Finance Theory: Betting Against Beta
One feature of the financial markets is that there isn't a linear relationship between risk and return. Cash is obviously the safest asset and carries minimal return. Moving up the risk scale to add some bonds and stocks tends to give you a fair amount of return without a ton of risk. But when you approach 100% equities and think about taking even more risk than that, you'll find that the volatility increases a lot, while the expected return only increases a little. The most commonly accepted explanation for this is that investors have return targets that they have to hit, so they all pile into the riskiest assets in the hopes of achieving their goals. The classic illustration of this is the efficient frontier, which shows the mix of cash, stocks, and bonds that produce the best expected return per unit of risk.
The Efficient Frontier
Source: Young Research
The same is true for fixed income, where institutional investors with long-duration liabilities and/or a desire to chase yield all pile into long-term bonds, causing long-term bonds to be overpriced relative to intermediate-term bonds. For example, if you take a quick look at the current yield curve, the 30-year Treasury actually trades for a higher price than the 20-year Treasury. The 30-year has more risk and less return, which appears to be some sort of market dislocation.
US Treasury Yield Curve, 11/3/2021
Source: CNBC
Practitioner research shows that Treasuries in the intermediate part of the curve have substantially better risk-adjusted returns than long-term Treasuries. The tendency for investors to completely ignore risk in the hopes of getting a slightly higher expected return is well known among academics and traders, and strategies that exploit it are categorized as "betting against beta," named after the widely-read finance paper of the same name.
How do you bet against beta? Safer assets tend to have better risk-adjusted returns than risky assets. The way you translate better risk-adjusted returns to actual cash is to use cheap leverage to do so. I laid out the theoretical basis for doing this in Treasuries in a 2018 article, but many readers felt intimidated by the need to use derivatives (Treasury futures) to execute the strategy. Leverage scares people, but since Treasuries are eventually payable for cash by the US Treasury, there's only so far the bonds can go in price from their eventual payoff.
A simple betting against beta strategy would look to leverage intermediate Treasuries to the same duration/volatility as the 30-year bond (NASDAQ:TLT). I can run a simple backtest for leveraging intermediate Treasuries and comparing them to long-term Treasuries to see how the return shakes out.
TLT (blue), vs. 2.25x leveraged 10-Year Treasuries (red) vs. 4x leveraged 5-year Treasuries (orange)
Source: Portfolio Visualizer
Leveraged intermediate Treasuries earned about 5% more annually than TLT did for the same risk (and more than SPY did over the same period), and our brief look earlier at the yield curve suggests that the irrational pricing in the Treasury market is alive and well.
Now, there's an ETF that will do this for you for 0.15% in management fees, which is a slam dunk. The ticker is TYA, and the fund was launched a few weeks ago by Simplify Asset Management, a startup ETF firm.
TYA: A Better TLT
The Simplify Risk Parity Treasury ETF (BATS:TYA) uses Treasury futures to match the duration of TLT by leveraging intermediate-term bonds (you can read the fact sheet and prospectus here). Research done by me and by many others has shown that this is historically a much better bet than investing directly in long-term Treasuries. There are two ways to use TYA, but both are good.
TLT yields about 2%, and over the next 30 years, you can expect to earn roughly that in coupons, plus the rolldown in the yield curve, which might kick in another 50 basis points annually in capital gains. I expect TLT to have a total return of 2.5% annually.
TYA currently owns 7-year Treasuries, leveraged 3x. Some back-of-the-envelope math on what TYA will return (rounded to the nearest basis point):
1. Coupons= 1.45% annually x 3 = 4.35% annually
2. Rolldown= 0.78% annually x 3 = 2.34% annually
3. Financing cost & management fee = -0.16% annually in financing cost (0.08% * 2) and the 0.15% management fee = -0.31%
4. Total return= 6.38% annually. Current advantage over TLT= 3.88% annually, in line with historical backtests.
Treasury Futures: Capital/Tax Efficiency
TYA uses Treasury futures, which are taxed under section 1256 as 60% long-term capital gains; 40% short-term capital gains. TLT coupons are taxed as ordinary income. For taxable investors, this creates an automatic advantage over owning cash bonds, reducing your maximum tax rate by 10.2 points (the top Federal tax bracket is currently 40.8% for TLT vs. 30.6% for TYA).
Where this gets even more interesting is since TYA is a leveraged product, it can fit into a bond allocation to give you full exposure to bonds for 1/3 of the price. If you were allocating 30% of your portfolio to bonds, 10% TYA will get you the entire 30% in bond exposure. Then, you can stack the returns by investing the other 20% in municipal bonds, which gets you the best of both worlds - exposure to Treasuries as a hedge at a lower tax cost, and exposure to munis for tax-free income.
TYA isn't quite a free lunch since if the shape of the yield curve were to dramatically change, then the advantage over 30-year Treasuries would not be as great. As such, it is possible for leveraged intermediate-term Treasuries to underperform, but as part of a rebalanced portfolio over a full market cycle, chances strongly favor TYA beating TLT.
TYA uses futures, which closely track the price of cash bonds, but there are some differences. It's not guaranteed that the price of Treasury futures will track Treasury bonds if there are sudden, large changes in interest rates, but historically Treasury futures have done a good job of doing so. One plus to TYA is that the fund is not constrained by its charter to invest in a certain part of the yield curve, but rather is allowed some degrees of freedom to buy what they believe is underpriced and sell what they believe is overpriced. With dislocations like the nonsensical 30-year - 20-year inversion, this is a clear positive.
TYA is a very new fund, they've picked up about $10 million in AUM in their first three weeks, but the liquidity has been good, with only a 3-4 cent bid/ask spread. I got filled at the midpoint when I bought it, and larger investors can buy/sell directly with the sponsor at NAV.
Conclusion
TYA should beat TLT fairly handily, and I view the risks related to the sponsor's use of leverage in the intermediate-term Treasury market as manageable. My calculations show a 3.88% annual advantage for TYA over TLT, while the risks of central bank tapering may actually make TLT a riskier product. TYA is a rare breed, with an expected return of over 6% and a historical negative correlation to stocks. Combined with the benefit of tax advantages, I think TYA is a strong candidate for your investment portfolio, which is why I've named it my top fixed-income pick.
This article was written by
Logan Kane
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Author and entrepreneur. My articles typically cover macroeconomic trends, portfolio strategy, value investing, and behavioral finance. I like to profit from the biases and constraints of other investors. Paywalled articles are available along with 1,000+ other authors by subscribing to Seeking Alpha Premium.You can read some more of my work for freehere on my Substack.
Analyst’s Disclosure: I/we have a beneficial long position in the shares of TYA either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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