ReSolve Riffs on Return Stacking with Corey and Rodrigo – “Ask-Me-Anything” #AMA
Traditional portfolios are faced with the prospects of depressed expected returns in the coming years, as implied by current stretched valuations of stocks, and near record low rates and credit spreads for bonds. Our recently released paper – Return Stacking: Strategies for Overcoming a Low Return Environment – co-authored by Rodrigo and our good friend Corey Hoffstein, shows how investors may materially improve their chances of success by allocating to uncorrelated managers that may offer more ‘bang for your buck’ and free up valuable ‘portfolio real-estate’. Fielding questions from the ‘Twittersphere’ as well as our live audience, this episode covers:
- The pitfalls of emulating large institutions with limited portfolio agility and mandate flexibility
- Stellar returns and recency bias – why so many investors remain anchored to the ‘60/40 portfolio’
- Why stocks and bonds are structurally not designed to thrive in high inflation and/or low growth environments
- How loose fiscal policy, layered atop highly expansive monetary policy, strengthens the case for persistent inflation
- A trip down portfolio theory memory lane
- Risk transformation and financial alchemy
- Leverage aversion – concentrated bets vs capital efficient diversified return streams
- Structural diversification, tracking error and absolute returns
- Return stacking as a form of liability hedging for advisors
- Finding structural edges and tilting the odds in one’s favor
The team also discussed the importance of separating the underlying components of any strategy, not only across asset-classes, but also beta, alpha, styles, and tilts, in order to use them as building blocks to create tailored portfolios with desired exposures.
There’s also an “Easter Egg” where Adam discusses the results of a forthcoming paper on the shockingly large potential benefits of trade and fee netting in multi-strategy products.
If you haven’t read our Return Stacking paper:
Strategies For Overcoming a Low Return Environment
Thank you for watching and listening. See you next week.
This is “ReSolve’s Riffs” – live on YouTube every Friday afternoon to debate the most relevant investment topics of the day, hosted by Adam Butler, Mike Philbrick and Rodrigo Gordillo of ReSolve Global* and Richard Laterman of ReSolve Asset Management.
Adam:00:01:00Man, I’ve been waiting for this one … Corey and Rodrigo on the hot seat, for weeks.
Corey:00:01:06I’m going to be a really bad guest on the podcast and just take over from the start…
Adam:00:01:12All right. So, what’s new, dude? Every time you come on you takeover. It’s almost like you’re a podcast host yourself.
The $10 Billion Masterclass
Corey:00:01:16Why is your Masterclass only for institutions $10 billion and less?
Rodrigo:00:01:22Well, if you don’t understand it, then we can’t explain it to you, bud.
Rodrigo:00:01:26Can you get off the channel now?
Adam:00:01:29For reals, Rodrigo. Why? Come on.
Rodrigo:00:01:31So the reason that we target that audience is because a lot of what we do is in the commodity complex, right? And so, there is a liquidity constraint with regard to what any institution can do in real size on commodities. There is CFTC limits for asset managers. I mean, AQR is bumped up on that already and can’t offer a lot of commodity-based features that they can on the institutional side. So that’s kind of the sweet spot. We’re not going to get an allocation from 100 billion dollar or whatever pension plan, because we won’t be able to implement it for them. So anybody, you know we prefer the $10 billion threshold, we’ll manage your money at $10 billion. But beyond that, it would be difficult to implement.
Adam:00:02:21You know, there’s a broader answer here, right, which is that big institutions just don’t have the liquidity, sorry, like the portfolio agility or the mandate flexibility to be able to take advantage of active strategies, right? Like, when you get into the 10s of billions and hundreds of billions, you just can’t run strategies on timeframes where the high Sharpe ratios live. So you’ve got to really just take advantage of long-term risk premia, right? So if you look at the Dutch pension plan, a lot of the major sovereign wealth funds, the major state pension plans, large corporate plans, like they just don’t run active strategies the way that we think about active, right? They think private equity infrastructure, basically, long-term risk premia.
Corey:00:03:10That reminds me of, and I think, I’ve told you guys this story, but a meeting I had once with Norges Bank, which is Norway’s Sovereign Wealth Fund, which, by the way, when they set up the meeting, I didn’t realize was Norway’s Sovereign Wealth Fund. It was the week after I was supposed to get back from my honeymoon, and these people from Norges Bank emailed me and said, “Hey, we’re going to be in town, we’d like to meet with you.” To which I was like, “Well, it seems like a Bank of America.” So I just said to them, I was like, “Look, I’m coming back from my honeymoon, I don’t have any time to prepare.”
I sit in the meeting with them, they then proceed to tell me they’re the Sovereign Wealth Fund of Norway. And I’m like, probably should have prepared for this meeting. Regardless, I was never getting an allocation. It was just sort of an educational introduction. They had read some of the papers I had written. But they were telling me at that point, they were starting a real estate investment. And to do it at a fund of their size, they had to hire 100 people so that they could then scour the entire globe for real estate opportunities, because for them to deploy that much capital, that’s what it really took.
Corey:00:04:11So to your point, there’s just the size limits that are beyond which it’s hard to do much other than just beta.
Mike:00:04:17I think it’s interesting too, when I hear advisors, allocators, individual investors who are smaller, obviously, and eschew the potential advantages that they have in being smaller asset pools, to go pursue some super institutional approach where it’s for $100 billion funds. Does it make sense to give up the potential portfolio agility you have in smaller pools, and then some mandates have more mandate flexibility too. Some don’t depend on a board, right? So if you have to maneuver through a board, and then if your board has expectations around the return streams, let’s say it’s a pension, right. So the actuarial side of it is there’s a capital stack here that I need to assign a long-term risk premium to, and I need to match that against the liabilities that I’m paying out. And so what is the risk premium of your active tactical strategy that I can put to my actuaries? And the answer is there really isn’t one. And so, or it’s hard …
Adam:00:05:30Well honest, quants will tell you that there’s a wide range and actuaries are able to use the empirical history of equity indices and bond indices and claim that those are the expectations where they can’t do that with active strategies. And so there’s constraints, yeah, that make it very challenging.
Mike:00:05:50So before we get too much deeper into this, I want to do a couple of announcements, right? One is that four dudes on a Friday talking investment stuff, is not advice. This is entertainment, baby. So, enjoy the entertainment. And what was the other one? Oh, yeah, make sure you’re smashing the Like Button, sharing the content, and all that great stuff. So if you are with us, just give us a thumbs up. And this is meant to be interactive today. So we’ve got questions that we’ve collected, which are the top questions for the Return Stacking paper, and we’ll go through those, but we’ll also be looking for participation if we can —
Adam:00:06:29I want to also ask because Corey, you co-hosted for me for last week in a backwards baseball cap, and some kind of quasi-sweater and like, there was a look that you were going for.
Corey:00:06:49I know. I got a lot of comments on that.
Adam:00:06:51And now you’ve got the, you know, your buttoned up, you’ve got the glasses on, your hair’s done. Are you going for a different personality?
Corey:00:07:00The hair is not done. You know, what’s funny is Rod was on a call with me earlier today, where I had to send someone a headshot, and the woman goes, I don’t know if you were on at this point, Rod. But she was like, “You don’t look anything like the headshot you sent.” And I was like, “Well, this is what I call pandemic chic.” I’m wearing like a Tommy Bahama shirt, I’ve grown out a mustache, and I’ve just given up on my hair.
Rodrigo:00:07:23This is my favorite new movie before we go live with Corey. Moustache, you have a curling up the moustache.
Corey:00:07:31Well, I have a problem which is one side naturally curls up. The other one naturally curls down. This is what happens when you have curly hair.
Adam:00:07:37Oh, there’s no way you can deal with that asymmetry, dude, that must drive you crazy.
Corey:00:07:41Yeah, the OCD really goes off. So this is a tantalizing conversation for everyone listening. So, thank you.
Adam:00:07:46Yes. Yeah. Exactly. All right. So, we are here today to talk about the new Stacking Returns paper. Before we get going, let’s talk about what motivated you guys to think about this theme, and why would we write this paper. For those listening, this is primarily the brainchild of Rodrigo and Corey. So Mike and I are going to kind of moderate a discussion and put Rodrigo and Corey on the spot for a change. So which one of you wants to go first? Why did you guys write this paper? What’s it for? Who’s it for? What problem are you solving?
Rodrigo:00:08:26Yeah. Corey, why don’t you start with kind of the evaluation, expensive markets and all that?
Corey:00:08:31Yeah. We can start there. So I think just about every major investment firm out there has been forecasting low real returns for a traditional 60/40 portfolio for the better part of, at least half a decade, most major firms since 2015, under the expectation that there’s going to be strong reversion in equity valuations, which are historically high right now. And that when you look at fixed income, the gravity is a little stronger, that your starting yield to worst is a pretty strong predictor of your forward nominal returns. So you subtract out inflation, even if you sort of discount inflation below what a lot of people think it’ll be, you’re still talking about real returns for a 60/40 portfolio that are depressed on a historical basis. You sort of contrast that to the experience everyone has had with the 60/40 over the last decade, particularly American investors who we deal with predominantly who have that home country bias and invest in the S&P. And it has been over the last decade, one of the highest realized risk adjusted returns for the 60/40 portfolio ever, going back at least 100 years.
Adam:00:09:51Especially on risk adjusted basis. Yeah.
Corey:00:09:53Yep. So you have this unbelievable total return, unbelievable risk adjusted return, and you contrast that with the expectation that going forward returns are going to be quite poor. And so we have this struggle, which is everyone is anchored to the wonderful performance of a 60/40. And it is becoming more and more difficult to have conversations with advisors and investors and move them off of that base, while recognizing that staying with that base is driving while looking in the rearview mirror. And so there have been a number of products that have come to market now that are enabling us to do new and interesting things with the portfolio. And I’ll let Rodrigo go into that a little bit more.
But the question was, how can we sort of bridge the gap, which is, people aren’t moving off the 60/40. But we need to find ways to introduce new sources of return and new sources of diversification, particularly potentially towards things like inflation, without making them very uncomfortable, the way that introducing liquid alternatives over the last decade did. And so that’s where a lot of this return stacking idea came from. Last thing I’ll say is I need to give credit where credit is due. Rodrigo came up with the phrase “return stacking”. I think it’s brilliant and how easily it explains what we’re trying to achieve, both on the pros and the potential risk side. So all credit to him for the paper title and the concept.
Rodrigo:00:11:19Thanks, Corey. I think the one thing that really drove me to try to find a better solution is the fact that when you compare how people perceive the expensiveness of a bond versus equities, they can see a low yield in bonds. And what has happened is that its caused investors and advisors to move up the risk scale, right, move up to more equities or equities that are bond-like or bonds that are actually high yielding high-risk assets that ultimately, you can see a line item that you might say it’s 40% bonds. But when you dig into it, it’s really just a different way of getting exposure to equities.
And the portfolios have gotten highly procyclical, meaning that whatever offset you might have gotten in a bear market or a negative market shock from bonds, it’s no longer going to be there, right? So you see more and more of these advisors, seeing the low yield in bonds, adding to equities to reach for yield, get a higher return without them realizing that it’s really putting their clients futures at risk. So that was, to me, I saw that and said there’s got to be something we can do to add diversification and improve that, help them keep their 40% bonds and stack different types of diversified returns on top.
Solving For Problems
Adam:00:12:40Is there any particular environment that 60/40 is specifically vulnerable to that we’re trying to kind of solve for here?
Corey:00:12:51Adam, I like, the volleyball, light, gentle language.
Adam:00:12:55I’m not used to softballs, man. I’m trying to serve you guys up.
Rodrigo:00:12:59You can also answer that one, Adam. What do you think?
Corey:00:13:03Yeah. I mean, you’ve done enough study on risk parity, you dive in.
Adam:00:13:09Well, yeah, I mean, I think everyone knows that both stocks and bonds are not structurally set up to thrive in periods of higher than expected inflation or lower than expected growth, right. Equities, by their nature, are designed to do well, during periods of abundant liquidity, benign inflation and better than expected growth. Bonds are designed to do well during periods of below expected or low inflation and below expectations in terms of growth. So, you have this completely other side of the macroeconomic picture that we really haven’t seen much of in the last 30 years, which is this period of high inflation, and where growth continues to come in a little below expectations, which some people call stagflation, where both bonds and equities are kind of designed to suffer.
And because of the flight to passive, and how well 60/40 has done over the last 10, 20, 30 years, very few people have felt the need to diversify into investments that are designed to do well during stagflationary environments. And there’s a reasonable probability, perhaps higher than we’ve seen in the last 20 or 30 years, that we may be entering into a stagflationary environment now, and at a period of extremely low expected bond returns, and probably extremely low equity returns. And so maybe now more than ever, for the generations that are currently investing, we should be thinking about how to hedge that inflation risk.
Corey:00:14:58And if I can do that, add one thing really quickly, Mike, before you dive in. I do want to say like, as much as I might discount that people are just anchored, or as much as I might sound like I’m just saying people are anchoring to the last 10 years, I do think there are some rational aspects of sticking with the 60/40, in some ways. For example, if we believe that returns going forward are going to be depressed, then two of the most important levers that you have to work with are fees and taxes. Right? So when we talk about introducing diversifying alternatives that are often a higher fee, and less tax efficient, people go, “Well, I don’t really want to sell my productive core financial assets to move into that space.”
Similarly, introducing something like commodities. Well, there isn’t really a clear answer as to whether passive commodity exposure, which you can get very cheaply, will give you a risk premium. So if you already have a low expected return, and then you start selling those productive assets to buy something that might have zero risk premium, even if it’s diversifying, now your expected return is that much lower. So I do want to just pause and say I do — not that I think that is a good answer. But I have heard some rational arguments as to why you might not necessarily make some of what seem like obvious asset allocation decisions.
Adam:00:16:18Yep. No, that’s totally fair.
Rodrigo: 00:16:20And that’s …
Mike:00:16:20I think that I think the other thing that you guys have covered, but maybe not explicitly as well, and I want to bring to the forefront here is the idea of diversification, and how the efficient frontier changes in the various different economic regimes. Maybe I can just show my screen here for a second, because I think this is — we haven’t looked at this graphic in a long time.
Rodrigo:00:16:46Is it different efficient frontiers.
Mike:00:16:48Yeah, over the decades, right. So if we — how come it shows my screen here instead of — okay. There we go.
Rodrigo:00:17:04But yeah, I mean, just generally speaking…
Mike:00:17:07Yeah, a challenge, real challenge. So you can see, in these efficient frontiers, you have the 60s, the 70s, the 80s, the 90s, the 2000s, and then the entire period. And the interesting thing is, in that period, where Adam highlights this idea of stagflation, which is the 70s, you can see that green line. The efficient frontier is, in fact, just simply a straight line. And it’s a straight line because there is no benefit of diversity in stocks and bonds. And that’s really the last decade where that happened. Another interesting one that maybe harkens back is the red, efficient frontier of the 2000s, where it’s actually inverted. And bonds are the higher risk adjusted return asset. And equities are at the lower right. And that was a function of excess value. We can drop that, I think, now and come back to do I …
Adam:00:18:04That’s just valuations, you mean coming off the 2000 top?
Mike:00:18:07Yeah. And so when you think about what you outline, Adam, as being the potential for a little bit more inflationary pressures as we go forward over the next decade, and how that has implications for rates, and looking at high equity valuations, this is very much like the late 1960s, the nifty 50s. And you get into a period where you have negative real returns for both stocks and bonds, and they’re correlated. Like, the big thing to me is, and they are correlated, like the 2000s. Well, yeah, okay, equities were pretty crummy. But stocks and bonds were not correlated. They were very uncorrelated. And thus, if you held a portfolio of both and rebalanced you actually fared okay. That’s not what happens in the 70s.
Rodrigo:00:18:58Yeah, yeah. And I think the issue is clear of having those two asset classes. We see the blind spots, but those who have seen the blind spots in the last 10 years and done something about it, have struggled, right, have, because of what Corey mentioned, right? What have you done? You grab the two best performing asset classes, reduce your allocation to them to make space for alternative strategies. Some of them may have been CTAs that have had, comparative to their previous 20 years where they were doing mid to high double digits. In the last decade, they’ve done low single digits, right. So if you’re dragging down 30% of your portfolio to add to these CTAs, or managed futures managers that have exposure to commodities, because you see the writing on the wall, you’ve gotten fired over and over again, and that’s one of the things that we address in the paper …
Adam:00:19:52You’re sure picking on managed futures. I mean, that I think you’ve got to expand that to basically every factor strategy, every other jurisdiction. You know, every other asset class has suffered relative to US equities and treasuries and credit.
Corey:00:20:15So can I toss out a tangential question because this was something I was pondering as I wrote my quarterly commentary, which was, you’ve had this large expectation for the last half decade, even going back to 2013, that markets are overvalued, you should see depressed forward returns. And we’ve almost seen the exact opposite. And in my head, I’m thinking to myself, well, is this sort of the recent research from … and I’m going to butcher his name, but … writ large, which is with this, there is no alternative type market, we’re in that, people are moving away from fixed income to buy riskier assets.
The positive realized returns has really just been a demand shock that’s been realized. And so we’re sort of — it’s hitting that escape velocity, that people are chasing the returns, they have to keep investing there because bonds keep getting less attractive. Even though they’re selling bonds, bonds aren’t getting more attractive, because central banks are keeping rates depressed, right? And so this is one of those like this is just going to continue, potentially until the marginal dollar stops having an impact.
Adam:00:21:25That’s sort of the inelastic market hypothesis or the precursor to that. Yeah. I mean, that’s certainly a potential driver of this effect. And I wouldn’t be surprised if it was a meaningful driver. And I think the state transition that we’re experiencing, if there is a causal driver that you can point to, for me, is the shift from a purely monetary accommodative policy to now a combination of monetary and fiscal policy where you’re now — it’s been financialization, which has driven growth exclusively over the past decade. And that has benefited an increasingly smaller fraction of society. And now we’re getting to the point where the political pressure is sufficient to, and probably catalyzed by some of the experiences during COVID, etc, that probably accelerated it.
But we’ve certainly seen a massive fiscal impulse over the last 18 months that we haven’t seen in decades. We’ve got all of this talk in Congress, and not just in the US, but in a variety of major global jurisdictions that are now contemplating massive fiscal packages. And when you’re beginning to take money out of the financial economy, and firehose it into the real economy, now you’re going — you have the potential for triggering demand for real assets, real durable goods, real consumption that just hasn’t been there for the last 10 or 12 years. So that is really the trigger that I think the market is reacting to, as we’re seeing market implied signals, that the market is concerned about an acceleration and unexpected inflation.
Moving Off 60/40
Rodrigo:00:23:21Well said, well said. That is, again, it’s a good argument, it makes total sense. Now try to move people off their 60/40 right now. Right? So this kind of goes back to the point. Yes, there is a value there. Yes, it is. I’ve been doing this for 10 years, as in reducing my exposure 60/40 and I’ve gotten burned, so I’m going back to 60/40. So back to how do we get to kind of patch that up, and also give people what they need in that transition period? Because eventually we’ll get to the point like we did in the early 00s or the mid-00s, where people underweighted US and overweighted BRICs, Brazil, Russia, India, and China. That’s the place to be, right, the US was not the area you wanted to be in.
So, the paper was an attempt to do a yes/and, rather than there is only one way to diversify. And the yes/and was facilitated by these capital efficient ETFs and mutual funds that had come out, allowing us to really create a stacked approach to the P&L that we can grab from different asset classes. So we start in the paper, once we recognized that advisors are not benefiting from a lower single-digit return of alternatives, what you can do is, simple solution was, grabbing the Wisdom Tree, NTSX is the ticker, where they basically grabbed the 60/40 portfolio and levered it up 150%, right. So what you’re getting when you buy, you give them $100, you are getting $90 of equity, and $60 of bonds. And what we showed in the paper was how when you grab NTSX since its inception, and only allot it 67 cents on the dollar, and compare it against 100 cents on the dollar to the Vanguard Balanced Fund, they are nearly identical. They’re basically the same equity line.
But the difference to the user of that product is that you have increased 33% of your portfolio real estate, that you can do a myriad of things with, right? If you think the markets are overvalued, but you can’t not participate, because your clients will fire you, you can just keep that in cash until the next COVID crash happens. And then you have all this dry powder to back up the truck in the asset classes and securities that you think are undervalued. That’s one way to stack returns above that, what you would get from simply buying and holding the Vanguard Balanced Fund. Right, Corey? You also went through another approach to stacking, like with the bonds. Why don’t you give everybody an example of that?
Corey:00:25:59Yeah. The stacking examples we gave in the paper, were by no means prescriptive. They’re just meant to be examples. But I think one of the questions that people often think about when they’re facing a low return environment as well, okay, if my beta is going to give me a low return, how can I get some alpha? And so the question becomes, are you going to take your 60 and try to find managers that can consistently generate alpha for you over the next 5, 10, 15 years. And the evidence is very thin, particularly, in US large cap equities that you can find managers that can consistently do that. So one of the ways in which return stacking can be used is to get your core beta with 66 cents, and then use the other 33 cents to allocate towards different risk premia that should realize much more consistently.
So, for example, you could take those $33, that Rodrigo mentioned that you freed up and put them in very short term, high-quality corporate bonds. So, maybe they’re going to give you 150 to 200 basis points a year, you get a 33% allocation, you end up with 60 bips. Well, now you get a 60/40 plus another 60 bips of returns on top, and that’s coming from an extra 33% exposure to very short term very high-quality corporate bonds. That’s a pretty attractive proposition, because I’m much more certain that that 30 bips or 60 bips, is going to be added on just about every year over the next 15 years, versus me being able to find an active manager that can add some alpha.
So, particularly, if you find an actively managed bond fund, where I think there’s more evidence that alpha can be generated, I think you can use this form of return stacking, to basically try to pick places where you can add some excess return much more consistently.
Mike:00:27:59You’re muted, Adam.
Adam:00:28:03I want to bring this back to sort of some of the fundamental theory that everyone’s familiar with in finance, right? I mean, go back to the 1950s, Harry Markowitz, and then Sharpe and Treynor, they sort of described an optimal portfolio allocation framework where you allocate to a maximally diversified portfolio or an optimal max Sharpe portfolio. And then if that portfolio is not expected to deliver the returns you need, then you simply borrow at the risk free rate, and lever the portfolio up to generate that excess return that you require. It’s very difficult for retail investors, for most advisors, even for small institutions to borrow using margin, for example, at rates that make that theoretical framework work in practice.
What’s great about the setup, as designed by the Wisdom Tree ETF, for example, is you’re using futures to achieve that leverage on that core portfolio, which means that you’re borrowing at a rate that is consistent with what the largest, most liquid, most creditworthy institutions in the world are borrowing at. And you’re able to use that borrowing rate to allocate to the other 33% of the portfolio. So the hurdle to generate an excess return on that 33% of the portfolio is as low as anyone can conceivably get, right. It’s a very, very low hurdle, because you’re borrowing at such a cheap rate. So almost anything that you layer on there, that has a reasonable probability of generating either a risk premium, or some sort of alpha is likely to be long-term accretive. I think that shouldn’t be overlooked.
Corey:00:29:58Yeah. That financing rate comment is really important, right? Because if we tried to do this, and I opened up like an Interactive Brokers account and tried to say, okay, I’ve got my 90% equity, and I want to borrow against my 10% collateral to buy Treasury futures, or whatever it is, or not Treasury futures to buy Treasury bonds, or something else, the borrowing rate they’re going to give me is not going to be the financing rate that’s embedded in Treasury futures. They’re going to charge me a much more significant premium, which makes that hurdle rate we have to overcome with the returns of whatever we’re stacking on top, that much higher.
So a lot of the questions we’ve gotten is, well, does it matter what you lever up? And the way I look at it from a portfolio construction perspective is, operationally it kind of does sometimes. But for the most part, you’re looking at your long a big portfolio, and then you’re short a financing rate. And your goal should be to get that financing rate as low as possible. So using things like Treasury futures, are not only potentially more tax-efficient than buying Treasury bonds, but the embedded financing rate is incredibly low.
Rodrigo:00:31:05Yeah, and I will say that what’s interesting is, if I can share my screen, I’ll show you guys the, I think Figure 2. When we compare the 67 cents on the dollar onto NTSX, and the 33% in, not even cash. I literally just made a zero yield in cash in contrast to the Vanguard Balanced Fund. All right. I’m sharing right now. You guys see my screen?
Adam:00:31:41We could. Now we can.
Rodrigo:00:31:44All right. So Figure 4 in the paper shows the Vanguard VBINX Fund, this is the 60/40 fund, right next to $67 to NTSX and the rest in zero yielding cash. And the performance is identical. And this is because that product uses the cheapest possible leverage you can get on treasuries. If I had added 33%, if I added a cash yield on that, even though it’s very low, you’re going to be able to bump up your portfolio by that, whatever money market fund that you can find, right? So it is that cheap. This is not theoretical anymore. This is real life results of being able to apply this structural alpha to a product.
Adam:00:32:29I want to make sure we acknowledge Amit’s, sorry if I’m mispronouncing, comments about the fact that short-term corporates at the moment don’t really provide any meaningful bump on cash, right? And obviously, this is true, corporate credit spreads are as narrow or almost as narrow as they’ve ever been. So this may not be the most optimal time to layer on with corporate spreads. But I think Corey’s point stands, right? Like, yes, it’s a narrow spread, but it’s the spread, right. And the point broadly, is that you now have 33 cents of extremely efficiently levered capital to apply to other risk premia, or active sources of return, to stack on top of your core 60/40 return, so you can have your cake and potentially have a little bit of icing on top.
Reactions to Stacking
Mike:00:33:32So what’s been the reaction of folks when you go through that and talk about the leverage for their, whether it’s allocators or individual advisors, how do they respond? Is it okay because the leverage is sort of cloaked? So it’s not explicit, it’s kind of built into some things. So they feel okay, or they can feel good, or they can get it through their compliance departments in parting this bit of leverage? What’s been the pushback on the leverage? We know there’s a great leverage aversion generally. So how have those conversations gone?
Rodrigo:00:34:10Well, yeah, I think you get people who are kind of new to this concept. I mean this is a concept as old as time, right? But for the retail space, we’ve never had to have this conversation before, because it wasn’t available before. So whenever you – this is why language is so important. I think it’s helped us quite a bit to be able to talk about creating portfolio real estate, stacking those returns on top. That’s helping quite a bit to get people across the line. But I think the first and most, the biggest kind of initial reaction is well, yeah, I’m stacking returns, but I’m also stacking a bunch of risk, right, you’re levering up stuff. We’re in an environment where I want to minimize and reduce risk for our clients. That’s not kosher. I don’t want to do that.
And so we go quite a bit into the fact that we can stack returns while not necessarily stacking risk on top. In fact, if you do it the right way with the right products, you could reduce maximum drawdowns and keep the volatility relatively the same. And that’s where a selection of your stack is important, right? We could have chosen a wide variety of elements to put into that 33%. But we chose strategies that have economic and behavioral reasoning for why they’re likely to continue to provide diversification, and they have a structural non-correlation to bonds and stocks. And that’s the futures space and the CTAs and systematic global macro, right?
So when you’re able to stack on top something that has low correlation to your tracking or buys portfolio, then you can stack returns while not stacking risk. So once you get them through that, this idea of things zigging when they’re zagging, and they’re both making money, you start getting them excited.
Adam:00:36:07Amit is making me excited. Come on. So Corey, here’s the first good AMA question. Right? So, a certain pirate of finance, once said risk cannot be destroyed, only transformed. So is that what we’re doing?
Corey:00:36:20I’m getting it thrown back in my face.
Adam:00:36:22Is it financial alchemy that you’re proposing here or what’s going on?
Corey:00:36:26No, not at all. Look, I think when people think about leverage, let’s acknowledge that just about every major financial catastrophe has involved leverage in some capacity, right? But it’s often very concentrated leverage. So you look at Long-term Capital Management or the credit crisis of 2008. Yes, there was huge amounts of leverage that ultimately were a cause of the problem there. But it was leverage that was concentrated into a single bet. Right? I think when people look at the return stacking, they get nervous about leverage. I like to point out, almost everyone uses leverage in their day to day life.
If you borrowed to go to university, great, you’re using leverage to invest in your human capital. If you used a mortgage to buy a house, great, you were using leverage to return stack real estate, very idiosyncratically, but real estate returns on top of your investment portfolio. Almost everyone uses leverage. If you invest in the S&P 500, the average company has like three turns of leverage, right? I mean, that’s what we want them doing. We want them borrowing at low rates, to invest in growth opportunities, that’s good use of capital. And yet, we don’t want to do it with our own investment capital.
So the way I look at it, is I say, I can get a return stacked portfolio. We’re not necessarily destroying risk, we can’t destroy risk. But what we can do is say if I start with a 60/40, and I introduce some return stacking to say, add managed futures. Well, I think those managed futures are going to reduce the risk of my portfolio in an inflationary environment. But they’re going to increase the risk of my portfolio potentially, in certain types of endogenous liquidity cascades, where there’s forced margin calls, and everyone has to de-gross at the same time, you’re just changing around where that risk is.
But I think the goal, ultimately, is that in using leverage, you can introduce excess return sources, and the added risk that you’re adding on top is appropriate for the amount of extra return that you’re getting. And you’re not creating concentrated risk in one particular environment. It’s not like we’re saying, take all that extra real estate and invest in the riskiest stocks you can, right? It’s trying to be an orthogonal source of returns, both from an asset class perspective, and structurally, the type of trades that are being made.
Liquid Alternatives Markets
Adam:00:38:56So do the liquid alternatives markets now offer sufficient options for this dream of orthogonal returns? What do we observe in some of the products out there now?
Rodrigo:00:39:11Yeah. So, I think this kind of leads to the other objection when we first started talking about this initial example of NTSX being 66%, and then you’re having the cash. The initial objection is, I can’t put 66% of my clients’ money in that, or my own money in a single issuer. Right? And also, I get $33 in extra real estate. Is that enough to make a massive difference in my portfolio? I mean, Warren Buffett made all his money by buying high-quality stocks, but then levering up 1.6 times, right? So it’s like a 1.6 turn seems quite reasonable, is 33% enough? Probably okay, but you can do better with now, and the availability of structured products.
Corey’s fund is basically 75% equity, 75% bonds with some tail protection. You know, the fund that we sub-advise to Rational is the best beta through risk parity, and on top of that, we stack systematic global macro. It’s another 100% on top. There’s Millburn doing the same thing with traditional equities as their beta. You got Eric Crittenden also doing the same thing with SPY. So you all of a sudden, especially those using futures, because leverage is so cheap in that space, you’re starting to see these beta plus alpha combinations that then allow you to minimize that objection, which is a line item risk objection, where you can put together seven to 10 different active managers using capital efficient strategies across different types of managed futures and a systematic global macro in a way where in the paper, we were able to get 1.6 leverage. 60% in alpha and 100% in the 60/40, right, in the traditional balanced portfolio, and that provided a pretty decent bump.
Adam:00:41:14I wanted to make sure that we spend enough time on the structure of the levered beta core, to make sure that people understand what’s going on there. Because I actually had a lengthy email exchange with someone I consider to be a highly sophisticated investor, who ended up not really understanding about the mechanics of how NTSX works. For example, he thought that if the equity sleeve declined, then the portfolio would be overly exposed to treasuries, and didn’t understand that there was going to be some notional rebalancing to keep the 90/60 equity/Treasury ratio intact along the way, right? So, Corey, I think you’ve maybe done the most digging on the underlying mechanics of that. So would you mind just going through what’s happening in that portfolio?
Corey:00:42:12Sure. So NTSX, specifically, you can think of, it’s an ETF, right, and they’re going to take 90% of the money invested and invest in the S&P 500. So as an ETF, you get all the wonderful theoretical tax benefits of buying the underlying equities. And in the US, at least, the ability to wash out a lot of the taxable turnover that’s happening in that passive exposure. And then the remaining 10% is being used to buy a ladder of Treasury futures. So 12.5 percent in two year, five year 10 year and 20 year, so equal notional amounts. And then the fund is being managed, I’m going to use air quotes for those who are just listening, and I’m going to say “actively” to maintain a 5% tolerance band around that 90/60. So when you get drift.
So right now, for example, interest rates have been going up. Treasury futures have been declining in value every day, some of that cash is being swept out of the collateral amount. You’re going to see a move away from that 90/60, maybe right now it’s more like 95/55. And at that point, that’s going to trigger a rebalance when it gets there to sell down some equity, buy back some Treasuries to get back to a 90/60. And conversely, let’s say it’s March 2020. Equities crash and bonds go up. Well, what it’s going to do is it’s going to start selling bonds to buy equities, right? Because it’s again, drifting away from that 90/60 exposure. So it’s just like a 60/40 in the very same way that when those weights get out of whack, it’s just going to rebalance. I think we get confused by the Treasuries. But I think if you just think of this as a 60/40, that’s just more. The logic makes a lot of sense.
Adam:00:44:04Yeah, 1.5 times the 60/40, right? So when you allocate two thirds of your capital to the 90/60, you end up with a full allocation to what is the equivalent effectively of the Vanguard Balanced Fund. And it, just like the Vanguard Balanced Fund maintains its relative exposures to stocks and bonds, this fund also maintains its relative exposures to stocks and bonds within the bands that you described, right? So you’re maintaining that 60/40 quality throughout the cycle, which I think is critical.
Corey:00:44:37I think the key difference between something like this and the Vanguard Balanced Fund is, Vanguard Balanced Fund is going to buy the total bond market, right? It’s not just US Treasuries, and it’s not going to be in this notionally equivalent ladder across the yield curve. It’s going to have asset-backed securities. It’s going to have credit in there, it’s going to have agency bonds. So a little bit of a different risk profile. But again, in the paper, we show 66 cents in an NTSX replicating portfolio versus the Vanguard Balanced Fund and they are incredibly close.
Adam:00:45:10And you’re able to benefit. I mean, the benefit of futures too, is you get this roll yield. Right?
Adam:00:45:15Which is a nice little extra boost. And at the moment, this roll yield is competitive with investment grade credit spreads.
Corey:00:45:21And potentially tax advantaged in the Treasury futures versus holding corporates. This is something people don’t necessarily know is that Treasury futures are taxed at a 60% long term 40% short term rate, versus most of your return in something like the Barclays Aggregate is going to come from your income and the income distributions. And so the actual, there can be tax benefits to implementing your bond exposure with futures.
Adam:00:45:49Yeah, so the after tax expected return is even more competitive with credit spreads. Yeah. Pasi is asking how often the NTSX rebalance happens, is that whenever the drift exceeds the band?
Corey:00:46:03I believe it’s when it’s triggered, yeah.
Adam:00:46:05Yeah. Yeah, I thought so too. What are some of the other objections? I know, one of the big ones, and Corey you sort of alluded to this earlier, was around the excess fees that you layer on to the portfolio when you take a third of the capital as an example and allocate to these alternatives. Have you found that there are return stacking alternatives that are able to substantially overcome the excess fees?
Corey:00:46:44Yeah. Before I get into the nitty gritty, practical implications, I think I’ll just take a step back and say, again, I think this is a very rational conversation to have. In a low expected return environment, fees and taxes are two of the levers we can control that we know have a profound impact, right, a direct impact. So when you talk to someone who’s a Bogle head, right, that’s a two fund or three fund implementer is getting global market beta in a 60/40 for three or four basis points, it’s hard to get them to move off that. What I try to communicate is, don’t look at the line item, right? Look at the total portfolio composition, and what we’re going to give you is the same 60/40, all right. So, think of that as your cake, and then the stacking is icing on the cake.
And the question is, are the extra fees that are getting put on for all the stacking, because a lot of these funds are more expensive, is it going to leave you with icing at the end of the day? As long as it leaves you with some icing, it’s worth it, right? And so I think if you don’t go line item by line item, but again, you think of it from a total portfolio composition, and Adam, you can talk to this. Like, you need to even incorporate some potential rebalancing benefits of return stacking, diversifying sources of return on. I think what you can find is, even if your actual average expense ratio of what you’re holding goes up, there can still be substantial excess return that can be generated over the long run.
Rodrigo:00:48:17Well, let’s remember why people are so conscious of the fee, right? You get a lot of these studies that show what happens when you pay your advisor 1% if you get to keep that 1%. What’s your terminal wealth look like? Right? It’s not a little bit, it’s a massive improvement, to reduce your fee from whatever you’re paying, from 1% to zero, if you just do your Vanguard funds, right? Logical argument, makes total sense.
What happens if we grab that 60/40 portfolio and stack 1% return after all the fees, the poor management? If that portion that you stacked on top has mid-single digits, right, after fees, after poor management, let’s say or like a bad decade, like we’ve seen in the last year, that portion, as long as it’s about 1%, like any basis point above your 60/40 is going to have a massive impact to your terminal wealth, right. This is the beautiful thing about this whole thing, that when you need to make room in your portfolio without leverage to add a non-correlated single-digit strategy, yeah, you’re taking away from the future of your clients. When you are able to keep that and stack, whatever it is, it’s a huge win. All of a sudden, something that’s single-digit and kind of shitty, ends up being an amazing addition. Right?
So I think that, you know, we go through the paper, is it stacking, returns or is it stacking fees? Yes, everything’s going to be a higher fee. But ultimately, you’re getting a completely different asset class, much more sophisticated. You’re getting access to leverage at the cheapest levels you can, professionally managed leverage, and you’re getting the rebalancing premium that you get from having all these managers doing this internally.
Corey:00:51:11Can I give a quick practical example of that? Right. So managed futures, which we talked about, had a really bad decade. Since 2011, the Credit Suisse Managed Futures Strategy, which is sort of pretty generic beta exposure, had an annualized return of 3.3%, with a number of years that it was down, right. But still, the net return was 3.3% after fees. So if you put 60% of that, on top of your 60/40, because you did return stacking, yes, maybe managed futures was disappointing if you had to sell equities to buy managed futures or sell bonds to buy managed futures. But when you talk about adding it on top as a diversifying source of return, suddenly that becomes very attractive even though it had a decade of very middling returns.
Adam:00:51:05Mike, you were going to say something I think.
You’re NOT Adding Risk
Mike:00:51:05Well, I was going to say that Corey explaining that, I think it’s Frej Ornberg. I think that is partially answering that question, right? If you’re levered anyway, no need to be scared or are the risks that you’re adding multiplicative. And they’re not. That’s the whole point, right? That as you add these, you have 100% exposure to the 60/40. It only costs you $67. So whatever you put in the basket of the 33, if it has a positive return, it is additive. And then you’ve got the diversity, right. And most of the funds that you’ve talked about in the paper, or the strategy types you’ve talked about in the paper, are structurally non-correlated to the 60/40. So this is where you can actually destroy risk. In a portfolio where you’re adding streams of returns that are not correlated, structurally not correlated to the main basket, you do, in fact, increase risk adjusted returns over the very long term, while preserving all of the returns from the 60/40. And I think that’s …
Rodrigo:00:52:30Yeah, I think that that objection — well, you covered the objection broadly, but there’s still always the real fear of everything correlating to one the wrong time, right? So there is something to be said about being levered, and everything just is completely offside at a time where there’s a liquidity crunch, right? So I think that’s something you do need to address. They’re generally momentary, like we saw, I think, in the last three days of the drawdown in 2020. We saw it momentarily in 2008, as well. And so yeah, you need to consider that.
And the way we considered it is by when we were sourcing the different funds that went into the stack return kind of index. We sourced those that had a little bit of tail protection to really fill that gap, that need that you can go long volatility or you know, long convexity when things all go awry at the same time.
So, it’s interesting because when we did, we back tested this portfolio using indices, right, we grabbed, 60% of it was SPY, 40% was AG, 30% was the SocGen CTA Index and 30% was Goldman Sachs, Macro Factor Index. We didn’t model in the tail protection and yet, from 2000 to today or to whenever we finished the report, the drawdowns were either better or slightly worse. It was, I think, slightly worse in 2020 without having modeled in the tail protection that a lot of these funds that we put in the paper have, right? So, you can imagine that adding that little extra juice there would help protect even further. So, it’s not a necessary thing, but it is useful, I think.
Mike:00:54:25I think the other side of it, Rod, is just to flip the question back and say okay, well what’s the course of action? Is it just 100% 60/40, is that the solution? And then we come back to the very beginning of the conversation for all those reasons we talked about initially starting yield, starting valuations of all cash flowing assets being expensive. So, you’re going to have to take some kind of risk. What is it that you would prefer to take, and how are you going to approach that?
Corey:00:54:51So Mike, if I can add a comment because you saying you can destroy risk really made my skin crawl. I think I almost like, jumped across the screen.
Mike:00:55:01I wanted to trigger you.
Corey:00:55:03Yeah. So I think mathematically not to — it’s always tough to talk mathematics. But one of the things we can do is we can plot on like an X axis the amount of leverage we’re using. And on the Y axis, we could plot the compound annualized growth rate of an asset when we apply that much leverage. So let’s keep it really simple and say we’re just buying stocks. At 100% leverage, aka, one for one exposure, you’re going to get some compound annualized growth rate. And then what if you do that 1.2 times leverage? Well, maybe your growth rate goes up a little bit. 1.4 times, maybe it goes up a little more. But if you do 1.6 times, what you might actually find is your growth rate goes down.
What you actually tend to find is it sort of looks like this curve. And the more diversified the portfolio is, the more leverage you can get before you fall over the tip of that curve. Now, the goal would be estimating that curve requires a lot of assumptions. And so if we want to reduce model risk, we don’t want to pinpoint the top of that curve, we want to probably be safely falling to the left side, taking too little leverage. So when we talk about a return stacked portfolio, that’s 60%, equities, 40% bonds, 30% global macro, 30% CTA, what we’re really talking about, is an unlevered portfolio that’s like 37%, equity, 25% bonds, about 19% CTA and 19% global macro. A pretty well diversified portfolio, and then we’re levering that up.
So the sort of technical approach we would want to take is, let’s build that portfolio and then plot this graph and say, where is that peak? And we can use it doing historical numbers, or we can try to forecast in certain ways. But where’s that peak where that’s the optimal leverage point if we know the future? And are we safely to the left of that while still being above 100. And at least the way I worked out the numbers, 1.6 times levered on this well diversified portfolio still puts you safely to the left of maximum notional leverage. I mean, you look at a Sharpe parity portfolio, actually not Sharpe parity. You look at a risk parity portfolio, as you guys know, all too well, that leverage point can be, I don’t know, 300% notional, because it’s so well … No, it depends on the target volume. You know what I’m saying.
Adam:00:57:27No, but the point is your margin of safety is extremely large at 1.6 times leverage, based on that portfolio construction, right? The optimal peak on that portfolio is probably in the neighborhood of three to four times. And if you were to use the empirical, max Kelly is probably well north of that, right. So, this is an extremely prudent level of leverage contingent on the amount of structural diversity in the portfolio.
Mike:00:58:01So I also want to get back to a question that was asked earlier that I think we’ve now evolved to which is, what ideas do you have for this if you already understand structural diversification and don’t really care about tracking error? Because we just started this risk parity conversation. So how would you guys think about that if tracking error is a much smaller behavioral bias
Adam:00:58:26Well, hold on, haven’t even talked about tracking error, really, actually. So let’s talk about tracking error, like the importance of tracking error, why you decided to structure the paper this way rather than going in sort of a risk parity core direction. And then talk about for those who are less, who claim to be less tracking error sensitive, what are some alternatives?
Mike:00:58:51I think that’s Ray Dalio’s pseudo name by the way. So I think —
Rodrigo:00:58:56Yeah, I think you know, when we first started talking about this, certainly my gut instinct was to stack returns by first creating the max Sharpe portfolio. So for every unit of risk you take, you maximize the unit of return, and then lever that up, right. But this has been our journey. Nobody likes — a few people like to listen to that, right? This whole thing started because an advisor asked me, I’m trying to create a retail version of the All Weather, the Cockroach Portfolio, the Dragon Portfolio, can you help me, and I said no. Look what happens when I grab your equities, your bonds, your gold, your tail, you get a …
Adam:00:59:39Hold on. The answer is yes, I can help you with that. But no, you don’t actually want it. You think you do, but actually, you don’t.
Rodrigo:00:59:48And I showed him I said, look, you let me do it. I did it on the screen for him and it did the back test for him. And what he saw was a high Sharpe, pretty steady equity line at a volatility of four with a return of four. That’s like you’re fired, you’re fired, you’re fired, it’s just never going to happen. So I went to bed, and he kind of just gave up. And I woke up the next day and I’m like, hold on a second, with Corey’s fund, with our fund, with Wisdom Tree, maybe we can create a levered version that hits, because the paper, like the Dragon Portfolio, has a volatility of 15% in the back test. Right. You need to lever that up pretty nicely. Why 15%? Well, because that’s what equities run at. Right. So by being able to use leverage with these products, I was able to go back to him and say, look, here’s your Dragon Portfolio, using leverage that hits like 8-9% volatility, which is probably, okay, you’re still going to struggle with a lot of tracking error, but, okay.
And we started thinking about publishing this paper, and I realized, this individual, this advisor is unique. Very, very few conversations happen when somebody’s seen the light. Almost every conversation is about how do I minimize my tracking error, while also recognizing I need diversification? I want something that goes up, one to one with S&P, but doesn’t have any drawdowns. Can you help me, right? And so, with the Stacking Returns paper, we could have gone both ways. But it made sense to us to address the biggest market, to try to help the people that are most susceptible to this future possible negative path for equities and bonds. And it made sense to do this, to create something that minimize the tracking error. People ask us if that’s what we do with our money. No, we’re converts, right? This is …
Adam:01:01:28Mike, how does this leveraged 60/40 allocation make you feel?
Mike:01:01:35Oh, God. Oh, God. Well, yeah, it makes my skin crawl a little bit much like Corey’s, me saying destroying risk. And I don’t mean that in a — I mean, that for me, personally. I just think that we are reaching a point of peak 60/40, especially when it comes to North American markets. And I’ve just been around for a couple of decades, a few decades doing this. And I’ve just seen the markets, how they sort of lull everybody into a concept, until the last dollar of that concept goes in. And there’s a decade-long period where things don’t work like was expected. So if we think about the 2000 Peak that started with the 1982 bull market, which started with interest rates at 18%, and brought them down to 6%. And how the conversion happened for people owning bonds and then getting convinced on stocks. The Japanese experience into 89. Like, I’ve just seen it so many times. And when you get such broad, vehement adoption, that equity risk premia, especially that of North America, and the US is clockwork, it works like a bond. It works like a CD or a GIC. When you get that kind of confidence, that’s where I get really uncomfortable. At the same time, I totally understand how advisors, allocators, board members are compelled to dance whilst the music plays. Very few can stand against the zeitgeist. And so I think that was the birth of this, the light bulb that went over in Rod and Corey’s head. Go ahead.
Corey:01:03:25No, I love that idea because one of the things that — after you write a paper like this, I always find you get to talk to a lot of interesting people and you get feedback. And Mike, your point there, that people can’t stand against this. One of the ways I’ve been thinking about advisors in the 60/40 portfolio is you can almost think of the 60/40 portfolio as the advisors’ liability. If they don’t deliver returns in line with the 60/40 portfolio, if they deviate too far negatively they get fired, right?
And so to me, another way of rethinking this return stacking is look, the first thing we’re going to do is we’re going to hedge your liability. You as an advisor have a liability that if you don’t return 60/40 you’re in trouble. We’re going to hedge your liability as capital efficiently as possible. And then we’re going to add something on top, and it’s very much like a pension in that sense. It’s just I’m looking at the advisor’s business.
Now, again, we’re using 60/40 as the example here. Does it have to be 60/40? No, you can do this in other ways. The reality is from a $1 basis the vast majority of money that advisors have for the clients they have ends up in a 60/40 balanced portfolio. So, it’s just sort of the biggest target market for us to address with this example. But to me, the point was, the advisor has a liability in this return stream. Hedge the liability, add whatever else you want on top.
Mike:01:04:48Yeah, I like that framework. So, I remember talking to Justin Castelli about this topic, right. Your client, if you’re an advisor, has a behavioral tracking bias. We’re talking to the largest market with the 60/40. But if you happen to live in San Francisco, that tracking error bias is going to be to a different main piece of finance, whatever it is. If you’re in a city, where everybody owns the company’s stock, I mean, you’re in an Apple complex, you’re at the Googleplex, that’s going to be the tracking error that you’re going to have to deal with. So I think if this expands, this concept extends far beyond 60/40. If you’re dealing with an individual who has a large single stock position, how might you diversify that large single stock position?
In fact, we have a few clients in that very spot where they have a large stock position with an extremely large tax liability that they don’t ever want to sell. So how might you use the excess margin available on those assets, in order to stack returns and diversify the returns if you’re never going to sell the asset? So, this is much more broadly applicable. And one of the things that an advisor, an allocator board member is tasked with doing is understanding what the tracking error sensitivity is, to the end investor that they’re dealing with. That’s the first prescription or the first thing that has to be determined by that individual? And then how do you go about bringing them to a more responsible place, if you will, that tracks their main index but provides excess returns? Anyway, go ahead.
Rodrigo:01:06:34It was the idea that our whole careers has been about, we’re smarter than you. The math is very clear. This is the way to manage money for 100 years, and there is no other way. Look at how intelligent I am. Why aren’t you doing this? But the truth is that we were dumb, because we didn’t take into account the utility curve of the individual investor, which has a behavioral bias, all types of behavioral bias. And when you take into account, you got your mathematically optimal positioning here, and then you have your behavioral need for belonging in a society where everybody’s winning and losing and at the same time, you need to put those two together, right? Our job, it’s presumptuous for us to think that everybody should do this one thing.
Our job as stewards of wealth, is to put together a portfolio where the end client is most likely to stick to long term, period, full stop. Right? Because you can provide a max Kelly type of investment strategy that helps you compound wealth at the highest rate, but nobody’s going to stick to that. Right? So why does it matter? Why are we even talking about it? And I think that this is a recognition of that, a recognition that there is a need for this. And our job is to help people do the best that they can with what they have. Right?
Tolerated Tracking Error
Adam:01:07:59Okay. So we started, Mike actually started this and I sort of backed it up a little bit. But he started by saying, for those who can tolerate a larger tracking error and are pursuing a more absolute return-type wealth trajectory, how might they begin to think about this problem from a beta and portable alpha type framework?
Rodrigo:01:08:31Well, again, I think we cover a lot of this, but there’s a bunch of different ways. I think Meb Faber talked about — he did a horse race between the permanent portfolio risk parity, Mohamed El-Erian. I’m sure you can add more things. I mean, certainly the way we like to approach it, which is a bit of risk parity, a portion of long/short commodities, systematic global macros, some tail protection is an All Weather approach to maximizing your Sharpe ratio, right? So there’s no, there doesn’t seem to be one answer to all of this, really.
But let’s say that you source an allocation, an asset class allocation from the Dragon Portfolio, from the Cockroach Portfolio, from risk parity, from El-Erian, you mix them together and you find whatever that optimal All Weather, ensemble of All Weather strategies are. Well, now you can lever that up, right? And so what we’re working on is trying to put together some sort of widget, hopefully soon, that has what we believe to be the underlying exposures across many different public funds, where you can type in this is the allocation I want, and this is the leverage I want. And it spits out how to put together these public ETFs and mutual funds to give you the exposures that you want at different levels of leverage, right?
So I think, from my perspective, a thoughtful approach would be that, source strategies where people are calling them All Weather, see if you like them, put them together, find the allocation, and then at this point, the widget isn’t up and running. But certainly, you can reach out to us and we can help you structure that using these public funds in a way that is useful to you, whether you’re an individual investor or an advisor. Corey, do you have any thoughts on that?
Corey:01:10:22Yeah, just I would say the tough part today is still that there’s not a plethora of funds that do this. And because leverage was historically a four letter word and probably still is, they don’t advertise that they do this return stacking. So coming up with a list of funds that actually do the return stacking, I think, Rodrigo, you and I put together maybe a list of 20 total. That said, the SEC rules changed as of last November or last October as to how much notional leverage can be used in a 40-F fund. It’s now based on value at risk.
So just as an example, it used to be if I wanted to take two year US Treasury futures and lever them up 10 times and put it into an ETF, I couldn’t do that, even though that was probably the equivalent duration risk of me just taking that ETF and buying 20 year US Treasuries, which was allowed. So now the SEC has changed their tune. And it’s not about notional leverage, it’s about your value at risk. And so my expectation would be there’s going to be a lot more funds that are incorporating derivatives providing you a lot more bang for your buck. I think you’ll see different currency strategies coming to market, a lot more in the Treasury futures space, commodity futures, hopefully. Because a lot of these strategies that could be done in hedge funds really got neutered when they were putting 40-F vehicles. Doesn’t answer your question as to what should people do if they want more tracking error, I’ll gladly admit, as a US investor, it is hard for me to fight that US country bias. I have not become a full convert to something like risk parity.
But what I’ve done with a lot of my money, I just have a lot of US equities that have a low cost basis, I really can’t sell them. They’re in taxable accounts. I’m sort of stuck with them for the long run. A lot of what I’ve been working towards is with marginal new money, trying to implement this return stacking via Treasury futures, and then using the freed up capital to buy things like managed futures, and strategies or private funds that I might have access to that I think give me a really good diversifying source of return.
Mike:01:12:24I think you actually have to ask the question, sort of above the, what do I do if I’m okay with tracking error? Well, the question really is, what do you believe about markets, asset classes, their returns and the risk, right? So if you embark on different types of strategies, like a risk parity strategy is saying that the return of the asset is directly related to the risk or the volatility that it has. And that is the underlying basic assumption. And then you can go through a minimum variance has a different set of assumptions, you can go through things like, well, how good you think your forecasting is on various asset classes, as you assemble the portfolio. And I think probably Adam, you can wax and wain on this a little bit more. But the, what’s the paper that you wrote that really goes through that in detail about …
Adam:01:13:22Yeah, The Portfolio Optimization Machine. Yeah.
Mike:01:13:23Right. Right. Which is, if you haven’t read that, that would help answer that question. I don’t care about tracking error. Okay, that’s fine. What do you believe about markets? And then going through The Portfolio Optimization Machine, there’s a framework there where you go step by step and you make decisions? Do I believe this, or do I believe that? And you go through the decision tree, and then lo and behold, you will have a decision where now your beliefs are congruent with what you’re reflecting into your portfolio. And that should be the base of beta on which you would stack returns, if I were to think about a framework to put that through.
Corey:01:14:03Can I add just one thing to that, which I would say I don’t think it’s enough discussion is, human capital is an asset. And most people can model their human capital as some sort of bond, corporate bond. And you can decide whether, how sensitive it is to default and that sort of stuff. But the reality is, a lot of us are like, if you don’t work in financial markets, in particular, very long, a corporate bond that should be taken into account in all of this discussion, right?
When you’re thinking about your investments and the liabilities you’re trying to meet in the future, it should not just be about your investment capital. It should be about the combination of your human capital, which is likely modeled as a bond, plus your investment capital. And if you can keep that holistic framework in mind, right, you can probably get rid of a lot of bonds if you’re young, out of your investment portfolio, because you have this huge long duration bond, that is your human capital.
And then again, a lot of the reason you see bonds come into the portfolio for someone who’s approaching retirement is because their human capital duration sort of goes away and turns into an option of sorts, right? They have the option to go back to work. So I think for those who can maybe think a little bit more holistically about their financial planning, which is probably anyone listening to this podcast, especially if you got to an hour and 15 minutes in, right, I would urge you to consider how that human capital element plays into it as well.
Mike:01:15:31I think that’s in the CFA, right? Are you a stock or are you a bond? That’s the same sort of framework you’re talking about, right?
Corey:01:15:38I’m writing put options personally.
Adam:01:15:42We all are, brother.
Rodrigo:01:15:45I think the next paper we’re going to write on Return Stacking is going to be an All Weather, like Return Stacking – All Weather Edition, so that we’ll be able to flesh out some of those ideas and how to think about that problem, how to put something like that together. But for me, it is an interesting discussion as to why one might want to, even with that human capital discussion, Corey. I mean, it’s just another type of bond, right? There are many types of bonds. It’s not just treasuries that we can do well with. There’s German bunds, UK gilts, you can get diversification, diversification is good, right? If we’re trying to create an All Weather portfolio, a max Sharpe portfolio or something like that, with the use of leverage, then it solves a lot of problems. And even if you’re young, you just need to be willing to take on as much leverage and volatility as you can stomach and be responsible with, right, in that All Weather strategy.
One of the things that continuing to add bonds does, if you’re levered up, people talk about how bonds are yielding one and a half percent, what’s the point? Well, bonds are yielding one and a half percent if you invest 100 cents on the dollar. But if you’re able to lever them up three times, then all of a sudden that one and a half percent return levered three times rivals that risk premium of equities, right? So if you put them in the right proportion with some commodities, and you are a young person, your bond as an individual that’s idiosyncratic added to that, and you use leverage, that’s actually, for me, a better option than what is commonly told to do which is the 100% equity portfolio. I think …
Mike:01:17:35A little close to home … from yesterday, dude, NFTs.
Rodrigo:01:17:40You know, that concentration risk, you can invest like an old person as long as you have leverage because then you’ll be like an old, very diversified portfolio with a lot of volatility and risk and return, right. So when you think about the Vanguard or whatever, any lifecycle fund, that starts with 100% equities and ends with 100% bonds. And if you’re looking at the Sharpe ratio of that portfolio, it starts very low because it’s in equities, historical Sharpe ratio is 0.3, then as you add more bonds to it, the Sharpe ratio starts going up to 0.5. And as you get older and start to decumulate, the Sharpe ratio goes back to 0.3. It’s an absurd way of managing life cycles.
And there’s also a sequence of return risk from that portfolio, right? If you look at the 60/40 portfolio, over the last 100 years, there’s many decades where you’re annualizing at zero in real returns, right? The best way to do it is to have that All Weather, and keep that same allocation, but start at 20 vol risk parity. And when you’re retired, finish up at non-levered risk parity and maintain your Sharpe ratio as consistent as you possibly can. That’s the next fund we should launch.
Adam:01:18:52Corey, Rick Hanes asked if you saw … the 200 SMA approach —
Corey:01:18:57Don’t ask me this
Mike:01:18:59Before we jump on to that one, I just want to wrap up on the All Weather side. So Adam, when you asked me what do I think about Return Stacking, it really is a relationship to the concentration in the S&P/US sort of balanced portfolio that makes my skin crawl. If it was based on an All Weather type portfolio structurally diversified, you know, pick what assumptions you want, I would feel a lot better. That would be my preference. And that’s what we run in our products.
I also think people, investors, allocators, etc, should be thinking about the fact that we have a debasing of the monetary system that’s going on, while at the same time rates are pinned at all time low levels. And if you’re an investor that is in that world, how might you take advantage of that for your own investing purposes? Let’s not even think about tracking error. How would I maximize returns? I’m a return seeking maniac. Well, I would borrow all the money I could at these insanely low, the cost, I would try and get as much non-recourse leverage as I could. And then I would try and construct a very diversified portfolio. And so you’ve got this set of circumstances that is laid at your feet, because central banks have done some things and stuff.
But you do have to think about the regime shifts that come through those periods of time where we’ve seen pinned rates, debasement of currencies in the past. They have occurred in the past, there are very different asset regimes. But what you’re saying with All Weather is I’m not sure how that’s going to manifest to someone and when it’s going to transition. And then when you’re stacking on top, you’re adding all those other types of asset classes that aren’t so commonly held, other types of strategies, and you’re doing it at almost free, in cost. Like when rates are much higher, if rates are 10%, it’s a little harder to do.
Adam:01:21:04Yeah, for sure. So, about that 200 SMA.
Rodrigo:01:21:12Sorry, Rick. What’s happening here is that we’ve written, Corey has written a ton on the timing/luck issue of any sort of rebalancing, any sort of trigger points, like 200 days, what’s so special about the 200 day? What about the 100 day, 150 day, the 300 day. Newfound and ReSolve co-created an index based on research that we came to at the same time with regard to maximizing the different types of trend signals that you can get, because no one can really foresee which one’s going to be better in the next period, you want to have them all. And you want to minimize your timing luck, you want to maximize diversification strategies. And that creates a much more robust portfolio where you’re not susceptible to any particular type of market.
So you want to be broadly correct about your signals rather than specifically wrong. And I think Corey has some examples in his back pocket on where the 200 day or the 10 month momentum signal is specifically wrong, and why you want to diversify away from that. So you can look it up, Timing Luck, ROMO or the Robust Momentum Index that we run. All the research is there on Corey’s website.
Corey:01:22:42Thank you for saving me from doing that.
Rodrigo:01:22:46So we’re coming up to the top of the hour.
Corey:01:22:49There was a good question here, though, that I think should be addressed, I don’t know if I can select it. But from Mike Caldwells, who was asking if there’s any due diligence considerations, when looking at these publicly available funds? I think that’s a great question, whether you’re an advisor or an individual. So Rod, I don’t know if you want to jump in, Adam, Mike?
Rodrigo:01:23:09No, I think it’s a good question for you, Corey.
Corey:01:23:11Oh, great. So I think with any of these funds, the first couple questions to ask are going to be, first of all, what are the assets that are within it? Are they passively managed? Or are they actively managed because these different strategies are doing this in different ways. So we mentioned the Wisdom Tree NTSX portfolio, that’s very vanilla. That’s going to be 90% equities. 10% cash 60% notional exposure to Treasury futures. Contrast that with something like PIMCO Stocks Plus, which is going to be bonds as the base, and then overlaid with about 100% notional exposure to the S&P 500, through futures.
So what’s important in trying to understand what’s going on in the construction is going to be cost, it’s going to be tax consideration. So you know, you’re getting wonderful 60/40 treatment on your Treasury futures with NTSX, but in PIMCO stocks plus, you’re getting 60/40 treatment on the S&P 500, which is a typically worse tax than if you were just buying and holding S&P 500 exposure. So understanding which asset is getting levered up, the implied financing costs of levering up that asset, whether it’s actively or passively managed, and the tax implications, are I think, are hugely, hugely important. Another product that’s out there is the DoubleLine Shiller Enhanced CAPE product mutual fund. I think I got that right.
Rodrigo:01:24:44It’s all those words in different order, but …
Corey:01:24:47Which is actively managed bonds with a total return swap on top that’s based on an actively managed equity index. So again, it’s the same sort of concept, stocks plus bonds levered up. But now it’s not passive equity and passive treasuries, it’s active bonds and active equity. And so you have to decide not just do you want this total leverage exposure, but how are they actively managing the bonds? How are they managing the collateral? How are they actively managing this equity index, and how do they play together? And so you have to be really careful when you look at these different products as to how the pieces are actually fitting together, and the tax considerations thereof.
Rodrigo:01:25:29And you want to reach out to the managers because like Corey mentioned earlier, a lot of people aren’t very public about the leverage they’re using. They don’t use the word leverage in these funds. They’ll talk about we have a 95% exposure to S&P. And then we have with the last 5%, we do a swap of some sort to get extra exposure to blah, blah, blah. So you’re not often getting a direct communication as to what type of leverage and how they’re using the leverage. You have to call, you have to dig, and you have to get the right answer, right.
So since this paper has come out, a lot of people that have been hiding are coming out of the closet with their leverage, right, and saying, oh, I want to be part of your list all of a sudden, right? Hopefully, we’re making it cool again, to talk about capital efficiency. But yeah, you do need to make the call, and you also need to diversify your manager risk. So we launched an index, based on the paper, in our website, if you go to InvestReSolve.com, go to strategies, and then in the indices, or Stacking Return Indices, you’ll see a version of the Stack 60/40 Portfolio and the managers that are chosen there. And a lot of them are overlapping managers, right? There’s two managed futures funds. Why do you want to do that. Because managed futures are notoriously divergent, like they’re not all going to give you the exact same type of trend, speaking of the 200 day moving average. So you have the opportunity here to diversify manager risk as well, while getting those stacked returns, right. So that’s, I think, a key thing, diversify your line item risk.
And then the other discussion and objection that we’ve had, especially with dealing with advisors that want to implement something like this, is that ultimately, when they go to their compliance and say, look, I have a model portfolio. Look at these 10 line items, I want to do this, they’re going to go search for those line items and see that there are alternative funds. And that will be like, at first blush, it’ll seem like it’s 100%, high risk, can’t do it. Right? So advisors are working with a compliance team to explain the concept. And what we’ve suggested is not to say, listen, you should replace what you’re doing. And just do this because it’s going to be a tough ask, you got to get compliance on board.
What we’re suggesting is create a brand new sleeve with a bit of assets. Convince one or two of your clients or yourself to do it. And let the numbers speak for themselves over the next three years, and slowly educate. Let people opt into this solution as time goes by because it is a compelling implementation. It is what institutions are doing. The most sophisticated people and institutions on the planet have been doing this for decades, and that’s why they’re crushing everybody in terms of returns; the Canadian Pension Plan, the Ontario Teacher’s Pension Plan. This is institutional quality concepts that eventually will show up in the numbers.
So yeah, the truth is that ultimately, you got to address the fact that it’s all alts, that there is leverage, you got to get your compliance behind it, and then you I think you need to let people opt in, rather than force it on them.
Adam:01:28:36Poor Amit keeps asking for the list of tickers.
Mike:01:28:40We can’t be more clear, we keep putting the link in there.
Adam:01:28:43We keep posting them. Yeah, maybe Ani just for posterity. Drop that link to the Stacking paper.
Mike:01:28:51I dropped it in as well on the thing. But yes, it’s in there a couple of times. Yeah, there’s a full list of … it’s indexed.
Adam:01:28:58There’s a model portfolio there if you really are looking for an example. Yeah, it’s an index. What I meant is an index.
What’s New in the Can
Mike:01:29:08And you know what, it’s interesting extending on this point. So here’s what you do in public markets, in publicly traded markets, right, these are all widely available funds. The next step is when you ask that question I always get, when that person asked that question, the fund to funds or not fund to funds I get excited because Adam, you’ve got some work in the can here. Maybe give everybody a little quick peek on what you’re seeing in a fund to funds structure versus a group of managers structure where you can do some netting, in sort of more sophisticated portfolios. What the outputs are and a sneak peek into some research that you’re working on maybe.
Adam:01:29:51Oh, yeah. Okay, sure. So the premise here was motivated by a conversation we had on this show with Chris Schindler a few months back, which I highly recommend that you go and listen to. The full thing is absolutely mind-blowing. And there’s 100 different amazing takeaways that would be accretive for most investors. But one of the things he mentioned was that there is a huge benefit in terms of total net returns to allocating to a multi-strat manager rather than allocating too many individual managers that each run their own independent strategy. And the benefits accrue from three different sources.
The first source is that when you run a variety of strategies in a single fund, then a lot of the times the trades that you’re putting on in order to execute on each of those strategies are orthogonal to one another, which means that often they will be netted, right. So, one strategy will be going long a market and another strategy will be going short the market. And if you’re running them in the same account with the same fund, you don’t buy and then sell, you just net the exposure. So your average trading is a lot smaller than it would be if you are running them in separate accounts, or in separate funds, right. And so you’re paying less commission and you’ve got less trade slippage.
The second is that you’re paying performance fees, right. So a lot of the time, these are active strategies that have performance fees, and the performance fees you’re paying are on two different things. One is the skill of the manager, and one is the noise of the strategy. Well, when you combine a bunch of strategies together, the noise, a lot of the noise, cancels out. So the noise term in that equation is much lower, and the proportion of the signal is much higher. So you end up paying a higher proportion of your performance fees on skill, and a much lower proportion of the performance fees on noise. And so your aggregate total performance fees paid is a lot smaller when you mix all of these strategies in a single fund, rather than when you have them across multiple different independent accounts or funds or strategies.
And the third source is a little bit more nuanced. But consider a typical allocation to alternatives, let’s just say you’ve got 70% in a core portfolio, you’re going to take 30% of the portfolio of your capital, and allocate it to alternatives. And let’s say, each of those alternatives, each has a volatility of 10%. Well, when you allocate to a variety of these different alternatives, if they’re uncorrelated, your total risk budget is substantially less than 10%, because when you combine all of these funds together, they’re uncorrelated, you get diversification of the total portfolio, volatility goes down, and your expected returns goes down commensurately.
When you combine them all in a single portfolio, then if you don’t re-leverage them, then the returns go down. But when you combine them, you can then rescale the total combined strategy back up to the original target risk, which means you’re then getting a substantial boost to your target return, or to your expected return.
So the combination of those three different things in the case studies that we examined resulted in about a 50% boost to expected performance from allocating to a multi-strat fund or multi-strat product, rather than allocating to a series of individual products where each product is trading independently, paying fees independently, and you don’t have the opportunity to rescale the total portfolio risk to achieve that potential target return. So, that’s coming out in the next few weeks.
Mike:01:34:10Beautiful. Well, we took it from the beginning to the middle and left them on that Star Spangled Banner note right there at the end leaving them, obviously, with bated breath for the next papers that are coming out.
Corey:01:34:25Can I just say I’m actually really excited about that paper, Adam. I think this industry focuses far too much on the next source of alpha when stuff like that is a structural edge when you think about it correctly, and is an edge that cannot be diminished. Right? You either do it correctly or you do it incorrectly. And if you do it correctly, it’s not something that crowding can get rid of. You are literally tilting all the odds in your favor, and I think that kind of stuff doesn’t get enough play in this industry.
Adam:01:34:56You know, it’s so nuanced because we talked about this a lot internally, because all of our strategies are massive multi-strats. Right? And what that means is you are eliminating to the greatest extent possible, the luck component, right, that noise component, which is maybe your strategy specification just happens to get really lucky in a year. And the vast majority of investors misperceive that luck as skill and then your fund gets a massive amount of inflows, and it can make a career, right? Some really good luck, that’s 99% of the time, just noise, makes careers, right? And we have shorted that opportunity in order to be able to maximize the efficiency of portfolios.
And so what it means is, we expect to sort of be in the second quartile all the time, and almost never in the first quartile because we just don’t have that luck, that excess noise factor that gets you into the top quartile, right? The reality is, funds that spend some time in the top quartile are a lot more likely to spend time in the bottom quartile, right? And it’s that moving from top quartile and the bottom quartile that ends up leaving investors with very mediocre returns over time. What you want is a fund that spends most of its time in the second quartile, never spends time in the bottom quartile. And that compounding effect ends up paying off to a massive amount of excess wealth over time.
So anyways, it’s a really interesting business decision, investment decision for the allocator. You have line item risk, you’ve got single custodian risk, single operations risk, there’s all kinds of things to consider. But I think this is an important concept.
Mike:01:36:52Did you touch on the actual manager turnover, right? So you’ve got these 10 non-correlated managers. You will absolutely have one that provides a 15 or 20% loss. And if you fire them at that point, that’s the asset that you had, and the performance fee is now gone, you have to hire a new manager at the new fresh performance fee. So manager turnover based on some arbitrary drawdown metric virtually guarantees a turnover of managers that increases the overall performance fee paid.
Adam:01:37:24Yep. And a lot of advisory firms have these arbitrary thresholds. If an alternative fund violates a 15% drawdown limit, that fund is automatically removed from the recommended list, a new fund is there to replace it. And all that means is advisors are forced to sell that fund, that’s in a drawdown. Keep in mind, the investors in that fund have accrued an asset. That asset is the value of the difference between the high water mark on the fund and where the fund currently is in drawdown, they’re giving that up. Now they’re going to go buy a new fund, that high water mark is reset at the purchase price. And you rinse and repeat so there’s a massive accrual of negative, or giving up on positive fee assets.
Corey:01:38:13What about the tax asset you create though? You know what, I’m not even going to go there. We could go another hour.
Mike:01:38:18You make a fair point, right? You have it, potentially a tax asset but many of these assets are, let’s face it, these are endowments and whatnot. So there isn’t tax deferred products.
Mike:01:38:28You’re right. If you do have a tax asset, it’s something that you need to consider. But a 20% free ride up to your high water mark, and abandoning that just through randomness, right? If you have 10 managers with a one Sharpe and they’re not correlated, and you have this metric, some of them are just going to hit the part of the bell curve that knocks them out for nothing, but just random noise.
Adam:01:38:53Well, the majority of it’s just noise. Absolutely. Yeah. It’s complete foolishness.
Mike:01:38:57Right. And as Rick says, good to investment when it drops 15%. That’s precisely right. Right? Review the manager, if nothing’s changed, it’s a normal drawdown, rebalance, add more. If it’s broken, okay, sell but that’s a very different, you know, I think broken is often confused …
Adam:01:39:18One day we’ll have an hour and a half conversation of what being broken means.
Mike:01:39:22Exactly. Precisely, which it needs at least that, at least that.
Adam:01:39:27Yeah, for sure.
Rodrigo:01:39:29All right, gentlemen. Are you guys all joining me for the private screening of Dune this Sunday?
Mike:01:39:33Yeah, I’m in I mean, I …
Adam:01:39:35I’ve got to run it by my boss.
Mike:01:39:36I absolutely said to my boss that I might be missing at 10 o’clock on Sunday. I’ll try and get you a ticket.
Adam:01:39:45It’s not this Sunday, right, it’s next Sunday?
Corey:01:39:45If my boss can’t show up, I’m not allowed.
Rodrigo:01:39:48Yeah, it’s this Sunday.
Mike:01:39:49Yeah, I didn’t tell my boss.
Rodrigo:01:39:53That’s why it’s a private screening.
Adam:01:39:57Anyway, thank you guys so much for listening. Please smash that Like Button, please like and share. And we look forward to seeing you next week. Corey, thanks a lot for joining us.
Mike:01:40:06Thank you. Yeah, thanks Corey.
Corey:01:40:07Thank you guys, appreciate it.
Rodrigo:01:40:07Thanks again, bud.
Rodrigo:01:40:09All right, gents. See ya.
*ReSolve Global refers to ReSolve Asset Management SEZC (Cayman) which is registered with the Commodity Futures Trading Commission as a commodity trading advisor and commodity pool operator. This registration is administered through the National Futures Association (“NFA”). Further, ReSolve Global is a registered person with the Cayman Islands Monetary Authority.