Happy New Year! We hope things are off to a great start for you following the holiday season. We’re a little glum here after last night’s football game, but we give a huge shout out to the hometown Huskies for making it to the National Championship. Quite an impressive and fun run and one we should all be proud of!
While it was a big start to the week for football fans, later this week could provide some huge news for financial markets. So that you’ll keep reading, we’re burying the lead here and we’ll start with some background. Do keep reading, as this pending product approval (or disapproval, whatever may come to pass) truly could be one of the bigger developments for financial markets in many years.
For that background, let’s start with this. There has been much talk about the 60/40 portfolio being dead. With bonds yielding one of the lowest rates in history (see 10-year rate below).
Keep in mind that when interest rates go down, prices of those bonds go up and vice versa. So, from the peak in the early 1980’s to the bottom in 2020, rates went from 15%+ to sub 1%. That means that prices of those bonds went up as the yields came down, and substantially so.
We had been pretty vocal about how bad the risk/reward was for many of the years since the Great Financial Crisis. Most of those years we hung out in “floating rate” bonds. Since that bottom in 2020, interest rates have gone up over 400 basis points or 4.0%. Now I know I said there wouldn’t be math involved, but there is something called duration of a bond that measures the interest rate sensitivity of each bond. To save us much of the math, at the bottom of the 10-year yield above, the “duration” was roughly 9. Which meant that for every 1% change in interest rates, the price of a 10-year treasury would change by 9%. We know that the 10-year treasury yield went up by over 4%, so in round numbers we would have expected those bonds to go down by roughly 36%. Oddly enough, if you look at the 7-10 Treasury ETF, it was down roughly 38% from peak to trough.
And the 30-year treasury was down over 50%, thanks to its higher duration.
And thus you have the reason for people saying the 60/40 portfolio is dead, though recent changes in bond yields have slowed some of that conversation. Meanwhile the 60/40 portfolio has slowly been getting a makeover in the last 20 years.
How so? It is through the use of “alternative assets.” These alternatives are assets that don’t necessarily act like stocks or bonds. They can go up or down regardless of what the rest of the portfolio is doing. Some of these assets could be real estate, art, and some more esoteric asset classes like private equity, long/short, hedge funds, etc.
It was mostly pioneered by Yale’s endowment and their CIO David Swenson, who sadly passed away in 2021. Here is a look at how Yale’s endowment was allocated.
A very small percentage of the endowment was allocated to traditional stocks and bonds. Now I will say, the Yale endowment has an advantage that you and I don’t. It will live on in perpetuity, while the rest of us mere mortals all have a finite time allocated to us. This makes them able to have a large majority of their assets tied up in illiquid investments. You and I, based on both our finite life span and our relatively small amount of investments (Yale has $41 billion), can’t properly get into some of the asset classes they do. When they say real estate, they are talking about whole buildings and 100s or 1000s of acres of land. Things that you don’t sell parts of, and things you may not find a ready market for. It’s difficult to diversify like them with anything less than maybe $100 million or so. Shy of that, we have to get creative in using some of the funds available to us like private credit funds (Flat Rock) and innovation (ARKK), or in the past we have owned listed real estate and floating rate securities.
Many of these asset classes didn’t come about until 1980s and since then there have been a proliferation of them. Hedge funds, long/short, arbitrage, leveraged buyout, and so on are all different types of investments that don’t “act” the same as traditional stocks and bonds and therefore add a level of diversification, which David Swenson labeled a “free lunch” because through diversification you could take two risky assets and combine them to get a less risky portfolio than either individually. It doesn’t mean there is no volatility, it simply means less volatility.
So now we have a “new” alternative asset that has been introduced. It’s been around since 2008 in the aftermath of the financial crisis. It is sometimes called blockchain and sometimes called crypto. Both accurate descriptions because they both describe a different part of the asset.
I don’t want to get in it too deep, we will likely have more conversations and outlooks on this asset class in the future. To make it simple, what was once a difficult asset to invest in will likely this week become available to mainstream investors. Since its invention, one could only own cryptocurrency (let’s use Bitcoin as our example) on the blockchain, but you needed to make sure you had your keywords and passwords safe and accessible. There have been millions of dollars irretrievably lost because of someone losing one or both of these. Here’s an article about a guy who lost his hard drive and it was thrown in the city landfill. On that hard drive was his key for 7,500 Bitcoin. In this story from September, it was worth $194 million, today it would be worth $345 million. The city will not let him go through the landfill to find his hard drive. That would certainly put you in a bad mood, huh? But then again, rummaging through the landfill probably would too. No winners here!
So, if everything I am reading is correct, the SEC will be authorizing as many as 10 new exchange traded funds (ETFs) to trade on various exchanges to track the price of the spot bitcoin. This will likely be one of the single biggest events in the market’s history. Nobody knows the numbers yet, but there could be 100s of millions placed into these ETFs, up to many trillions. We will have to wait and find out. But it does open up another asset class that has high volatility, but low correlation. Here’s the chart below.
The closer to 1 an asset class is to another, the more they act the same. Conversely, if they are closer to -1, they act inversely. For instance, ice cream sales and umbrella sales are largely inverse to each other. Meaning, that when the weather is nice, people are probably not buying umbrellas and are more likely buying ice cream. The opposite is true for rainy Seattle weather in the winter (okay, maybe a bad example…have you seen the lines at Molly Moon’s on a rainy 40-degree day? You would think you were in Key West!). Anyway, you get the point. You can see that Bitcoin has a “low” correlation to stocks and bonds. That gives a portfolio more diversification to it, even though a very volatile asset class may be added.
Above is the chart of Bitcoin since invention. The line that I highlighted is when I first learned about it. Yes, that’s right around $300 per Bitcoin. Good thing I didn’t throw any money at it, right! Then again, I would have probably lost my hard drive or my password and have severe regrets because it’s worth so much today. Besides, I have a friend that did invest back then, but when it shot up to $1000, he sold it all. That could have happened to me too.
Anyhow, you will likely see this splashed over every website and news outlet when it happens. Keep an eye out and let’s see how fast money flows into this new asset class.
That’s it for today, I hope you have a great week. If you have any comments or questions regarding crypto, blockchain or anything else, please feel free to reach out to us.