One thing we try to do with our 2025 Outlook: Animal Spirits, which we released last week, is translate our views into portfolio actions, since that’s ultimately what matters. You won’t have to dig far to see how our Carson House Views are woven throughout, making it convenient to access advice and insights that align with a consistent market narrative.
As we wrote in our Outlook, we think that economic strengths clearly outweigh areas of weakness, and the opportunities likely have a higher probability of coming to fruition than the threats. We believe that economic momentum, an easing Federal Reserve (Fed), and pro-growth fiscal policy will continue in 2025, but we may also get a lift in the national mood that economists call animal spirits. As a result, we expect this young bull market to continue in 2025 and recommend an overweight to stocks.
At the same time, we also remind the reader that the largest peak-to-trough pullback in 2024 was only 8.5%. So, prepare for a likely double-digit correction at some point during the year. We would also note that our views lie on a probability continuum and are neither 0% nor 100%. In short, we could be wrong — or there could be a potential black swan event (which by definition, is not predictable). So while we like equities, and are overweight, we still recognize the need to diversify the portfolio in the event that things go awry. But how is the question.
Which Is the Best Diversifier of Them All?
One of the deepest scars of 2022 was the failure of bonds to act as a diversifier. The bond market had the worst year in its history during a stock bear market. It doesn’t matter if bond prices will move back to par over time — bonds didn’t do their job when many investors needed them most.
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Looking back at the history of major stock declines, bonds — long-dated Treasuries in particular — have often been one of the best diversifiers during stock selloffs, but not always. Broad commodities often see sharp declines during equity selloffs, but in 2022, commodity exposure was a far more powerful diversifier than fixed income. And gold was also a better diversifier than either during the Great Financial Crisis and in 2018. The point is that bonds, especially long maturity Treasuries, are often an effective diversifier during stock declines, but it does depend on the environment, and bonds aren’t the only diversifier.
Bonds struggle as a diversifier when 1) rates are low, 2) inflation moves higher and 3) the Fed has to aggressively raise rates. The first condition has substantially improved. Our starting point on the third is already fairly elevated. Inflation is the main risk, but even in that case, we have a better environment. Still, given inflation uncertainty, we continue to recommend diversifying beyond bonds, including asset classes like managed futures and gold. But that does raise the question as to how to make room in the portfolio for all of these diversifiers, given we’re also overweight equities.
Enter Capital Efficiency
Say we have 70% of a portfolio allocated to stocks and 30% to bonds. A deflationary recession may be unlikely in our view, but still possible, and so that is the level of bond exposure we think sufficient to diversify the equity overweight (relative to a 60% stocks — 40% bonds portfolio). Yet, along the same vein, there is also some likelihood of an unexpected resurgence of inflation, in which case we’d want to have some managed futures in the portfolio. The only way to “make room” for that is to reduce the equity overweight, or the bond allocation, neither of which is something we want to do.
The good news is that we can do this using exchange-traded products (ETFs) like WisdomTree’s Efficient Core portfolios or Newfound/Resolve’s return stacked portfolios (full disclosure: we have been using these funds for years now). As an example, what this allows us to do is achieve $1 of exposure to equities, while also achieving $1 exposure to bonds. So, if we hypothetically allocate say, 10% of our equity allocation to a more capital efficient solution, we achieve 10% of equity exposure PLUS 10% of bond exposure. That frees up 10% of the bond allocation to allocate to managed futures, since the bond allocation can be reduced from 30% to 20%.
Of course, the question is how capital efficiency, or “return-stacking,” is achieved. The answer is leverage, via futures contracts. Leverage is usually a dirty word in our business, mostly because it’s often used to amplify similar or identical bets and that can turn ugly when there’s volatility (example, investing a $1 in a stock, and borrowing $1 more to invest in the same stock). However, for capital efficiency, the extra dollar that is borrowed is invested instead in a typically uncorrelated asset (like bonds, or even managed futures).
There is also the question of financing rate for the money borrowed. Interest rates are much higher now, but as the folks at Newfound/Resolve explain, borrowing rates are much more competitive when you use futures. They also point out that as long as you expect risky assets (like stocks and bonds) to have a positive return in excess of cash, the level of interest rates should not matter to applying leverage to capture the risk premium (as you can do with futures).
As I wrote at the top, we’re optimistic about the outlook for stocks in 2025. But we also believe bonds are likely to outperform cash. Here’s a hypothetical illustration of how we seek to diversify our diversifiers using capital efficiency, as opposed to the traditional approach where we have to sacrifice one of our diversifiers (either bonds or managed futures).
An Old Idea
Capital efficiency is not a new idea. It’s similar to one explained by Cliff Asness, co-founder of AQR Capital Management, in 1996. In a rather tongue-in-cheek response to the question “Why not 100% equities?”, he argued that an investor willing to bear the risk of 100% equities can do even better with a diversified portfolio. Asness used data from 1926 through 1993 to show that a levered 60/40 portfolio (1.55x) exhibited similar volatility to a 100% equity portfolio but had a higher return. Jeremy Schwartz, WisdomTree’s Director of Research, showed that the concept worked even out-of-sample between 1994 and 2018.
The following table compares returns, volatility, and drawdowns for portfolios of 100% stocks (Russell 3000), bonds, and cash to a 60/40 portfolio and a 1.5x levered 60/40 portfolio (with the 1-3 month Treasury rate used for financing). The period is the last 30 years, through 2024.
As the table illustrates, an investor comfortable with equity-like volatility would have been better off with the 1.5x levered 60/40, which has a higher return than equities with similar levels of volatility (hypothetically, looking back over the last 30 years).
On the other hand, an investor could also use a levered strategy to create a more capital efficient portfolio. They could allocate two-thirds of capital to it – giving them 60/40 like exposure – and overlay alternative asset classes using part of the remaining capital, ideally dampening volatility and drawdowns. Crucially, this approach also lowers the “hurdle rate” for the alternative allocation, whether it’s managed futures, gold, or something else. These alternatives now only have to beat cash, instead of stocks and/or bonds (depending on which one you would “sacrifice” to fund the alternative allocation in a traditional approach).
We believe capital efficiency is an important portfolio construction tool, even more so when there’s uncertainty about the macro environment we are in. That leads to questions about which diversifier can potentially work best. Using a capital efficient portfolio helps answer that by saying “why not use all of them”, without sacrificing the amount of exposure you want to any particular diversifier.
Carson’s Chief Market Strategist, Ryan Detrick and I discussed a lot of the opportunities, and risks, associated with policy (monetary and fiscal) when we talked about our 2025 Outlook on our latest Facts vs Feelings podcast episode. Take a listen.
For more content by Sonu Varghese, VP, Global Macro Strategist click here.
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