Diving Deep On Return Stacking

Today I want to dig into a couple of different things related to return stacking. As a quick explainer, return stacking is the use of leverage in a portfolio to add an alternative asset class/strategy on top of the more typical mix of stocks and bonds. This is usually done with the intention of adding an uncorrelated asset class to a portfolio in an attempt to reduce portfolio volatility. A simple example could be 50% in stocks, 50% in bonds and then using leverage one way or another to add 10% in managed futures. Managed futures tend to have a negative correlation to equities so adding them into a portfolio (leveraged or not) could reasonably be expected to lower portfolio volatility, no guarantee of course. 

My interest in return stacking (also referred to as capital efficiency) goes back a little over 20 years when I worked briefly at Fisher Investments. I've told this story here many times but basically, a couple of the smarter guys there were fascinated by the idea that 2% short in Nikkei Futures, 98% in cash equaled the return of the S&P 500 for the decade of the 90's. I don't know if the numbers were accurate but the concept is pretty clear. There is value in getting the market's return with less capital at risk. Another manifestation of this that we explored here was Nassim Taleb's barbell portfolio idea which was taking huge risk with 10% of the portfolio and using cash proxies for the the other 90%. At least one of the holdings in the high risk tranche would, by his reckoning would go up a lot to provide a good overall portfolio return. 

Where I believe in taking bits of process from various sources to create your own process, as opposed to leveraging up to achieve some sort of desired portfolio effect, I frame it in terms of leveraging down. I've written about that many times and we'll explore it here in just a bit. 

From the standpoint of Return Stacked Portfolio Solutions who are kind of leading the charge in the capital efficient space, they are not the first ones to do this but they have three funds now and put out a lot of research to support the concept. One argument for return stacking that they wrote about recently is to avoid tracking error, the extent to which the portfolio deviates away from whatever benchmark is being used. 

In that paper they say that starting with a 60/40 portfolio and wanting to add an alternative usually means reducing either the 60 (stocks), the 40 (usually bonds) or taking a little from both so that maybe you end up with 55% equities, 35% in bonds and then 10% to some sort of alternative strategy. If the portfolio benchmark is 60/40 then the 55/35 allocations can lead to tracking error. What return stacking allows for then is to keep the 60/40 and then add something else, managed futures is the thing they talk about the most because that is what their product lineup offers but this could also include plenty of others like merger arbitrage, convertible arb or a different form of long short. 

I alluded to this in another post, maybe they are having a conversation I cannot hear (Deadwood reference) but this argument makes no sense to me. Maybe leveraging up makes sense for a better risk adjusted result or maybe it doesn't but if you are going to incorporate some sort of alternative strategy in some measurable proportion then you are seeking out tracking error...for at least part of the stock market cycle anyway. If no tracking error was your priority then is 2022, at 60/40 you would have been down 16.87%. If you took steps to incorporate alternatives intended to lower correlation and you chose the right one(s) then you were down less, you had tracking error. 

Portfolio 1 above is 55% Vanguard S&P 500 (VOO), 35% iShares Aggregate Bond ETF (AGG) and 10% AGFiQ US Market Neutral Anti Beta Fund (BTAL). Portfolio 2 leverages up to 60% VOO, 40% AGG and 10% BTAL and Portfolio 3 is 100% Vanguard Balanced Index Fund (VBAIX) a proxy for a 60/40 portfolio. In 2022, the leverage actually hurt returns. I'd need to dig in deeper to know whether the leverage usually is a drag, usually helps or is a coin toss but maybe leveraging up to return stack is a bad idea? BTAL is a client and personal holding.

A goal that tries to avoid tracking error might be where you seek market equaling returns but with less volatility or capital at risk. 

You can see the portfolio construction and the result. I limited it to a bull market on purpose, the CAGRs are close and the standard deviations are closer. Portfolio 1 though has much more exposure to equities without taking interest rate risk. In 2022, Portfolio 1 was only down 8.52% versus a decline of 16.87% for VBAIX. So not less capital at risk maybe but lower volatility. I would describe this as leveraging down, using a negatively correlated strategy to allow for increased equity exposure. As I indicated above, this is how I incorporate return stacking into client accounts. Note that I don't mean 25% in BTAL or in any alt, I think that is a bad idea, but using alts to allow for a little more equity exposure so that I can avoid the biggest risk I see out there which is the combo of bonds having unreliable equity beta and interest rate risk. 

Although I have not done this in any client accounts, I do think there is merit in using something like the WisdomTree US Efficient Core ETF (NTSX) which leverages up in such a way that a 67% allocation to the fund equals a 100% allocation to a 60/40 portfolio. A 67% weight to NTSX tracks very closely to 100% VBAIX. Putting the remaining 33% into cash proxies potentially adds another 166 basis points in yield (prevailing 5% yield on cash times .33) to the result from VBAIX. 

Here's a slightly different idea, taking a small step in the direction of what the return stacking guys have in mind.

Portfolio 1 allocates 70% to NTSX, 25% in T-Bills and 5% in BTAL. It obviously tracks very closely, there is a little bit of a more defensive bias embedded with the small weight in BTAL but it was still down almost as much as VBAIX last year. This could be played around with to go a little heavier into NTSX and defensives to create something that would do a little better in drawdowns but the combo of NTSX, T-bills and BTAL left a lot in cash which would be useful for managing sequence of return risk. Obviously an example of almost no tracking error but with far less capital at risk. 

Above, I mentioned that Return Stacked Portfolio Solutions has three ETFs employing some sort of return stacking, actually the third one isn't out yet but is coming soon. The first two provide 100/100 exposure. RSBT is 100/100 bonds and managed futures and RSST is 100/100 domestic stocks and managed futures. The third fund will be the Return Stacked Global Stocks & Bonds (RSSB). Each dollar invested provides $1 in global stocks and $1 in (global?) bonds so a 50% allocation to RSSB would equal 100% exposure to those two asset classes leaving 50% to put into cash or do other things with. 

Capturing 100% of the market effect with only 50% of your capital is an intriguing idea assuming it tracks correctly and depending on how it is leveraged (my hunch is it would own stocks mostly and access the bond exposure in the futures market but we'll know soon enough). Fully invested with 50% safe on the sidelines on its face would be a fantastic way to manage sequence of return risk. Of course in the case of the coming ETF you'd need to want global stocks and whatever the bond exposure is (still not clear to me) but as a concept, capturing 100% of the market with 50% of your money has merit. You wouldn't be leveraging up. Repeating, the influence is to look at return stacking, understand what it is doing and then leveraging down more so than leveraging up.

Thinking forward here to close out, chances are I would not want whatever bond exposure will be coming with RSSB. Maybe this is a couple of iterations down the road but I can see where it will be possible to create your custom "ETF" where you blend together whatever you want and embed leverage in the context we're talking about to replicate 100% of a portfolio with maybe only 75-80% invested leaving the rest to manage sequence of return risk. Maybe this is a blockchain thing, not sure but there are ways to use leverage to lower risk and volatility which at a high level is the point.  

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