suddenly crashes, this insurance can pay off huge.

A tail hedge is not literal insurance in the fact that there is not a company on the other side collecting premiums and paying claims. In reality, the tail hedge is formed simply by buying aggressive, far out of the money options that would not pay off except for in an exceptional event. Overall, our expectation of the fund is to provide a reasonably high, albeit volatile source of return in normal environments; but also provide some portfolio protection in those rare but dramatic market crashes.

NTSX/NTSI

Like SVOL, NTSX and NTSI also employ derivatives like futures to execute the strategy. The similarities between the funds end there, however, as NTSX/NTSI have a much simpler objective.

One of the most popular benchmarks for portfolio management is the simple “60/40” portfolio. 60/40 simply means that 60% of the assets are in stocks, such as the S&P 500 for U.S. investors, and 40% are in bonds. Our moderate benchmark at WJ, for example, is a 60/40 mix of stocks and bonds.

These funds seek to replicate that “60/40” mix, but with 50% leverage. What that means is that if you put $1,000 into one of these funds, you would be given $1,500 worth of exposure. Applying that same 60/40 mix to the $1,500 gives you $900 of stock and $600 of bonds. Both NTSX and NTSI do the exact same thing, except NTSX buys US Stocks while NTSI buys international stocks.

Our objective with these funds is not to simply leverage the portfolios. While leverage does increase returns, it increases risk by the same amount as well. These funds are called “efficient core” funds because they allow us to be “efficient” with clients’ capital.

What does that even mean? Suppose a client with $1 million wants a 60/40 stock bond mix. Ordinarily we would have to buy $600k of stock and $400k of bonds to fulfill that request. However, with an “efficient core” fund that is 50% levered, you would only have to use 2/3rds of that $1 million ($666,666 * 1.5 = $1 million). That leaves you $333,333 in unused dollars that you can use to buy other investments. That is an efficient use of capital!

Common Theme

The common theme of these funds is that they give us the ability to do things we cannot easily do ourselves. Applying leverage to a portfolio, when used conservatively, can help us to add more diversification to the portfolio without having to sacrifice as much return during the good times. Applying these tools ourselves is difficult operationally and is outside of our core expertise. However, more and more funds like this are being created that can help give us the tools to make a better portfolio.