Return Engines

The investment world is so vast that it can feel infinite. There are thousands of stocks an investor can buy; too many even for a whole lifetime. The bond universe is even richer and, if we add derivatives, commodities, and the rest of the assets produced by Wall Street's financial engineering, the possibilities are almost endless.

Each asset family has some common traits that give rise to similar properties. For example, following Harry Browne's Permanent Portfolio logic:

1. Stocks tend to do very well in economic growth scenarios. Companies are the ones that benefit from prosperity.

2. Long-term bonds work well when nominal or real rates fall. That often happens in deflation or recession, but, if there is high inflation, fiscal stress, or a loss of confidence, they can suffer a lot.

3. Gold is not a perfect hedge against every inflationary period. It produces no cash flow, but it usually behaves better when real rates are low or negative, there is monetary stress, the market seeks refuge, or confidence in fiat currency falls.

4. Even cash has a function. As Warren Buffett would say, it plays a role similar to oxygen and is crucial in recessions. It reduces volatility, avoids forced selling, and lets you take advantage of drawdowns in other assets.

These are the four basic asset types Harry Browne chose for his Permanent Portfolio. Each one has a different role and different properties. We can see how they complement each other using ETFs as proxies:

		A	B	C	D
iShares 1-3 Year Treasury Bond ETF	A	—	0,61	0,15	-0,19
iShares 20+ Year Treasury Bond ETF	B	0,61	—	0,12	-0,24
SPDR Gold Shares	C	0,15	0,12	—	0,05
SPDR S&P 500 ETF Trust	D	-0,19	-0,24	0,05	—

The result is that no pair is strongly correlated and some even move in opposite directions.

You can already sense that this strategy has a better Sharpe ratio than simply buying the S&P 500. It uses the benefits of diversification discussed in the previous post to build a more robust portfolio, better prepared for different scenarios.

The result is a better return/risk relationship.

The problem, or the blessing, for many investors is that today there are so many options inside each asset class that many get trapped in only stocks or bonds. That is a shame, because the most interesting part can come from doing "mix and match" between different asset classes or investment strategies. What matters is not "diversifying" for the sake of it, but getting exposure to assets with fundamentally different engines. We already talked about this in the previous post on diversification:

Today we return to the topic, but in a more practical way. We are going to talk about different return engines for a portfolio.

We are going to present 5 examples of investment strategies whose "return engine" is not directly tied to typical assets. The idea is to understand, in practical terms, what we were talking about in the previous post when we mentioned "different fundamental drivers".

Each strategy gets paid for assuming a different risk and benefits from different scenarios. Just like Harry Browne's Permanent Portfolio, the fact that the reasons and payment conditions are different from the rest is a good sign that it is a diversified bet.

Strategy 1: Trend following

Trend following is a stupidly simple strategy: buy the trend.

Buy what goes up. Sell or short what goes down.

The bet you make here is in favor of price persistence. The idea is that markets do not always incorporate information all at once. Sometimes they digest it slowly. Sometimes people react late. Sometimes they sell in panic or buy because of FOMO. You ignore short-term noise to bet on the trend, which is a different bet from any traditional asset.

That is why it can do well when the trend is long and durable, either up or down. Thanks to this strategy, even when trading equity indexes, you can make money in bear markets as long as the trend is durable.

The problem? Sideways markets are your enemy. Sudden moves and very fast trend changes work against you.

But, as mentioned above, this is an independent engine. It does not mainly depend on companies earning more money or on stocks going up. It depends on there being trends persistent enough to capture after costs. That is what makes it interesting as an independent return engine with which to diversify the portfolio.

Strategy 2: Carry

Carry is the return you expect to collect if the price does not move: coupon, spread, rate differential, roll yield, or premium received. Put another way, you get paid to hold a hot potato and pray it does not explode.

You get paid to wait on the train tracks. The problem is that sometimes the train passes.

Here you collect an observable premium today. You are paid by whoever wants to hedge, finance themselves, reduce exposure, buy liquidity, or get rid of volatility. In currencies, you buy currencies with high rates and finance the position with currencies that have low rates. In credit, you collect spread for assuming default risk. In options, you sell volatility and collect premium as long as the realized move is not too violent.

This can look like easy money, too easy. But that is not true.

Carry is not free money: you collect a premium today, but normally in exchange for exposing yourself to abrupt losses when volatility rises, liquidity dries up, or the world stops behaving in an orderly way.

The fun part is that you can do carry in currencies, bonds, credit, commodities, options, or equities. You have a thousand options. The form changes, but the logic is similar: you collect something while the bad scenario does not appear. It works while everything goes well and stops working when the risk materializes.

The good part is that it is a different engine from the typical stock and bond engines. The bad part is that many carry strategies look uncorrelated in normal times, but become highly correlated precisely in liquidity crises.

It is important to keep in mind that none of these strategies is perfect.

Strategy 3: Merger arbitrage

Merger arbitrage bets on the outcome of an announced corporate transaction. The drivers are not whether the company is undervalued or the quality of the business; the main driver of your bet is that the deal closes on the expected terms and within a reasonable timeframe.

If the deal closes, you collect the spread. If it breaks, you discover why the spread existed.

In merger arbitrage, you buy the probability that a transaction closes, and you are usually paid by shareholders who do not want to wait for that to happen or investors who do not want to carry the risk that it does not.

Simple example: a company announces that it is buying another one at $50. The target company trades at $48. That $2 gap exists because the market is not sure the transaction will be completed. It also reflects time to close, rates, financing, regulatory risk, shareholder votes, litigation, and market conditions.

It can fail for a thousand reasons: regulation, financing, shareholder vote, litigation, deterioration of the business... You are paid for assuming these risks.

Because we want exposure to the risk that the transaction closes, but we do not want to value whether a given company is expensive or cheap or whether it should go up or down, in stock-for-stock deals part of the exposure is usually hedged by shorting the acquiring company in the exchange ratio set by the deal.

Merger arbitrage is another classic case of picking up pennies on the train tracks. When it goes well, you make little; when it goes wrong, you lose a lot.

Strategy 4: Cat bonds

Cat bonds are catastrophe bonds. That is, you sell protection against extreme insurance events: earthquakes, floods, hurricanes.

If the event does not happen or does not trigger the contract, you collect premium. If it happens and meets the trigger conditions, you can lose part or all of the principal.

There is not much mystery. An insurer or reinsurer wants to transfer part of the risk from its balance sheet. You provide capital and, in exchange, collect a premium.

Again, the most interesting part is that the fundamental driver of this bet does not depend on the S&P 500, on companies beating expectations, or on anything remotely related to the financial world. It depends on mother nature not going too crazy, so the correlation with other strategies and asset classes can be low.

Strategy 5: Macro relative value

This strategy is a bit esoteric for anyone not inside the industry. Macro relative value does not simply try to guess whether an asset will go up or down, but to find relationships between assets that seem mispriced and exploit them.

You are not betting on the asset itself. You are betting on its relationships with other assets.

The idea is that there are relationships that should hold over time because of economic logic, political logic, or whatever else, but they can suffer temporary dislocations due to forced selling, extraordinary situations, market noise, etc. The strategy is based on betting that those relationships will normalize again.

Instead of betting that "the bond goes up," you bet that the difference between two bonds narrows or widens.

And you can do it with any type of asset. You can buy the 5-year bond and sell the 10-year bond. You can buy Italian debt and sell German debt. You can buy one currency and sell another. You can buy one oil contract with one maturity and sell another with a different maturity.

The real position is not the asset, but the spread, the curve, the slope, the basis, or the convergence.

This has a clear danger: there may be a structural change that alters the relationship forever, the relationship may take too long to correct, or it may even get worse. This is especially problematic because people often use leverage to extract returns from these small dislocations. We all know how LTCM ended.

Again, the interesting part is that the return engine can be fundamentally different from that of other assets.

What You Are Really Buying

These 5 strategies are only an appetizer of what can be done by incorporating strategies beyond the "buy & hold" of stocks and bonds.

Strategy	What you buy	Where the return comes from	When it hurts
Trend following	You bet that trends last	Price persistence, slow reaction, and forced selling	When the market goes sideways or turns suddenly
Carry	You collect a premium for holding uncomfortable risk	Observable premium: coupon, spread, rate differential, or sold volatility	In crises, volatility spikes, and devaluations
Merger arbitrage	You bet that the deal ends up closing	Spread for time, break risk, and regulatory obstacles	When the deal falls apart
Cat bonds	You carry the extreme risk insurers do not want	Insurance premium for absorbing extreme risk	When the event triggers the contract or liquidity dries up
Macro relative value	You bet that mispriced assets come back into line	Dislocations, forced flows, and spread normalization	When there is structural change, too much leverage, or liquidity dries up

One important warning: a return engine being different does not mean it is independent, that it has positive expected value, or that it will protect you exactly when you need it. Many alternative strategies look different in normal times, but correlate in crises because they share the same hidden risk: liquidity, leverage, forced selling, or the need for financing.

That is why we look for strategies where the fundamental risk driver is structurally different, to minimize the chances that everything correlates in a crisis scenario.

The Fundamental Idea

If you do not understand every strategy, do not worry: that is normal.

First, because I have not bothered to go deep into each one. Second, because many are easy to understand, but it is not obvious whether their expected value is positive, whether they persist, or whether they are worth it. A strategy having a different engine does not mean it is good, cheap, accessible, or suitable for any portfolio. Diversification only helps if the engine has positive expected value after costs, taxes, fees, bad timing, and implementation mistakes.

I preferred to keep the article brief so it works as an appetizer. Whoever wants to go deeper can pull the thread and fall down the rabbit hole.

The important idea is the fundamental one: diversification comes from owning assets with different return engines.

Imagine you have a car competing in a race. The S&P 500 can be a very powerful engine, but during some periods it can stop working and the car will stop moving forward; in the financial world, you can even go backwards. By spreading the power across several engines, you can make the car move forward even in bad scenarios for one of them, although that may make it slower overall.

It is a long race, not a sprint. There will be scenarios where your engines do not work or work worse, but the problem is that you do not know what the future holds. Instead of betting everything on one engine that will work well under certain assumptions, which may not hold, you decide to carry several fundamentally different engines. It is no use carrying two engines that shut down at the same time under the same circumstances.

This is the fundamental idea of this post: to present some strategies that can act as different engines from the rest and can help in scenarios where the typical engines do not do well, even if they are not as powerful and make you lose speed.

Not Everything Is As Pretty As It Sounds

All these engines sound better when you explain them than when you live through them.

The backtest is beautiful and the idea of diversifying risks is attractive, but watching your neighbor indexed to the Nasdaq leveraged 3x make more money than you still hurts just as much as before. Maybe even more.

All this effort just for someone who did nothing to beat you in the race for years?

The same thing happened with the Permanent Portfolio. People love diversification right after drawdowns and abandon it as soon as they forget the pain of losing their savings.

Every portfolio is being paid for assuming certain risks. The question you have to ask is whether all those risks look too similar. The key is to understand which engines move your portfolio and make a conscious decision about the risks you assume.

Conclusion

The conclusion I want to leave in this article is twofold:

1. Looking at different asset classes is interesting because their "fundamental drivers" tend to be very different.
2. Even within the same asset class, there are strategies with different fundamental risks.

Many investors confuse diversification with having more positions, when what matters is not depending on the same economic scenario disguised in many forms.

You do not need to be the wolf of Wall Street to use and understand "alternative strategies". Some of the strategies mentioned can be approximated through ETFs or funds; others remain difficult, expensive, or directly inaccessible for individual investors. The good thing is that the trend favors retail, and the individual investor increasingly has more tools available.

The important part of this article is not so much the particular strategies, but understanding what sits underneath. Understanding why they are different from the rest and why they exist. Understanding what diversification really means, as well as its costs and virtues.