MI270: How to Improve a 100% Stock Portfolio Using Return Stacking w/ Corey Hoffstein

25:53And now I'm distilling those learnings into a simple course for you or for anyone in your life who you might want to share the gift of knowledge with. With my How to Get Started with Stocks course, you can master the principles of excellent lifelong investing with valuable insights for both beginners and pros. The course covers 10 different sections, beginning with the basics of what a stock actually is and how the stock markets work, the strategies to optimize your retirement savings, how to pick great companies for the long term, what to look for in ETFs, and how to monitor your investments, plus so much more.

26:24To begin getting smarter about investing, just visit theinvestorspodcast.com slash get started with stocks. That's theinvestorspodcast.com slash get started with stocks. And for a limited time, you can use code stocks15 for a 15 % discount at checkout. All right, back to the show. And then I just want to go to the extreme example where why wouldn't someone just lever up all the way? Why wouldn't they sell all of their stock portfolio and just go in 100 % this leveraged fund? Yeah. So the way I would phrase it, right? If you were to say, okay, I've got a hundred percent stocks and I just really want to hit the gas.

27:05Let's do a hundred percent stocks and layer on a hundred percent managed futures and layer on all this other stuff. Leverage creates path dependency. So what do I mean by that? Well, leverage, you're inherently borrowing money. And so you have to post a certain amount of collateral to be able to borrow that money. If the market starts to move against you, you have to keep paying up collateral. So if you are, say, let's go to the extreme, 10 times levered, you have a dollar and you're making it act like$10 and the market goes down 10%, you will have wiped out your entire portfolio, right? Less extreme.

27:39If you have a portfolio that's levered up three times and the market goes down 33%, you will have wiped out all your collateral. So you have to ask the question, like, what's the prudent amount of leverage to use to make sure you never hit that point where all your collateral is wiped out? It is very, I think, first of all, person dependent and portfolio dependent. The more diversified the portfolio, in theory, the more leverage that can be applied. But I think there's like the optimal number that comes out from mathematical studies. And then there's the prudent number, which tends to be far less than that, right?

28:14That's something you can probably stick with and will probably still be very beneficial versus the unlevered portfolio. And I guess when I was thinking about the strategy, I was wondering for a buy and hold investor who maybe doesn't sell investments, they just want to keep this long-term outlook. Is this something that can be implemented with that or would there be times where you get out of it completely? So I think this is a way of rethinking how you build your portfolio, right? To make it align much more with the tenets of modern portfolio theory or the way institutions have been doing this.

28:51This is how I strategically allocate. My portfolio actually very much looks like 80 % stocks, 20 % bonds, and like 30 % managed futures. I lever up my portfolio. That's how I invest. I actually would probably prefer to have a little less equity and a little bit more bonds and managed futures. I'm working towards that, but I have some taxable account issues I got to work through. But I think to go back to our example of your 60-40 investor versus someone who buys a mix of NTSX, the levered 60-40 and DBMF managed futures, I think there's a strong argument that you could just hold those two, two-thirds in NTSX, one-third in DBMF.

29:28And that's a great strategic all-weather portfolio. You're 33 % levered, and arguably it should, based on sort of the historical numbers and understanding the way these positions diversify each other, hopefully enhance your returns over the long term, as well as help manage risk during certain environments like 2022. Similarly, if you have a 60-40 and you sell some of the bonds to buy our ETF, ideally it'll do the same thing. So there's different ways you can put this together, but I absolutely think it's a way to reframe how you should be allocating strategically. Okay. And I asked that question because say, for example, other leveraged funds, daily leveraged funds, like say a three times daily leveraged just S &P 500 ETF.

30:12If you hold that long term, they'll eventually be that drag. And then it's almost it's not beneficial to hold it very long term. Sometimes it's only a few months. And so that's where I was kind of wondering, like, is there any issues if you hold this fund for five years? Is there any types of drag and performance or volatility or anything? So where that comes from with the daily reset funds is this idea of variance drain. Everyone's heard the example, right? If you lose 10 % of your money, you need to make up 11 % to get back to break even. That concept is what we would call variance drain. It's asymmetric in the way the returns compound.

30:48When you do a three times levered fund, you basically, the equation is Is your compound growth rate is your expected return minus one half the variance? Well, the more you lever the fund, that volatility, that variance of the investment goes up and up and up, especially when it's concentrated leverage. And so when those daily reset funds have that sort of variance drag that gets bigger and bigger and bigger, when you look at combining assets that are diversified and you lever them up, you don't get the same variance drag effect because you might actually be first reducing the volatility by adding all that diversification and levering it back up just gets to the same volatility that you might have had in your undiversified portfolio.

31:34So it's not quite the same thing. But on sort of the same thread, one of the big pushbacks with leverage is that every financial catastrophe in the history of mankind has probably included leverage. I remember post 2008, all these investment brochures that said no leverage, no shorting, no derivatives, right? Those were sort of the bad words at the time. And it's absolutely true. Leverage is basically at the core of every financial catastrophe, but leverage isn't there alone. Leverage is there with its partner concentration, right? I would never, ever, ever say it's a good idea to say, hey, I'm a 100 % equity investor.

32:08Let me use leverage to go 200 % or 300%, right? Using leverage to buy more of the same thing is usually a bad idea. Using leverage to buy something different that can diversify you and zig when your original investment zags, I think that can be a very prudent use of leverage. Again, you can overextend yourself. You need to be careful, but it can be a very prudent use of leverage. So leverage in and of itself is just a tool, right? But you need to be thoughtful about how you use it. Concentrated leverage is the dangerous thing. And it's concentrated leverage that creates that variance drag in those daily reset levered strategies.

32:45Okay. And that kind of got into my next question I was going to ask you on who might this strategy not be good for, or I guess what are the mistakes people make when implementing it? So I guess you just named one, but are there any other kind of common mistakes people make? Yeah, I'm absolutely biased. You probably don't want to ask the guy who does all the cooking, who shouldn't eat the meal. I obviously think this is a great idea for everyone. Again, the reality is there's sort of two very important points here. Objectively, I can say I think the numbers are better. What's important is whether someone can behaviorally stick with this.

33:19If they're uncomfortable with leverage, if they're uncomfortable putting the portfolio together, if they understand stocks and bonds, they don't understand alternatives, or they don't understand leverage, don't touch it. Just do what you're comfortable with. That is the most important thing when it comes to success in your long-term investment plan. You need to take enough risk and you need to be comfortable with that risk to earn the returns. If you are going to put yourself in a situation that you're going to capitulate at exactly the wrong time, it's going to do permanent impairment to your portfolio and that doesn't benefit anyone.

33:46So first and foremost, it needs to be something people are comfortable with. Again, from there, I think it's all about blending this idea to say, what's the core portfolio I want? How can I introduce diversification to that core portfolio and how much risk am I willing to take? Someone who's a retiree, right? There's a reason we tend to de-risk portfolios into retirement. They no longer have income. They can't suffer large drawdowns or those withdrawals that they're taking, create all sorts of sequence risk for them. And so to suddenly take someone who's a very conservative investor and use leverage to layer on a ton of equities in the name of diversification probably doesn't make a lot of sense, right?

34:25We don't want to like dramatically move people up the risk curve. If we can say, take someone who's very conservative and add a little bit of equities and a little bit of managed futures and manage to keep them in the same risk level, that's great, right? So we want to be very conscious of it. It's like, what's the appropriate risk level for each investor? What's not only like their risk capacity, but their risk tolerance, make sure we stay there and just try to build a more diversified portfolio with that constraint in mind. And I guess to me, what's so cool about this strategy is that in normal times, even if there's a large drawdown, if you use a leveraged strategy like this, like historically you were better off in most cases, but it broke down recently.

35:08And I kind of want to get into this with you now, because if you look at the funds since 2021, they did horribly. And so I kind of want to talk to you about the factors that affect the effectiveness of this strategy. Yeah. When we say the funds did horribly, let's be specific because my fund wasn't even around. But the funds that did horribly, right, were these levered stock and bond funds. So I'm going to pick on PIMCO because they've got a really long track record. They've got a fund called their PIMCO Long Duration Stocks Plus Fund. Buys long duration bonds, corporate bonds, so 20 plus year corporate credit, and then they layer on top S &P exposure.

35:44Every dollar you give them, giving you a dollar of long duration bonds and equity. That portfolio absolutely kicked ass through 2020, right? From its inception through 2020, I think it was top in its category, as it should be because you're getting the returns of both stocks and bonds every year at a period when interest rates were around zero. So the cost of financing was basically nothing. Then 2022 comes around and stocks and bonds sell off simultaneously. And for every dollar you have invested, you are getting$2 of exposure. And long duration corporate bonds sold off just as hard as equities.

36:19So I think that portfolio at one point last year had a 50 % drawdown, if not more. So full pause, that sounds kind of horrible, right? But let me take a step back. If I said to you, okay, you're an all equity investor, take 100 % of your money and put it in this. Yes, you were worse off for sure. You would have made a lot more money during the run-up. you would have lost a lot more money in 2022. But your risk profile is also higher. Like it probably wasn't a good match from a risk perspective. But if you were a 50-50 investor, right, you invested 50 % of your money and 50 % of your money in stocks and 50 % of your money in bonds.

36:52And I said, well, let's replace that with for every$100, put$50 in this fund. And then we're going to have$50 in cash that you could invest in, say, managed futures or diversifying alternatives. Yes, the fund was down 50%, but it's down 50 % on half your money, right? And so when we look at the actual dollars lost, it would have been the equivalent amount of dollars lost as if 100 % of your portfolio was in the 50-50. And so if you use this strategy, right, to use these capital efficient funds that are giving you more exposure for every dollar invested to replace the same number of dollars in your portfolio, and then you're using the extra portfolio sort of canvas you have that's left over to buy diversifying alternatives, you can actually do better.

37:36So if you were a 50-50 investor, 50 % stocks, 50 % bonds, you were probably down like 20 % last year, maybe more. If you took 50 % of your money and put it in this PIMCO fund, man, that fund was down a lot, but it was half the money. So you were probably down an exact same amount as 50-50. And then if you took the other 50 % and put it in managed futures, which were up 20 to 30 % last year, you actually ended up way better off, even though that line item of the PIMCO fund was down much more. So to me, it's super critical to think about the dollar exposure you have when you invest in this and make sure that you're using the capital efficiency, not just for getting more of that concentration, but can we replace existing capital to free up room in our portfolio to buy diversifying alternatives that can do well when our core portfolio isn't going to.

38:25Right. And I think my language there might have been a bit harsh because everything was down. Most things were down a lot last year. And I do want to ask you, though, because it does make me wonder just about the relationships, because this strategy, I guess, relies or some of them rely on the fact that stocks and bonds are not perfectly correlated. So what would happen in a world, I guess, what could break this strategy is what I'm wondering. Yeah. So let's go again to Wisdom Tree as the example, the 90-60 portfolio. Again, if you put 100 % of your money in that, you've got a 60-40 levered up 1.5 times.

39:02If stocks and bonds go down at the same time and go down significantly, you're going to lose a lot of money. I mean, that's exactly what happened last year, right? And so the risk is typically for that style of portfolio that's concentrated in stocks and bonds, it tends to be inflationary impulses that are the risk. Maybe the second subtle part of your question is, is there something that could literally make this strategy blow up? Could this be like XIV, that inverse volatility ETF that literally imploded on a single day? Well, for that to happen, you have to think through that you sort of needed to all happen on a single day.

39:38And your 90-60 portfolio would basically have to lose, if I'm doing my math correctly, I think it's 66%. It would have to have a 66 % drawdown in a single day for you to basically blow up. I have to double check my math on that. So the likelihood of that portfolio having a 66 % drawdown in a single day, I don't want to say that'll never happen because if a nuclear bomb went off, God forbid, yeah, you might see that, right? Crazy things happen in the markets, but it's a really extreme situation because even if you have a really big drawdown one day, the portfolio is going to rebalance itself. It's going to end up selling some stocks, refreshing its collateral for the treasury futures, getting itself back in balance, and then it's reset.

40:22You really need like a sudden one day the market opens down a huge amount, 50%, bonds open down 30, 40, 50 % simultaneously for that type of strategy to actually blow up. Let's take a quick break and hear from today's sponsors. Hey, it's Sean O'Malley, just popping in with a quick message. If you like this podcast, well, I've got great news for you. We've got a handful of other shows for you to explore, from learning about Bitcoin to embracing a richer, wiser, happier lifestyle. Just go into your podcast app and type in We Study Billionaires to find our collection of shows. We Study Billionaires is our flagship podcast, and we've made a name for ourselves over the years by interviewing the best investors in the world, including Ray Dalio, Howard Marks, Joel Greenblatt, and many, many more.

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43:54That's theinvestorspodcast.com slash tip-finance. All right, back to the show. So what are some risk management strategies or things that investors should do if they are implementing this strategy? Yeah. So again, using return stacking to double down on the same risks, I think is the big mistake I see. So for example, we'll use the PIMCO, excuse me, the WisdomTree example. If you're a 60-40 investor, you put two thirds of your money in this WisdomTree product to get effectively 60-40 exposure and you have that$33 left over and you put that$33 in stocks, you're probably going to have a bad time.

44:39All you've done is levered up way more equity exposure. If you were a 60-40 investor, you were probably there at a risk tolerance reason or risk capacity reason. You have suddenly added a tremendous amount more risk to your portfolio. On the other hand, you take that$33 and you put it in super short-term, high-quality, institutional-grade corporate bonds. That's probably great. You're probably going to clip some extra coupons. You're probably going to capture a little bit of extra alpha, but it's not like you've dramatically changed where you are on the risk profile. So I think for me, what's really important when you consider what you're stacking on top of your portfolio, it's how is it going to change your overall risk profile?

45:16And how does that fit with your risk capacity and your risk tolerance? Ideally, you're trying to blend things that zig and zag at different times, but correlations are by no means perfect. Past returns are really predictive of future results. And so I think you really need to think about from an economics perspective, you know, why should something behave a certain way? why should it be different from stocks? Why should it be different from bonds? And what's sort of the tail risk that these things could all behave the same way? How long can that happen for and can my portfolio survive it? And then one thing is there's lots of, I guess, expectation, at least from the guests that I've spoken to about how things could get worse still with, I guess, the total stock market going down, earnings needing to downgrade a bit.

46:00And so would this be a bad time to get into a leveraged strategy? Could it be a bad time if someone's fearful that the market would go down more? Yeah. So let's maybe walk through two or three examples here. If you're a 100 % equity investor and you want to replace that with like Wisdom Tree or Pimco's products that are going to give you the same amount of equity and then layer on some bonds, that might not be a great idea if you think there's more inflation risk to come, If you think the Fed's going to keep tightening or you think this is going to be an inflationary recession where stocks and bonds sell off at the same time, yeah, that would be a bad idea.

46:35On the other hand, if you free up capital in your portfolio to layer in something like managed futures that have historically done well during prolonged equity sell offs or inflationary bear markets, that might be a great time to use a little leverage. So again, it really comes back to what you're implementing. What we've been really excited about, and the reason we brought it to market a product that for every dollar you give us, it's a dollar of bonds and a dollar of managed futures, is because there are a lot of the investors we work with who just start with that 60-40 framework. The reality is we work with a lot of financial advisors on a dollar-weighted basis.

47:10They tend to be dealing with pre or early retirees who just tend to have a 60-40 portfolio. They looked at 2022 as a wake-up call to say, if we enter a decade of prolonged inflation, this is probably a problem for our retirement planning. And so to be able to replace some bonds with a product that maintains the bond exposure and then overlays managed futures, where managed futures have historically done rather well during inflationary environments and done well during equity crises, it makes them feel more confident in the financial plan that they've laid out, that hopefully the drawdowns are going to be less severe and that the spending plan is actually more achievable.

47:48So again, I think it's very dependent upon what you're incorporating. And I cannot advocate enough that if you're going to use this concept of return stacking, it's not to add the same risks you already have. You really want to think about what diversifiers you can put into your portfolio. Right. And I do want to ask you about the commodity return stacking funds out there, because I know there's one, I can't remember the ticker offhand, but what are your thoughts on that? Is that an efficient way to get commodity exposure? I'm actually, so the one that I'm aware of is the wisdom tree. I believe the ticker's GDE, where it's for every dollar you give them, it's 90 cents of equities plus 90 cents of gold is the one I'm aware of.

48:32Yes. If you like commodities, I think that can be totally fine. If you're someone who wants gold in your portfolio, maybe you like the Harry Brown permanent portfolio or something like that, where you want a constant allocation to gold, this can be a thoughtful way to introduce it. Again, just making sure you understand or have some sort of concept of when you think gold will and will not perform relative to the other assets in your portfolio. I will say personally, I am not a huge fan of commodities or gold as a standalone asset class. I much prefer managed futures when it comes to things like inflation.

49:08We use it as a very big umbrella term, but there's all different types of inflation, right? There's monetary inflation, there's supply chain driven inflation, there's demand side inflation. And the way that those sorts of inflations end up getting expressed in global asset class prices are very different, right? When you look at 2022, the way inflation played out, the best trades were along the dollar and short bonds. It actually wasn't even, I mean, it was a little bit long oil at the beginning of the year, but gold never responded to the type of inflation that we had, right? And so for me, a dynamic strategy like managed futures that can adapt to whatever trends are presenting themselves in the market is my preferred way to try to build in some resiliency in my portfolio to inflation, but to each their own.

49:52And again, what I love is that folks like us and WisdomTree are bringing these building blocks to market so that people can build the portfolios they're confident in. I have had a few guests talk about how they believe we could be seeing these waves of inflation coming back. And so in that context, then what do you think is a prudent way to invest if that reality would happen? Yeah. If you look at the 1970s, probably one of the scariest charts is you look at year over year CPI changes from the 1970s and you get this early wave, late 60s, early 70s, where inflation crests at about 6 % and comes back down.

50:30And then you get this second wave a couple of years later where it crests up around 12 % and then comes back down. And then the third wave at the end of the decade into the early 1980s, where it goes up to, I think, to 16, 17%. And that would just be brutal psychologically, economically, from a business planning perspective, that's very difficult. Now, there's a large number of arguments as to why you sort of saw that three-wave inflation cycle in the 70s relating to sort of the way monetary risk was managed, getting off the gold standard, understanding how fiscal and monetary policy work together, geopolitical instability.

51:06There's arguments why that shouldn't happen now, but there is a historical precedent, right? There are these bullwhip effects that exist in the economy that are tough to control, that can lead to these push and pull of supply and demand, that can lead to inflationary impulses. Arguably one of the reasons why the Fed may stay sort of more hawkish, higher for longer than I think a lot of people forecast, even with a lot of people feeling out in earnings recession. But to go back to your question, to me, again, the best way to play that risk is for me personally, a strategic asset allocation to manage futures that I hold stocks and bonds.

51:41And then I try to use this concept of return stacking to overlay managed futures on top of my portfolio. And the last question I'll ask you is if you could leave our listeners with one piece of advice to just help them become better investors, what would that be? There is a phenomenal piece of literature written by Cliff Asnes from AQR that's called, I believe it's called Seven Lessons for Investing Big Money for the Long Run. And he originally wrote it back, I think it was 2009. I found one copy on the internet of it ever. I don't even think AQR has it published on their website. But if you Google that, you should be able to find a PDF of it.

52:19And the reason I love it, it was originally written for institutions, but it is some of the most common sense, basic reminders about investing. Like you have to take risk to earn reward. Like it's a fundamental idea. A diversified portfolio is inherently better than an undiversified portfolio, right? It's just like these very basic seven ideas that I think sometimes, especially me who lives in a very wonky quantitative world, I can sort of like get off and stuck in the land of esoterica, like to just reground myself with these core principles and say, investing shouldn't be that hard. Stick to these sort of like core basic ideas, get the big muscle movements right, and you're going to be okay.

52:59To me, I think I would urge readers to go read that. I think it's just a great foundational piece of wisdom from someone who's been as a track record as a tremendously successful investor. That is awesome. I'm definitely going to go search for that after this. I love Cliff's work. So thank you for sharing that. My pleasure. I will make sure I send you a copy so that at least you can have it. And before I let you go today, though, where can our listeners go to learn more about you, your work, and everything you do? Sure. So you can learn more about our ETFs at returnstackedetfs.com. And then you can find me mostly on Twitter at C.

53:37Hofstein, where my wife would tell you I am there way too frequently. That sounds great. I will make sure to include all of those in the show notes. I want to thank Thank you again for coming on today, Corey. Thank you so much, Rebecca. All right. I hope you enjoyed today's episode. Make sure to follow the show on your favorite podcast app so that you never miss a new episode. And if you've been enjoying the podcast, I would really appreciate it if you left a rating or review. This really helps support us and is the best way to help new people discover the show. And if you haven't already, make sure to sign up for our free newsletter.

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