Executive Summary

• Consistent with its bullish volatility and bearish risk parity thesis, the Kekselias portfolio achieved 1.31% in YTD total return to outperform the US Aggregate index while maintaining negative correlations vs. equity performance
• A quarter of the Kekselias portfolio’s risk capital are allocated in interest rate and currency futures, and they are responsible for capturing both short-term volatility spikes and relative underperformance of long-maturity bonds
• Three quarter of the portfolio’s funds are allocated in 1-month and 3-month T-bills to benefit from rising interest rates and generate income via high-quality assets, contrary to the consensus “reach for yield” in credit instruments
• The portfolio’s investment thesis are anchored upon emerging research on costs of prolonged monetary easing, rising instability risks in non-bank financial institutions, and negative impacts from outdated monetary frameworks
• The Kekselias portfolio maintains its bias toward capital preservation and views relative performance vs. bond indices an insufficient measure, for they have become “lower beta” risk asset indices under rising credit issuance
• An additional benchmark for bond investors should be relative performance vs. equities under adverse conditions

Kekselias vs. indices and large bond funds

Two distinct cohorts of instruments populate the Kekselias portfolio: cash assets (cash bonds) vs. interest rate and currency futures. As the portfolio steadily liquidated its S&P 500 index ETF positions (initiated in 4Q 2009) between 3Q 2017 to 1Q 2018, the proceeds were allocated to both 1 and 3-month T-bills. Consistent with its bullish volatility thesis, the portfolio increased exposure in 2s long (via TUs) and 5s30s curve steepener (via FVs and WNs), while interest rate, USDCAD, and USDJPY futures were used to express tactical views. Portfolio return at 1.311% YTD as of December 9^th to outperform a number of bond funds and the US Aggregate index while maintaining negative correlation vs. stocks:

Astute observers would point out the sharp divergence in performance between Kekselias portfolio’s futures instruments (light blue) and portfolio aggregate return (dark blue), and this can be explained in terms of risk allocation:

• A quarter of the portfolio’s risk capital are allocated to interest rates and forex futures aiming to achieve the dual objective of positive carry (meaning the portfolio earns passive income overtime) and negative correlation with risk assets, which include but not limited to equities, credit instruments, illiquid assets (from real estate to private companies), alternative “reach for yield” expressions such as fine arts and rare cars, and so forth
• Three quarters of the portfolio’s risk weight are in short-term (1 and 3-month) Treasury bills following a shift from investing in S&P 500 index ETF for 9 years; as of December 9^th, 1-month T-bills yielded 223 bps, and 3-month T-bills yielded 233 bps, and these are attractive yields on a risk-adjusted basis

With the futures positions generating outsized gains during both equity and interest rate volatility (lower stock prices and higher long-term bond yields), the portfolio benefited significantly from declines in risk sentiment in February and October, as well as during bloodshed in bond markets in May and again in October. Furthermore, long positions in front-end and belly of the Treasury curve (2s and 5s) would earn higher income overtime relative to long bonds. In effect, even the portfolio’s aggressive counter-cyclical positions generate income, while the same cannot be said for outright short-equity and short-vol strategies advocated by some prominent hedge funds and family offices:

Kekselias portfolio’s ability to benefit from market volatility across asset classes is certainly a double-edged sword, for rallies in equity markets and declines in long-term Treasury yields would dent performance (as seen during much of the 3^rd quarter). This scenario is cushioned by the portfolio’s outsized holding in T-bills, which would generate steady income; this is evident in the steadiness of aggregate portfolio return.

Furthermore, policy-induced “yield-seeking” also became risk-additive for a number of bond funds, as managers allocate cash to credit instruments to “enhance yield,” a strategy that is counterproductive in today’s macro environment.

Risk exposures anchored on durable investment these

Kekselias portfolio’s bullish volatility and bearish risk-parity risk exposures, including last year’s decision to progressively liquidate equity index ETF on strength to preserve capital, are anchored upon the following investment these:

• More research now suggest policymakers mistook structural disinflationary pressure as a result of globalization as cyclical shortfall to maintain a dovish bias [bearish long-term interest rates]
• Uneven growth and worsening inequality as a result of prolonged and highly distributional monetary easing emboldened anti-establishment insurgents, and the ensuing pivot to protectionism threatened to lift price pressure [bearish long-term interest rates]
• Higher long-term bond yields as a result of waning policy support and reflationary pressure would dampen risk sentiment to affirm yield-curve flatteners as bearish volatility expressions; additionally, a flat yield curve with low term premium would allow financial excess to build, thus exacerbate financial instability [bearish risk-parity]
• Financial markets face a roundabout path in the “snapback” of bond yields amid a growing “debt trap” [bearish long-term interest rates]
• As debt issuance (non-bank financing) displace bank loans in institutional funding, asset price volatility would trigger weakness in the real economy (financial instability to precede data slowdown) [bearish risk assets]
• Prominent policymakers and mainstream economists overlooked impacts of monetary policy on real yields and estimates of the natural rate, leading to prolonged policy error where easing and lower natural rate became part of a closed feedback loop [bearish long-term interest rates]
• Non-bank financial institutions would likely be at the center of the next financial crisis, thus putting consensus risk exposures (such as constituents of the US Aggregate index, S&P 500 index and tech-stocks) at risk from redemption flows (shadow bank-run) [bearish risk-parity]

The Kekselias portfolio is focused on risks of a debt crisis as a result of policy-induced “yield-seeking” across non-bank financial institutions, which led to the rise of “zombie” firms sustained by plentiful liquidity (large asset managers became the most prolific creditors). Given this macro backdrop, a deleveraging crisis triggered by fears of inflation would offer little respite to both bond and equity investors, and it would be an optimal scenario given the portfolio’s risk profile.

The portfolio’s worst case outcome would be renewed expansion in central bank balance sheets as adverse developments unnerve policymakers (some are already calling to extend ECB net asset purchases into 2019). Expectations toward this scenario would again depress term premium (flatten the yield curve), lower non-bank funding costs to ease pressure on “zombie” firms and boost risk sentiment. As financial conditions ease, rate hike expectations would rise anew to pressure front-end Treasuries. This would be negative to Kekselias portfolio’s 2s long, 5s30s curve steepener and short USDJPY, although higher short-term bond yields would allow the portfolio’s T-bills to buttress the decline in volatility.

Fortunately, a number of central banks are beginning to suffer from stimulus fatigue as policy costs mount, and Claudio Borio of BIS aptly summarized major central banks’ dilemma: “policies that are too timid in leaning against financial booms, but then too aggressive and persistent in leaning against financial busts, may end up leaving the authorities with no ammunition over successive financial and business cycles.”

An additional benchmark for bond investors

One may recall non-institutional investors (buyers of institutional mutual funds) are consistently given advice to “diversify” risks by allocating into bonds. Unfortunately, major bond indices have since become more correlated with equities following the avalanche of credit issuance. Therefore, investing in “reaching for yield” bond funds can no longer act as a hedge to equity risks. As a result, bond portfolios should track relative performance vs. equity indices to highlight and discourage excess risk-taking (in duration, credit and liquidity risks), for beating the US Aggregate and maintaining negative correlation vs. equities during downturns would prove a bond investor’s mettle.