Trade Like It's 2008
Return-stacking ETFs are back.
Earlier this week, we listened to Bloomberg’s Trillions podcast, which featured Corey Hoffstein, CEO of Newfound Research. His firm is a quant shop that helps investors through the provision of return stacking ETFs.
The concept of return stacking is not a new one, in fact it was big back in 2008. However, it’s coming back with a bang, and this time not just for institutional investors.
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The full podcast can be listened to here.
What is return stacking?
Return stacking is an investment technique that aims to combine multiple strategies or asset classes into a single portfolio without requiring additional capital. This is done via taking on leverage, either via borrowing funds or using products such as Options in order to benefit from inbuilt leverage potential.
This approach allows investors to gain exposure to multiple return streams, potentially enhancing diversification and returns without proportionally increasing the amount of invested capital.
For example, imagine you had £100,000 to invest and wanted exposure to stocks, US Treasuries, gold and oil. Instead of putting £25k into each of these assets, you could use return stacking to gain £50k worth of exposure to each. The idea is that if stocks perform well and you get the steady coupons from Treasuries, safe haven gold flows and high beta oil, the combined portfolio may offer a better risk-adjusted return than a simple split portfolio.
How Hoffstein is implementing it
Our example was a basic one to get your head around the concept of return stacking. In the real world, here’s how Hoffstein goes about building his return stacking ETFs:
Let’s say you invested £100k in one of his ETFs. His team would take that money and invest it mostly in US stocks, for example 75% in a S&P 500 tracker. The other 25% would go into short term Treasury bills.
He would then use those assets as collateral, and borrow money using them. Let’s say he can borrow 90 cents on the dollar for T Bills and 70 cents on the dollar for the S&P 500 tracker. His combined 80 cents is then used to get exposure (or stack) other assets on top, giving gearing on the portfolio even though the initial investor has still only put in £100k. Interestingly, Hoffstein says he can provide a 2x leverage on his products, i.e 100% leverage.
His ‘portable alpha’ approach comes in how he selects what assets should be stacked on top of each other. Ideally, they should be uncorrelated to what’s already in the portfolio. For example, if he puts 75% in the S&P 500, it doesn’t make sense to use the borrowed funds to also invest in the same index.
A key element to his alpha strategy is that it doesn’t have to be a long only managed strategy. He could be long equities, borrow money and then use it to get short the Japanese Yen. In such a way, it not only helps to reduce correlation but also diversifies the portfolio.
How it was used in 2008
The concept of portable alpha from leverage was used extensively in the years leading up to the financial crisis. However, it blew up in a way that serves to illustrate all of the main risks of the strategy.