Bread Vs. Cake Part II

October 22, 2009


Although corporate bond prices seem to be weakening, this was a fundamental trade. It was not a technical move. M&A should provide less risk than corporate bonds if a market panic returns. MERFX’s worst loss in 2008 was about -18 percent, while HYG and LQD experienced maximum drawdowns of -34 percent and -29 percent, respectively (Figure 4). ARBFX’s drawdown was a little less than MERFX’s. Longer term, we expect M&A funds to provide 7-10 percent in annualized returns, which is much better than our expectations for HYG and LQD.

On Oct. 1, 2009, we added 6 percent to gross exposure (3 percent before imbedded leverage) to the ProShares UltraShort 20+ Year Treasury ETF (NYSEArca: TBT) at $43.25, which brings our exposure to near 24 percent (Figure 5). Our original weighting was 20 percent before selling some shares at $58 on June 10, 2009.

We seek to buy the NASDAQ 100 Index (the PowerShares QQQQ) at $39 and $37 (each trade equals about 7.5 percent of gross exposure). Portfolio beta will be limited until year-end, when we rebalance assets (Figure 5).




Cusp beta = assets whose prices do not normally synchronize with stock prices. For much of this summer, the Reuters/Jefferies CRB Index (commodities) and the United States Oil Fund, LP (USO) decoupled from stocks, while gold continued to advance with the S&P 500 Index ($SPX). We are long energy shares (PowerShares Dynamic Oil & Gas Services (NYSEArca: PXJ) and Energy Select Sector SPDR (NYSEArca: XLE)) which is primarily beta (things that usually move with $SPX). We are long agricultural commodities (PowerShares DB Agriculture (NYSEArca: DBA)), gold (SPDR Gold Shares (NYSEArca: GLD)) and gold stocks as a source of cusp beta.



When we manage risk, we factor beta and cusp beta as a single source of return that is directionally correlated with $SPX price trends (Figure 6). The above examples represent 37 percent of the AI 75/50 Portfolio’s gross exposure, which total 127 percent (Figure 13).

Gold will decouple from stocks if its currency value is prized more than its inflation hedge value when and if deflation risks reappear, which is one instance when gold might lose its cusp beta status; another instance would be severe inflation. Severe deflation or severe inflation would also cancel cusp beta for commodities.


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