Is long vol a better risk asset hedge than a 60/40 traditional asset allocation? Question posed by @Ksidiii and one we touched on in earlier convo. A thread on my opinions. 1/x
First, 60/40 (which I'm using as shorthand for a bond allocation; the exact % may vary) has a long history, and works very effectively when equities and rates have positive expected returns and when their correlation is <1 or better yet negative. 2/x
Second, long vol positions as an allocation have a shorter-but-still-long history of delivering significant boosts to long run returns when tail events occur--e.g., Mar 2020, Sep 2008, etc. 3/x
The theory is clear, and there have been *a few* great investment managers with small, managed long vol exposures that have delivered tremendous boosts to long run portfolio performance by generating $$$ when equities tanked, and allowing investors to BTD, basically. 4/x
The primary difference in a portfolio allocation to FI vs. long vol is that FI is positive carry, while long vol is negative carry. You get paid to own bonds, and you pay to buy insurance. Bonds usually pay off, and insurance covers tail risk. 5/x
Some good FI managers outperform, and so the positive carry is great. Some good vol managers outperform, and so the negative carry isn't as painful. Both of those give a little edge to long run portfolio returns. 6/x
I believe we as an investing culture should evaluate strategy by some generic benchmark for each asset class, and tactics by success of an investor or manager against the benchmark of each asset class. Blah blah blah b/c of portable alpha and TRS. 7/x
In that light, whether FI is "better" for portfolios than long vol depends on return of some generic bench for inclusion in portfolios for each, not about whether a manager is a "good" manager in either strategy. 8/x
In that light, and b/c must evaluate strategic allocation based on passives, positive carry FI beats out passive negative carry long vol every time...because of carry. 9/x
BUT that shouldn't preclude TACTICAL long vol positions when market conditions make that a reasonable r/r in the short term. 10/x
Maybe now is such a time, b/c expected returns in rates are relatively low and long vol is relatively cheap, but that's not an ALLOCATION decision, it's a TACTICAL one. And that's what I'm cooking tonight. 11/11 fin.
PS: This is probably the sort of opinion that deserves an academic paper with a lot more supporting evidence and historical returns, but I'll leave that to someone more patient than I.

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More from @lebas_janney

22 May
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It was a big help! 1/x
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I've spent a lot of time throwing rocks lately, so I'm going to try and be a little constructive and talk about negative interest rates.

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