TAIL LIQUIDITY

Most equity diversification allocations rely upon correlations to deliver value to portfolios. We built Tail Liquidity (CTL) to target consistent negatively correlated returns to equities to avoid relying upon correlation assumptions. To achieve this consistency, we rely upon a different lever than most, especially in the volatility space. Our return profile comes from an always-on convexity with respect to directional movement. When the market falls, the strategy has an increasing short market exposure. When markets rise, the strategy has a decreasing short market exposure.

Three Main Value Levers

Tail Liquidity is designed to be an unfunded portfolio construction tool which improves portfolios through three main value levers.

1. Take more risk day1 – Tail Liquidity is an unfunded, truly negatively correlated portfolio ballast allowing investors to increase equity & equity-like allocations.

2. Redeploy capital during drawdowns – Tail Liquidity proceeds are unencumbered cash directly in client accounts allowing for immediate redeployment during market pullbacks. 

3. Improve tax efficiency – Tail Liquidity itself is tax efficient, accelerates the potential of tax-loss harvesting, and ensures the portfolio never ossifies.

It Works!

In the past year, we crossed 3-years of live management of the strategy. Without a doubt some periods were better than others, as is usually the case in investing, but the important takeaway is that the three main value levers delivered as expected.

Source: Convexitas Calculations

A completely static, buy-and-hold portfolio comparison of 60/40 to 100+CTL resulted in increased annualized returns with slightly less volatility and a ~5% reduction on peak to trough drawdown. Said another way: better, more consistent returns with less downside.

While this illustration rebalances at month end to avoid bias, we recommend that clients initiate these rebalances based on actual market movement rather than by fixed calendar periods.

A recent real-life example of the value which can be created from risk vs timing-based rebalancing was August 2024. Tail Liquidity provided enough unencumbered cash the first week of August from the Yen carry trade unwind for most clients to redeploy capital, yet for the calendar month of August, the S&P500 was UP 2.4%. A calendar period based rebalance would have missed this opportunity. Opportunistic rebalancing is a prime example of why we deliver the strategy in SMA format: immediate access to liquidity is an important value for a portfolio tool.

The tax efficiency of utilizing Tail Liquidity as a portfolio construction tool is maximized through rebalancing and continual tax-loss harvesting (TLH). A full discussion of the interaction between opportunistic rebalancing of Tail Liquidity’s proceeds and tax loss harvesting is beyond the scope of this note, but if you are interested in more on this topic please contact us.

With all of that said, looking at a static return stream with some basic tax rate assumptions is simple, and the results are significant. The majority of fixed income holdings are taxed at the income-tax rate making these distributions fairly tax inefficient. Additionally, the 60/40 portfolio does not have a consistent source to create losses in a static environment as its “long only”. Tail Liquidity creates a “long/short portfolio” resulting in a source of losses in all market environments. A combination of more tax efficient longs and the ability to source losses in all market environments dramatically improves that tax efficiency of a portfolio even with a static implementation.

Tail Liquidity has been able to provide a positive experience for clients. The three main value levers to improve portfolio construction have delivered reduced volatility, improved pre-tax returns, and greatly improved after-tax results in comparison to the 60/40 portfolio.

Q4 2024 Commentary

Risk adjusted returns logged a second straight blockbuster year with greater than 25% returns on low realized volatility. Very few periods in history have provided such returns with low risk just by holding the index.

The election absolutely dominated the quarter. Realized volatility (actual market movement) was ~10 for the month leading into the “event” and yet, implied volatility (the price of options) was in the mid-20s. This elevated option pricing with limited movement is a very difficult environment for the strategy. Making things even more difficult, the market trended higher. Once the event rolled off the calendar volatility cratered, resulting in a November that generated the entire underperformance for 2024. The decision which would have yielded the best results would have been to dramatically reduce exposure into the election, but that was of course unknowable at the time and would have left the strategy very under positioned to capture our downside targets in this somewhat extreme situation. It is a delicate balance to deliver downside protection goals while acknowledging the elevated pricing of known events: we acknowledge this was not our best performance, believe we learned some lessons about sizing for known events and believe we can improve going forward.

Starting 2025, volatility looks far more in line with historical norms. The year ahead appears to be ripe with potential events which do not have a specific date on the calendar- the first day of Jan alone included two 1% intraday swings. Our risk-driven active management aims to take advantage of the potential sneezes from surprise headlines in the year to come.

The ability to rebalance and acquire more assets in 2022/23 has allowed clients to continue to improve returns from both the accumulation of additional assets during draws and accelerated tax loss harvesting, while long only diversification continued to provide very little diversification:

• We believe relying on correlations is a major cause of wealth destruction and is why we built Tail Liquidity. You don’t have to rely upon basis to bonds, or even equity implied volatility.
• Tail Liquidity’s goal in isolation is to capture 50% of the downside in markets in exchange for giving up 20% of the upside. Additionally, with separate account implementation, the strategy is collateralized by existing assets without disturbing the tax basis of those assets.
• Unencumbered cash liquidity provided by Tail Liquidity during drawdowns allows for opportunistic reinvestment and/or serving distributions without selling assets.
• Negatively correlated overlay increases portfolio dispersion and reinvestment increases tax lots, accelerating tax-loss harvesting potential.

The goal of Tail Liquidity is to allow investors to take more equity risk day one and redeploy capital during drawdowns. Investors that would have chosen to use Tail Liquidity as their portfolio diversifier instead of fixed income could have experienced higher portfolio returns, while experiencing less of a drawdown during 2022.

To round out our discussion of diversification and 60/40 portfolio comparisons, Tail Liquidity is a clear winner due to its more predictable negative correlation to equities than fixed income of late.

Enhanced Semiconductors

A focus on artificial intelligence and processor innovation drove semiconductor sector returns over the past two years. These chips power not only AI’s sophisticated models, but nearly every aspect of modern life. The semiconductor industry's dynamism and constant evolution present both opportunities and inherent risks. Convexitas’ Enhanced Semis strategy offers a unique way to access accelerated upside while maintaining ETF-like risk on the downside.

CES was created as part of our founding philosophy for delivering positively convex strategies in a relative value framework for the wealth channel. That means we start from an edge in the options pricing – think of it like value investing, but with option prices themselves rather than value from the stock’s fundamentals. Then we utilize this edge in options to construct a strategy with simple transparent goals.

• Greater than 1:1 upside: CES should achieve better returns than an ETF allocation on the way up.
• 1:1 downside: CES should achieve similar returns to an ETF allocation on the way down.
• Neutral to positive carry: CES should achieve zero to slightly positive returns when the Sector is unchanged.
• Client earns additional returns on collateral as the above profile is delivered unfunded via a Separately Managed Account (SMA).

If your practice and/or clients want to allocate to the semiconductors sector, this strategy with these easy to communicate goals could be the best means of directing an allocation to the semi sector.

So has the strategy consistently delivered these goals?

Breaking up performance into monthly increments, the consistency is well illustrated. From the left/lower table to right/upper table:

1. Months when the Semis Sector was down 5% or more, Convexitas Enhanced Semis (CES) experienced almost exactly 1:1 downside.
2. Months when the Semis Sector returned less than +/- 5%, CES experienced positive carry.
3. Months when the Semis Sector was up 5% or more, CES experienced better than 1:1 upside. 

CES now has over three years of live track record and returns has been very much in line with the stated goals. Even though three years is not a significant amount of time, we have experienced very different market environments to stress the resiliency of the strategy.

• 2022 was a down year where the strategy outperformed due to active rebalancing.
• 2023 was a highly correlated rally where the core edge delivered significant outperformance.
• 2024 had a significant dispersion in returns during a significant rally, challenging the core edge in strategy.

Semis were highly rangebound during the last quarter of 2024, and the sector ended effectively unchanged. Going into the quarter, implied volatility had extremely different expectations with SMH volatility in the high 30s to low 40s. The actual realized volatility turned out to be closer to 20. The event calendar included both the election and NVDA earnings whichn anchored volatility at a much higher level than the index achieved throughout much of the quarter.

Convexitas Enhanced Semiconductors (CES) is a short-dispersion strategy. This means our edge is created from index volatility being cheap relative to single name volatility due to a mispricing in correlation across sector constituents. Said another way, the sector tends to move in the same direction much more than what is priced into the index options. For most of 2024, this was not the case and was a problematic environment for our core edge.

Source: Convexitas Calculations

The semiconductor sector had spectacular performance in 2024 and significantly outperformed the S&P500 and NASDAQ. When looking at the individual names, it tells a very different story. Only 4 of the 25 names outperformed the index. More amazingly, 14 of the 25 names were DOWN with the index up 39%. This is a lot of return dispersion and a detriment to a strategy that is levered to the stocks being correlated on the upside.

An index can only achieve this type of outcome when the heaviest weighted names drive most of the performance- exactly what occured in 2024. At the end of 2023, NVDA / TSM / AVGO were in the Top 5 sector holdings. After the 2024 returns, they ARE the Top 3 holdings in the sector accounting for almost half of the index.

Concentration of performance is problematic for a short dispersion strategy. The strategy aims to achieve accelerated upside by selling single stock puts that we view as expensive relative to SMH sector etf calls, allowing the strategy to buy more upside calls than it theoretically should be possible in the absence of the relative value mispricing. So when the majority of names in the sector go down but the sector etf is higher due to the performance of only a small group of names, enough short put positions of the strategy can lose money even though the sector is higher. This is THE risk in a short dispersion strategy and 2024 was a dramatic year of dispersion for the semis sector.

Even with a difficult environment for the strategy, CES has achieved ~15% annualized outperformance and almost 32% annualized absolute performance since inception. We strongly believe our core edge remains intact even after an outlier year. If your practice or your clients are interested in allocating to Semis or AI, CES is a great tool due to leveraging the structure imbalances in options markets during each of during down / neutral / up markets.