Talk Your Book: Return Stacking

0:00Today's Animal Spirits Talk Your Book is brought to you by Newfound Research. Go to Thinknewfound.com for research. A lot of dorky quant stuff there, but really good. Return stacking stuff. Corey is king of the dorks. Yeah, he really is. Thinknewfound.com. I've been reading it forever. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnick and Ben Carlson as they talk about what they're reading, writing, and watching. All opinions expressed by Michael and Ben are solely their own opinion and do not reflect the opinion of Ritholtz Wealth Management. This podcast is for informational purposes only and should not be relied upon for any investment decisions.

0:40Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:48Welcome to Animal Spirits with Michael and Ben. We talked to King of the Dorks, Corey Hofstein, who is one of my favorite quantitative writers. Ben mentioned earlier that we've, I don't know, Corey's been doing this for a long time. I think I've been reading it for probably more than a decade. And he explains things in a way that is digestible for, let's just say like the layman, right? That's what we are when it comes to some of this quantitative stuff. I feel like Corey also takes a lot of quantitative stuff that you and I have researched and read over the years and also pulls a piece out of it that you've never thought of before.

1:25Like his idea of diverse timing of signals. Rebalancing luck. Yeah, rebalancing luck, like when you rebalance, whether it's a tactical strategy or an asset allocation and how luck plays a role and how to diversify that. So it's like diversifying your diversifiers. Well, Corey's an interesting person in this business because this is a business and Corey's an entrepreneur. He's a business owner. And so later in the show, I won't step on too much of it, but we talk about like, how do strategies succeed? And it's not always the smartest or the fanciest. It's what will the market buy? You and I have seen so many strategies presented to us over the years where the person is the smartest person in the room and they lay out the strategy and they assume, I am so smart, people are going to throw me money.

2:10And that is just not how it works. Yeah. So what Corey's done is he spent a long time building a following, explaining his ideas, and the proof is in the pudding because they launched a couple of return stacking ETFs, which we talked about today, and the assets have taken off. So there's clearly an appetite, clearly a product market fit for what he's built at Newfound. So I hope everybody enjoys this episode with Corey Hofstein. We're joined today by Corey Hofstein. Corey is the president of Newfound. He's the founder. He's the portfolio manager of of the return stack ETF. Do I have that sort of right?

2:57Well, we don't have a president at the company, but I'll take the title. He's the vice president to the assistant regional manager. Corey, we're excited to have you on today. We're going to talk about, I don't know if your life's work is too strong of a word, but you've been working on the concept of return stacking, portable alpha for a long time now. For people that are unfamiliar with this term, what are we about to talk about today? Yeah. So this is a heavy way to dive in, And maybe a little bit easier way is to talk about the problem we're trying to solve. Sure, let's do that. I think that's really important here.

3:28A lot of investment products and concepts are trying to solve a return problem or they're trying to solve an income problem. The core concept of return stacking is trying to solve a diversification problem. So what do I mean by that? Well, in this wide industry that we have, there's very few things that we actually agree on. You get a bunch of investment people in the room, and we can argue ad nauseum about just about every aspect of investing. We love to split hairs, don't we? We absolutely love to. But still mostly agree. Yes. Still mostly agree on the big principles. But one thing we all agree on, I have yet to disagree with someone on this, is the concept of diversification.

4:06That more diversification is better, all else held equal. Now, that all else held equal is doing a lot of heavy lifting. But, you know, if you have nine stocks that you like and you find a 10th stock that you like, in expectation, adding that 10th stock to your portfolio is better for you. You will achieve your outcomes with greater consistency. And so typically we want more diversification in our portfolios. But when we look around the industry, and I'm sure you guys have better insight into this than almost anyone, the average portfolio tends to look a heck of a lot like 60 % stocks and 40 % bonds.

4:44And you don't have a considerable allocation to things like commodities or gold or alternative investment strategies. It's hard to even get people to invest outside the U.S. when you're a U.S. investor and get that international diversification. And so a lot of my work is focused on, well, why is this the case? I think one reason is there's a little bit of recency bias. You think? Yeah, last 10 years, right? Stocks and bonds have done really well. And US stocks and bonds have done really well. But as someone who's focused their career on alternatives, what I really came to believe is that the reason diversification is so hard is because for most people, it's a process of addition through subtraction.

5:28Now, what do I mean by that? Well, if you want to add gold to your portfolio, I got to sell Apple, you got to sell Apple, or you got to sell, you got to sell something, right? You got to make room. And what that does is it creates this really high hurdle rate. If you have to sell stocks and bonds to make room for gold or commodities or an alternative investment strategy, you're selling things that are typically more transparent, have a lower cost are more tax efficient. And also from just a pure behavioral perspective, you have a more better emotional understanding of. Ben, you wrote a piece recently, I think it was this week or last week, 20 lessons over your 20-year investment career.

6:08And I think I would guess 19 of those were emotional, emotionally based. So many of the lessons are just the best portfolio is the one you can stick with. And to your point, the people who do make a change will toe in the water and they're like a 2 % position, which doesn't move the needle anyway. Right, right. And so what happens is these diversifiers become very hard to stick with. I'm going to steal a phrase from Cliff Asnes, who's on Barry's podcast, Masters in Business, when he talked about this. He said, you know, you get 10 years of underperformance in a diversifier from a statistical timeframe, that's a blink of an eye.

6:45Like for us sitting in the ivory tower of asset management that's meaningless. But from a behavioral perspective, in emotional time, that's an eternity. To ask an investor, hey, take some of your hard-earned money, and instead of sticking it in stocks and bonds, stick it in this alternative that went nowhere for a decade, it's just not going to happen, right? And Coy, when the diversifier is something like managed futures, and you have to explain to a client, a regular person who just goes to work and just wants to have somebody watch their money. Sorry about this. That short wheat position really hurt last quarter.

7:18It's like, why the f*** am I short wheat? Exactly. Exactly. And so it's nothing against managed futures, good, bad, or otherwise. But even professionals would be hard pressed to stick with something like that that underperforms over a decade. Even if statistically that's meaningless, guess what? We don't live in statistics. This is a real world. Layer on top of that higher fees, less transparency, less understanding, easily understood for your average person, less tax efficient, right? The worst part, especially with something like managed futures, is you can have a loss and owe taxes. And that could be, right?

7:49So then clients are going to really love you for that. So it makes structural diversification really hard and it leads to performance chasing. And we see that in the numbers, right? So we have these problems, right? We want diversification, but it's really hard to structurally do. And so when we think about what is the ideal diversifier, it's something with positive expected returns. It's something that's uncorrelated to stocks and bonds, but more than anything, it's something we can stick with. Sounds like you're talking about Dogecoin. Well, all right. This is where the magician pulls a rabbit out of the hat and says, and by the way, I've got the perfect thing for you.

8:23This is where I should do my salesman pitch if I've found the perfect alternative investment. I actually would say, I don't think there's any alternative investment that perfectly fits that. But I think what we can do, there's no magic diversifier, but I think what we can do is think about a better way to build portfolios. So my proposal would be, what if instead of having to sell stocks and bonds to make room for a diversifier, there was a process by which we could keep our stocks and bonds and add the excess returns of that diversifier on top of your portfolio? Effectively stack those returns on top so you can keep your stocks and bonds and get that additional return stream.

9:02And that's effectively what we're trying to do with return stacking, is allow investors to achieve a different means of constructing a portfolio so they can have their traditional asset classes that they're comfortable with, but introduce these alternative diversifiers as well. So even if its expected return is lower than stocks and maybe even lower than bonds or similar to bonds, if you add it on top, it's going to be additive and not take away from the portfolio. Yeah, exactly. Exactly. So let's say you think stocks are going to be up 10 % and bonds are going to be up 5 % and gold will be up 2%.

9:36Well, you could still add gold on top and get that additional return stream on top of your stocks and bonds. Where's that lawnmower coming from? Dude, can you hear that? It's comically loud. The dude literally just walked right outside my window. And he's like, I think he's got a leaf blower that he's literally blowing out my window. Uh, okay. Um, all right. So by the way, Corey, your explanation of that was much better than me diving in. So, so well done there. Um, where does the return, where does, where do you get the money to, how do you get a dollar 10 cents for a dollar or whatever it is?

10:14Yeah. So, so ultimately what we are doing is by stacking returns on top, we are, we are using a form of leverage. And so we have to tap into, uh, financial futures markets to, to access that leverage. So for people who have never traded futures, this can sound sort of opaque and potentially difficult to understand. So again, I'll try to use an example. We have a fund called the Return Stacked Global Stocks and Bonds ETF, RSSB. And the idea here is that for every dollar you give us, our goal is to give you a dollar of global stock exposure plus a dollar of treasury exposure. Why is that useful?

10:55It's not that we think that that portfolio will necessarily outperform global stocks. Where it's useful is as a tool for capital efficiency. So if you, say, had a 60-40 portfolio and you sold 10 % of your stocks and 10 % of your bonds and bought 10 % of this ETF, that ETF exposure would give you back both your 10 % stocks and 10 % bonds. But now you've got 10 % cash with which you can do whatever you want. Within the ETF itself, to get you$2 of exposure, when you invest a dollar, we're going to take it and invest it in equities. And then we're going to buy US Treasury futures contracts. And the leverage is embedded in those futures contracts.

11:36They're going to provide the total return of Treasuries minus the embedded cost of financing for that leverage. And so when I said earlier, we're stacking the excess returns. When I say excess, I mean in excess of sort of the short-term T-bill rate, which tends to historically be the cost of leverage embedded in these treasury futures. So does the cost of these futures, I mean, T-bills, money is expensive right now. So is this going to eat into return? Like all else equal, you would much rather be paying 2 % for the leverage than 5.25 % or whatever it is? Well, there's two arguments here. There's one argument, which is expected returns are always in excess of the risk-free rate, right?

12:23Why would you buy stocks if you didn't think they were going to outperform T-bills? Why would you buy bonds if you didn't think they were going to outperform T-bills? Why would you buy anything if you didn't think it was going to outperform T-bills? So at the end of the day, we should expect excess returns to always float with a premium on top of T-bills. That's a very academic answer to your question. So I guess you could have said four years ago, it was way cheaper to borrow, but you had no yield. So it was a similar trade-off. Right. So let me give a more practical answer, which is, okay, we take our 60-40, we sold 10 % of our stocks and 10 % of our bonds, and we put 10 % in RSSB, and now we have 10 % in cash.

13:00If we leave it in cash, uninvested, we will have a drag. If we put it in T-bills, those T-bills will basically offset the cost of financing and we should have a return almost identical to our 60-40. If we put it in, say, something like a managed futures fund, well, when you invest in a managed futures fund, which is an alternative investment strategy, they take the cash and they invest the cash in T-bills. And then they trade global futures contracts, both long and short, to try to create a positive return. The cost of the leverage will offset with the return of the T-bills, and you effectively get the positive, hopefully the positive expected return of the managed future strategy.

13:38And so again, it's at the portfolio level, a lot of this stuff nets out. But effectively, what you're just trying to say is, do I think the thing I'm stacking on top, do I think it'll outperform T-bills? If the answer is yes, then it might be an attractive thing to stack on top. So I'm sure a question you get all the time. All right, so this is wonderful. I've got my 60-40. I'm going to sell 10 % of the stocks. I'm going to sell 10 % of the ponds. I'm going to give you 10%. And now I've got 10 cents to do whatever I want. Well, Corey, what do I do with that 10 cents? Yeah, there's a lot of things you can do.

14:08And it largely depends on your objective. I have some strong opinions here. But let's start with something simple. This is something that PIMCO has been doing in their Treasury Plus and, more famously, their Stocks Plus programs going back to the 1980s. And what do they do? they basically, instead of buying T-bills, they buy slightly riskier, slightly longer maturity bonds. They buy asset back, they buy credit, right? So you say, okay, if I think the T-bill is going to give me 5%, can I build a portfolio that's slightly riskier that gets me 5.5%, 5.75%. And in doing so, right, if you can generate a little bit of excess return above that cost of financing, you're adding that return on top of your portfolio, right?

14:53So their source of alpha comes from picking bonds that they think will outperform T-bills, but they're getting stock-like beta with an alpha coming from bond selection. Very innovative. And again, this goes back, this is not a novel concept. This goes back 40 plus years that people have been doing this. Now, what I would say is, again, most people are starting at a 60-40. I have, in my futility, tried to convince people the 60-40 is not the most well-balanced portfolio, but that's where almost everyone sits. So starting there, the question becomes, do you want to add excess returns or do you want to manage risk?

15:26If you want to add excess returns, I think it's all about finding a combination of investment strategies that you have high confidence in that can outperform cash with a good deal of consistency. And here, I think there's a lot of interesting things you can do. Like if you look towards some of the diversified alternative funds that are out there that are going to give you simultaneous access to a whole bunch of alternative investment strategies. AQR has one. Stone Ridge has one. You buy a handful of these funds and suddenly you're exposed to managed futures and long short equity and style premium reinsurance and cap bonds and Bitcoin and all sorts of stuff within two funds rebalancing internally.

16:06There's a lot of great diversification. And if you think that's going to outperform cash, great. You've stacked all of those alternative returns on top of your core stocks and bonds as maybe a better way to generate excess returns, right? One of the things, one of the conversations I have with a lot of people is why do we all keep fishing in the same pond to beat the market? Why do we always keep, instead of buying the S &P, we buy all these active stock pickers when all the evidence suggests, go read the SPIVA report, that you're unlikely to find a manager that's going to beat with any consistency over any meaningful time period.

16:38But there's all these other asset classes that have positive expected returns that you don't have exposure to. Maybe we just stack those. The other way you can go is say, look, the 60-40 portfolio, as 2022 laid bare, has some holes in it. Inflation risk in particular affects both stocks and bonds. And that is very relevant for retirees. Maybe we look to stack something that can help plug that hole. And that might be something like commodities, or it might be a more active strategy like managed futures trend following that has historically done very well during those types of periods. And so you can keep your core stocks and bonds and hopefully layer something on top that helps sort of smooth those sharp edges of risk that still exist in your portfolio.

17:22I assume managed futures performed really well in like late 2021, early 2022, when they could short bonds and also go on commodities. I assume a lot of those products did pretty well. Yeah. So what you saw in sort of early 2022 was strong positive commodity trends. Commodities tapered off through the rest of the year, but long US dollar, short bonds, short equities was a really big trade across the managed futures trend complex. And I think the SockGen trend in next was up 25 % in 2022, right? So, you know, it's not if you carve out 10 % of your portfolios in overlay and add some managed futures, which are up 25%, you're only adding two and a half percent, right?

18:03You need to sort of think about sizing this. But again, it's helping just smooth some of those edges and add in a diversifier. I assume the other one is you're talking to a conservative investor and a lot of retirees are like this who say, listen, I know it's suboptimal, getting back to the emotional thing, but I want to hold 5 % of my portfolio in cash or 10%. You use your fund as an offset of that cash. So you go one to one. If you have 10 % in cash, you put 10 % in your fund and hold the cash in T-bills and it works as an offset. That's kind of like a conservative trade-off as well, right? Yeah, that's another way you can do it, which is people like to have cash around for a number of reasons.

18:38There's advisors we talk to that for compliance reasons have to have cash around or they want cash around so that they can more easily take fees out. Clients want cash around for withdrawals. High net worth investors like to have cash around when they get cap calls, which can be at the worst possible time and they don't want to have to liquidate public investments. One of the things you could do is you could, you know, free up, sell some stocks and bonds, buy something like our return stacked global stocks and bonds fund for its capital efficiency, free up some of the portfolio and leave that part in T-bills.

19:08And effectively, what your portfolio return should look like is the portfolio you started with. But now that those T-bills are sitting there if you need them. And when you draw on them, you're effectively borrowing capital at the rate the US government does, right, at the T-bill rate. And then you can just rebalance your portfolio back to sort of return the capital. You mentioned that PIMCO and certainly other institutional investors have been doing this for decades. What is it inside of the ETF wrapper that allowed this to be brought to the masses? Yeah. So PIMCO, as I said, started doing this in the 1980s under their Treasury Plus and Stocks Plus program.

19:42This became very popular among institutional investors. Ben, I'm sure you've heard of it in your prior career as portable alpha, something that got very popular around 2006 and then dwindled in popularity in 2008. And one of the problems here is we're using leverage. And a lot of the institutions that were implementing this were effectively selling equities and then replacing it with S &P 500 futures exposure. And to get$100 of exposure, they only had to put up$10 of capital. And then they could take the other$90. And they started investing in hedge funds. And part of the problem was the hedge funds they were investing in were investing in illiquid assets.

20:22And they were investing in assets that ended up losing money at the exact same time equity markets lost money in 2008. And so I learned about what it meant to be gated in a hedge fund. That was fun. And then you had the gating issues, right? So all of a sudden you had, you know, you had a lot of leverage that was being used. These, these institutional investors had to come up with capital to post margin for their leverage, but weren't able to rebalance out of their hedge funds. And that that's a real problem. So the way we've tried to structure this is say, look, you really only want to make sure if you're going to use leverage, you got to match liquid with liquid.

20:53You can't be matching liquid with illiquid because then you can't rebalance. But the real innovation that - Right, sorry to cut you off. So you don't want to do this fund and then put the excess in private equity or something. Yeah, or real estate or something like that. I mean, you can, but you don't want to do it in large size because rebalancing your portfolio is going to be almost impossible. And again, you want to be able to rebalance here. So we like, for example, stacking things like managed futures, liquid alternative strategies that we can easily rebalance in and out of. To your question, Mike, what allows this in an ETF today there was a rule passed by the SEC in, I believe it was February 2020, called the 18F4 rule.

21:31And it might surprise some people, but the SEC had never really provided clear guidance as to how derivatives could be used within mutual funds or ETFs. They were used, but there was no hard and fast limit as to how they could be used, no concrete guidelines as to how much leverage would be tolerated by regulators. The 18F4 rule, or what's also called the VAR rule, provided very clear guidelines for asset managers as to how we could use derivatives to bring products like this to market and stay well on sides from a regulatory perspective. How does this go wrong? What's like a really lousy environment?

22:10What should investors that are new to this be aware of? Because it sounds like a free launch. Of course, that doesn't exist. What are some of the things that might be obvious to you, but less so to the listeners? We mentioned the phrase is portable alpha. Another thing this is called is capital efficiency. I love the term return stacking, which came from my colleague Rodrigo Gordillo, because I really hope it illuminates the concept that this is we're adding returns on top. So if you have your 60-40 portfolio, we are ideally stacking additional return streams. That can be both a good thing and a bad thing, right?

22:42If you have your 60-40 portfolio and what you stack on top loses money at the exact same time as your existing 60-40 portfolio, you're going to lose more money on the way down. So for example, what I wouldn't do necessarily is be a conservative investor, use the capital efficiency to open up 20 or 30 % of your portfolio and then take it and put it in, I don't know, Bitcoin or take it and put it in the NASDAQ, right? All of a sudden, you've massively increased your equity exposure, but you haven't created any diversification benefit in your portfolio. At that point, it's just leverage. At that point, it's just leverage.

23:20And leverage isn't a bad thing. I know leverage gets a really bad rep. Leverage shows up at every major financial catastrophe. But the thing I like to say is leverage always shows up with its friends' illiquidity and concentration. You talk to a lot of advisors. How do you explain the concept of leverage to them in this structure? This is leverage without a margin call. This is leverage without a margin call. I mean, look, within the fund, can we get margin called? Absolutely. But we're trying to use a very prudent amount of leverage and we're matching liquid things with liquid things. So here's an example, maybe a little bit more extreme, is we've got a fund called the Return Stacked U.S.

23:57Equity and Managed Futures ETF, RSST. Every dollar you give us, we're going to give you a dollar of S &P 500 exposure plus a dollar of managed futures exposure. And so it's a 13, 14 vol managed futures program. That's a high vol ETF. The vol of that product is around 19%. Ideally, over the long run, these things are uncorrelated. But in the short run, managed futures might see positive trends in equities and load up on equities at the same time. So today's a perfect example. We have a decent amount of equity exposure in our managed futures program because there have been really strong trends in equities.