Risk Update – July 2020

A Reuters article mid-month titled “Global debt hits record high of 331% of GDP in first quarter: IIF” got us thinking a bit.

In a world with that much debt outstanding, that has just gone through an unprecedented negative GDP shock (Figure 1), what choice do policy makers have other than extreme financial repression? We’ve written a lot about the explosion of Central Bank interventions in markets, and the increased accompaniment of fiscal side stimulus, sort of de facto shifting a significant portion of the world into some form of Modern Monetary Theory (MMT), which as we always point out is neither modern, nor a theory.

[Quick side note, along with our past note on MMT https://convex-strategies.com/2020/01/10/risk-update-november-2019/ we would also like to recommend a look into a new book by leading MMT advocate, Stephanie Kelton, entitled The Deficit Myth. It is generally considered to be very clear and approachable, and based on a review from our old friend Dylan Grice does indeed lead to the conclusion that MMT is neither modern, nor a theory.]

Figure 1: US and Eurozone Y-o-Y GDP

Source: Bloomberg

Figure 2 showing US Treasury 10yr Real Yields makes it pretty clear that financial repression is exactly what they are going for. We’ve overlaid that with the inverted Gold (XAU) prices to show the logical relationship between those two items, ie. financial repression is simply currency debasement, or broadly speaking inflation.

Figure 2: US 10yr Real Yields and Gold (inverted)

Source: Bloomberg

Going back towards the end of the previous cycle, just before the Fed decided it was necessary to cut rates to zero and commence the mindless exercise known as Quantitative Easing (QE), how would respective investments have done in US Treasuries (the thing the Fed, mostly, is buying) versus the inverse of the thing they are printing (USD), Gold? While certainly not as stable as sitting on a book of Treasury Bonds, there has been a lot more upside to holding the shiny metal, the inverse of fiat currency.

Figure 3: US Treasury ETF vs Gold ETF (normalized)

Source: Bloomberg

In the great big world of wealth management and institutional investing, which more or less universally revolves around a core premise of the “Balanced Portfolio”, it is pretty safe to guess that there is a lot more (dead) capital tied up in Fixed Income, due to its supposed portfolio benefit thanks to the modern era phenomenon of Central Bank reaction function, than there is holding Gold as an alternative.

Some of you may recall that, right at the end of our January update, we slid in a sample portfolio that included Gold – https://convex-strategies.com/2020/03/12/risk-update-january-2020/. In that note we labelled the portfolio Convex++, but in general when we are talking about it we simply call it the “Dream Portfolio” – Long Equities, Long Vol (2x levered, “always lever the hedge”), Long Gold. Looking backwards, it appears one would have done quite well on a compounding basis by replacing the Fixed Income component of your Balanced Portfolio (we use 60% Equities/40 Fixed Income below) with Long Vol and Gold in a Dream Portfolio (60 Equities/40% Long Vol/20% Gold).

Figure 4: “Dream Portfolio” vs Balanced Portfolio

Source: Bloomberg, Convex Strategies

Gold, along with being the anti-Central Bank wunderkind, has an interesting correlation with Equities. Interesting in that it is very inconsistent, fluctuating regularly between +50% and -50%, making it quite a useful portfolio compliment. Importantly, Gold also has unbounded, potentially infinite, upside. You can’t really say the same about Bonds as their yields approach zero. Of course, Bonds have had an all critical negative correlation to Equities over more recent decades (again, thanks to Central Banks), but at some point the reliance on that starts to become a self-criticality type risk in its own right – note the third week of March this year.

Figure 5: SPX vs Gold Correlation

Source: Bloomberg, Convex Strategies

Figure 6: SPX vs US Treasury Correlation

Source: Bloomberg, Convex Strategies

As we discussed, again, in our April 2020 Update (https://convex-strategies.com/2020/05/21/risk-update-april-2020/) the preponderance of wing returns, both up wings and down wings, during the End-of-Cycle risk unwinds and subsequent recoveries, is where the compounding benefits of convexity in an investment portfolio really start to show. This would seem to be the case in Figure 4 above with the Dream Portfolio versus the Balanced Portfolio. The period of separating compounding, of the relative performance as wing returns are realized, appears to have just started again.

The latest annual announcement by Singapore’s Government Investment Corporation (GIC), considered a leading light in the world of Sovereign Wealth Funds, gives some insights into the challenges that fiduciary managers face, both in terms of their long term strategies, as well as in the current global circumstances.


We regularly simplify these “challenges” in what we might term our “It’s Just Math” series on convexity, and its importance in compounding capital. This theme, naturally, runs throughout all of our musings, but can be followed through these series of Updates – May, August, October 2019.


We update below, through June 2020, our adapted version of the old University of Chicago presentation. Very simply, this is just comparing the hypothetical realized returns of a (not uncommon) concave/negatively convex return portfolio versus a simple 0.6x beta to the SPX index. The point of this is simply to show the impact of performance in the wings on the compounding of capital. It’s just math.

Figure 7: Hypothetical Concave vs 60% Beta Benchmark Annual/Arithmetic Returns

Source: Convex Strategies

Figure 8: Hypothetical Concave Portfolio vs 60% Beta Benchmark

Source: Convex Strategies

Figure 9: Hypothetical Concave vs 60% Beta Benchmark Compounded/ Geometric Return

Source: Convex Strategies

Compounding is driven by performance in the wings. What drives the above sort of implied compounding destruction?

  • Fees and expenses. Costs in general, but particularly fees that are linked to correlated returns. Paying away 10-20% of the upside returns of correlated risks, but keeping 100% of the losses, is a sure way to impair compounding.
  • Investment exposures with bounded, seemingly uncorrelated, upside, but unbounded correlated downside, eg carry trades, short volatility, levered low vol type strategies. It is easy enough to picture the orange dots in Figure 8 as approximating the payout of a short put option, that now infamous analogy of Hedge Fund performance net of fees.
  • Short term return objectives. The incentivized targeting of probabilistic “expected returns”, as opposed to long term compounded returns, creates a focus on performance at the centre of the probability distribution, not the wings.
  • Pro-cyclical Gaussian based risk methodologies, eg. Value-at-Risk type constructs that encourage risk taking when valuations are high, and vice versa. Think of it as negative gamma risk management, buy high and sell low.

Figure 10: Dream Portfolio vs HFRX Index

Source: Bloomberg, Convex Strategies

Just to remind folks of the mathematics, Figure 11 shows the implication of flipping the hypothetical concavity to convexity. This, to our minds, is the absolute number one key to improving compounded returns in a portfolio. Not timing. Not asset allocation. Not factor modelling. Not the latest hot investment strategy. Yet, we struggle to find anything from fiduciary asset managers or wealth advisors discussing their efforts to improve convexity in their investment strategies. We do, on the other hand, see quite a lot discussing all the other stuff!

Figure 11: Hypothetical Concave and Convex vs 60% Beta Benchmark

Source: Convex Strategies

Figure 12: Hypothetical Concave and Convex vs 60% Beta Benchmark Compounded/Geometric

Source: Convex Strategies

Our view remains the same. During the last 15 years, probably the greatest period in history for the Balanced Portfolio, with equities to all-time highs and interest rates to all-time lows, we believe investors still would have done (much) better being in a positively convex portfolio that includes a long volatility component. Looking forward 15 years, now with interest rates in the vicinity of zero, we suspect replacing the disappearing portfolio benefits of fixed income with the explicit risk mitigation of long volatility, allowing a greater allocation to growth/risk assets, makes even greater sense. If, as we suspect, we are in an end-of-cycle type tug-of-war between risk-unwinds and policy stimulus, then we are likely to continue to see outcomes realize in the wings, meaning the compounding benefits of convexity are getting delivered now. We don’t know if policy makers will succeed in maintaining, even expanding, historical extremes in asset prices, or if they will be overwhelmed by the ‘unprecedented debt burden meets pandemic cash flow’ catastrophe. Either way, we are convinced the right answer is convexity and compounding. Have to say it again – IT’S JUST MATH!

Figure 13: Volatility / Correlation ‘Comet’

Source: JP Morgan, Convex Strategies

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