Friday, March 29, 2024

Incorporating Return Stacking?

Return Stacked ETFs wrote a short paper in support of their ETF suite about how to incorporate return stacking into a portfolio. For anyone new, return stacking, also known as capital efficient, involves leverage to build a diversified portfolio. Return Stacked currently has three funds. RSBT is 100% bonds and 100% managed futures. RSST is 100% equities and 100% managed futures. RSSB is 100% global stocks and 100% US bonds. There are funds from other providers that do a similar strategy with various other asset classes and percentages. 

Looking at RSSB. The idea is not that you would put 100% of a portfolio into that fund. A 50% weighting would equal (there's some nuance here to learn about but this is close enough for today's post) putting 50% into stocks and 50% in bonds but with RSSB only 50% of the dollars would be exposed to risk assets.  The remaining 50% could just sit in cash earning interest.

Hopefully that gives some context but that isn't how Return Stacked positions their funds.  They offer various solutions of course but the one I've seen most often is as follows. Assume a portfolio is simple 60/40 all in a fund like Vanguard Balanced Index (VBAIX). Sell 10% of the VBAIX position, put 5% (half the VBAIX proceeds) into RSSB. That 95% invested equals 100% in VBAIX with 5% left over for something. That something could be cash to manage sequence of return risk. That something could be one or more alternative strategy funds in search of a better risk adjusted result. That something could be an attempt to add alpha with a holding that would hopefully outperform like an individual stock or thematic ETF, even Bitcoin. 

I'm most interested in that second one, improving risk adjusted results. The first idea for sequence of return risk, yes, the numbers will pretty much work out as far as replicating 100% with 95% invested as described. Trying to add alpha (as described, you'll see that referred to occasionally as 'portable alpha') comes down to picking the right stock or narrow ETF or getting the timing right for a crypto. 

The idea then is to see if we can get their concept to work. Does adding 5%, or some other percentage, on top of a 60/40 portfolio improve the result in any way whether that is better performance, smaller drawdowns, less volatility or some combo of those three? The way I backtested it, Portfolio 1 in each instance is 100% VBAIX. Portfolio 2 in each instance is an unlevered mix of mostly VBAIX with a smaller allocation to one alternative. Portfolio 3 mimics return stacking with 100% VBAIX and then a small allocation to one alternative stacked on top of the 100% so obviously it leveraged. 

You can play around with this on Portfoliovisualizer yourself but I started with 5% weightings to the alternatives and the differences were almost nothing. Even 10% didn't offer much of a difference but at 15%, there were some differences. Get ready for a lot of images. 

The return stacked version using BTAL gives up 19 basis points of growth versus plain vanilla VBAIX with a standard deviation that is noticeably lower. In 2022, the return stacked version outperformed plain vanilla 281 basis points but was still down 14.06%. 



The return stacked version with managed futures outperformed by a noticeable amount but it was much closer with standard deviation. In this one, the return stacked portfolio was down 12.49% versus down 16.87 for plain vanilla in 2022.



In the third one, we're using AQRIX as the alternative. There was plenty of outperformance, the standard deviation was quite a bit higher and in 2022, this return stacked portfolio lagged VBAIX by 184 basis points.



And the last individual alt with the Merger Fund. Very little difference in return or standard deviation. In 2022, plain vanilla and return stacked were only separated by 11 basis points.

I tried to select alts with different attributes. BTAL is IMO very reliably negatively correlated, managed futures less so because it has a better chance to go up when markets are going up, AQRIX does its own thing and is capable of helping in a decline and MERIX is a reliable absolute return type of strategy. 

A little more realistically for me, this last one divides the 15% to alts equally among the four.



Again, there is a little outperformance, the standard deviation is a shade lower and in 2022, the return stacked version outperformed plain vanilla by 131 basis points. 

Would any of this be worth it to you? There's no wrong answer. Is it worth it to you? One to frame an answer could be to ask whether the complexity is worth the incremental benefits. 

We've constructed many theoretical portfolios with competitive returns as all that we've looked at today but with much lower volatility and a much better result in 2022. The big difference between those and today's attempt to replicate the Return Stacked portfolio is the decision to avoid bonds as captured in VBAIX or other portfolios using the typical aggregate bond exposure. 

In writing about the Return Stacked funds before, I typically include that to use these funds, you have to be ok with bond exposure they are using which approximates the aggregate index. 

If you've ever studied top down portfolio construction you've probably read that getting asset allocation decisions correct accounts for about 70% of the return achieved. Our experience in past blog posts doing similar exercises, excluding bonds, supports this tenet of top down theory. Case in point.



Portfolio 2 allows us to increase the weighting in equities from 60 to 65%, get a higher CAGR but a lower standard deviation with a decline in 2022 of 9.89% versus plain vanilla 60/40 at 16.87 and our attempt to mimic return stacking which fell 15.56% in 2022. Again, avoiding bonds was the more important decision. In a way, upping the stock exposure to 65% is a form of leverage but we are using the alts to "leverage down" as I've described it. The alts are more effective as diversifying equity volatility as we've seen countless times.

I would encourage anyone to do this sort of exploration in portfolio construction. I think the Return Stacked guys are definitely on to something here, I just think that for now, there is better way to incorporate what they are talking about into a diversified portfolio. 

The information, analysis and opinions expressed herein reflect our judgment and opinions as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation. 

No comments:

Risk Parity Funds Still Don't Work

It's been a while since we bagged on risk parity but Bloomberg gave us a good prompt to revisit the strategy. Apparently a few state pe...