And this was. sort of mind breaking was that the alpha, if we can call it alpha, that was being generated, the excess return above the S& P 500 of this program, was not coming from the asset that investors were trying to get exposure to. It wasn't coming from the beta. It wasn't coming from security selection within equities. It was coming from where PIMCO thought they had skill, security selection in bonds. And they were able to port that alpha on top of the S& P 500 beta that investors wanted.
And thus, the concept of portable alpha was largely born. It was actually originally called transportable alpha, eventually shortened to portable alpha.
Hello, everybody, and welcome to the ReturnStack Portable Alpha webinar. thank you everyone for joining us today. My name is Rodrigo Gordillo and, uh, today we're going to be talking about Portable Alpha. I'm the president of Resolve Asset Management and co founder of the Return Stacked ETFs. And it's my pleasure to have you all join us for what I think is going to be an enlightened discussion on a topic that's gaining significant traction in financial media.
I mean, We've had close to 350 people sign up for this webinar already, which is actually the largest group that we've had in any one of these webinars thus far. And there's just honestly an incredible update and discussion around the topic recently. We're super excited to cover it all in detail today. And we're very lucky to have with us Corey Hofstein, the Chief Investment Officer of Newfound Research, my fellow co founder of the Return Stacked ETFs.
Corey's an absolute visionary in quantitative investing and portfolio construction. He really is known for his innovative approach as to tackling complex financial topics and making them as accessible as possible to the advisor and investor community. So he's a great person to have on board today. Of course, the focus being Portable Alpha. This strategy.
really involves separating beta, which is passive market returns, from alpha, which is the excess return from active management, to help us build more efficient and diversified portfolios. Now, of course, this concept isn't entirely new. It actually dates all the way back to the 1980s with strategies that like a PIMCO, PIMCO stock plus, um, concept that has been around for a bunch of decades. Corey will cover that in detail, and You know, it died for a bit.
We're going to cover that as well, but recently it's got a resurgence and as advisors and investors are seeking to enhance returns or better risk manage their portfolios in what is likely to be a low yield environment, right? We have high valuations in stocks. We're starting to see yields come back down again. And so today what we're going to cover is four major things.
We're going to cover an approach that institutions have used since the 1980s to pursue excess returns in their portfolios and see how we can transfer that over to the retail space. How we can pursue alpha in high conviction, high opportunity areas without disrupting the, you know, hallowed core stock and bond exposure that everybody needs to have exposure to. And how this approach can be used to introduce alternative diversifiers and may even help curb some behavioral biases of using them.
Those alternatives and ultimately we're going to try to give you some examples of how one can implement it today. So, throughout this webinar, I'll be moderating the discussion and I may post some questions to Corey to unpack these concepts as thoroughly as he can. We do encourage you to submit questions via the chat function. I'll try to address as many of those as possible during the Q& A session at the end.
And I think we're ready, but before I pass over the mic to Corey, We did have a few poll questions that I'm hoping that the audience participates in. Um, so the first poll question is how many people here are A. actively using Portable Alpha slash return stacking and portfolios today? B. how many people are contemplating the use of Portable Alpha and return stacking in portfolios? And C. don't currently use Portable Alpha or return stacking in portfolios today?
All right, I see that the poll is moving along. Give that a few seconds to get a nice sense of things. Oh, it's looking good. Option A is, uh, is winning though. Moving around. Give it five more seconds. Okay, I'm going to end the poll there for everybody to see, um, and we're going to share the results. So we see, um, around 45 percent of people are currently using it, 36 percent are contemplating it, and 20 percent around 19 percent are not, uh, currently using it.
Okay, so just a quick follow up question, um, the next, uh, could you put up the next one, Ani, please? Of those who do use Portable Alpha, um, what has been the most significant challenge to implementing it in your organization? And the first question is, lack of understanding and experience, poor experience in the past, or you struggle finding reliable overlays? Okay. Lack of understanding and experience is 49%. Poor experience in the past is 16%.
And then struggle finding reliable overlays is. Okay, great. So this will kind of give you a good feel, Corey, for the audience and their sophistication. It looks like we have a lot of people here with, with some experience, so we might be able to delve deeper into the topic. But without further ado, you have
the floor. Well, wonderful. Thank you, Rod. Really excited to talk on this topic today because it's a topic I'm really very passionate about and I don't want to bury the lead here. Rod talked about all the things you're going to learn. I want to talk about what I hope you take away. And for me, the core concept that I hope you take away is that being thoughtful.
about how you actually structure your portfolio may be a much simpler and I would argue smarter way to pursue outperformance and diversification, uh, particularly versus traditional means. And that's what portable alpha and more broadly return stacking is all about. This is an idea, as Rod mentioned, that select institutions have been using for decades and it is, I think, gaining.
Relevance again because it's not just limited to institutions who have coverage from banks that are now able to implement this, but through mutual funds and ETFs this is a concept that can now be implemented by everyone. So let's start with what is the problem that return stacking and portable alpha are trying to solve. Now on this slide, what I have is a breakdown of the MSCI All Country World Index.
So this is a global equity benchmark broken down mostly into regional components and then within those regions broken down by market capitalization. And I've highlighted two slices. That big blue slice on the right is U. S. large cap, which as of today is Over 50 percent of the MSCI ACWI index. So if you are a global investor, you are over 50 percent of your equities are in us equities. And then that green slice is international developed EFI, small and mid cap coming in at just 7. 7%.
And what I want to highlight here is for each of those categories for us, large cap and EFI smid cap. What I did is I went and I found what's called the success rate of active managers, uh, in, in actually delivering excess returns versus their benchmark. So I went to the Morningstar active versus passive barometer report. And I said, over the last 15 years, what percent of managers in these categories have actually beaten their benchmark.
And if you look at the U. S. large cap slice there, what you see is less than 10 percent of managers actually beat their benchmark over the last 15 years. In other words, if you 50, reround the clock 15 years ago and just chose a manager at random, you had a less than 1 in 10 chance of identifying a manager who actually would beat the benchmark. Compare that to the EFY small and mid cap. It had over four times the success rate, right?
So you had a four times better chance if you were just choosing at random of actually identifying a manager who would go on to beat the benchmark and deliver those excess returns for you over the next 15 years. Now, my guess is for all the U. S. allocators on this call today, 99 percent of them have never even looked at evaluating an EFI small cap, mid cap manager. And that's largely because one, this is a global pie.
Most U. S. investors actually have a much larger slice of U. S. large cap equity because of A home equity bias. Um, but two, when you have so much exposure to U. S. large cap, that's where you want to focus your efforts, where all your capital is allocated. And yet you have this trade off where, where the majority of your capital is allocated is actually the place that's hardest to find alpha.
And, and even though the EFE small and mid cap has a four times better chance of delivering alpha historically, I'll point out it's still below a coin flip that you would have actually been able to identify a manager At random. And so particularly in the U S large cap space, it's a big question of, do I have the manager search skill to find that one in 10 manager who is actually going to deliver alpha for me over the next 15 years? And if not, what do I do with this massive part of my portfolio?
That's eating up all my capital. Now this was a question that PIMCO faced in the 1980s, not in equities but actually in bonds. They ran a large number of treasury mandates as well as a large number of fixed income mandates that were benchmarked. To broad U. S. fixed income. What I have here is a snapshot today of how the Bloomberg U. S. aggregate bond index has broken out. And what I've highlighted is the treasury allocation. 44 percent of this benchmark is in treasuries.
And so if we're trying to beat this benchmark, this is almost a 50 percent slice in which security selection really isn't going to help us. A 10 year U. S. treasury is fungible with all the other 10 year U. S. treasuries. And so unless we're willing to take credit or duration risk, go outside U. S. treasuries to maybe corporates or something else, this is a big chunk of the, of the pie that becomes very difficult for us to try to beat.
And again, just eats up a lot of dead capital from an active risk perspective. So, What did PIMCO do? Well, some very clever PMs realized that instead of investing in U. S. treasuries themselves, instead of actually buying the bonds, they could use derivatives, capital efficient derivatives, to gain exposure to the asset class and only have to use a little bit of that capital, of that say 44%, only give a little bit of that capital as collateral and free up the rest of that cash to invest.
So if, for example, if they invested it in cash, um, they, they would basically end up with the same return. So let me walk through this, because this can be a little bit confusing without an analogy. Imagine you have a million dollars and you're looking at buying a million dollar house. One of your options is to just buy the house. Right? You give them the million dollars, and in return, you get a house. And that's effectively what you'd have on the left side of this equation.
You, you bought the actual asset, and you would earn the actual return of that asset. The other option is that you go to a bank, and you get a mortgage, and you finance your purchase. And you keep that million dollars, and you get the return of the house. Minus the financing cost of that mortgage. And so long as you take that million dollars and invest it in something that's going to offset that financing cost of the mortgage, you're net neutral.
But you now have all that cash available to you if you want to use it. And what the folks at PIMCO realized was, well, they could take all that cash that's available to them and say, well, what if we not just tried to offset that cost of our mortgage, but what if we tried to outperform it? What if instead of investing in short term T bills, which are effectively the cost of financing embedded in treasury futures, what if we took a little bit of duration risk?
What if we took a little bit of credit risk? What if we went out on the risk curve a little, not a lot, just a little, to try to get a yield pickup? And if you work that equation through and say, well, I'm still getting the returns of the U. S. Treasuries, Minus the embedded cost of financing, but now I'm taking all that cash and investing in something that's going to outperform that financing.
Well, now all of a sudden I took a big dead slice of my portfolio where I couldn't perform security selection, where I didn't think I had an alpha edge, and transformed it to add the ability to create an alpha edge. Here, where PIMCO said they thought they had an edge in selecting short term bonds. And so, in effect, they were able to port all this sort of short term bond selection alpha on top of the U. S. Treasury position they had that was the otherwise dead space.
That happened in the early 1980s. This is what they call their bonds plus program. In 1986, S& P 500 futures launched and PIMCO pretty quickly realized, excuse me, it might've been 1983, either way, 1980s PIMCO pretty quickly realized that the same thing could be done with equities, right? If you were an investor and you had a U S equity mandate, PIMCO said. Well, give us the cash. And what we'll do is we'll get you S& P 500 exposure through S& P 500 futures.
They're going to track that S& P 500 exposure perfectly. They're going to have a cost of financing embedded, but if we take all the cash that we freed up and we invest it in short term, slightly riskier bonds, you know, slightly, maybe short term corporate bonds, try to get a little bit of yield pickup versus that cost of financing, suddenly we are going to be able to provide you S& P 500 returns plus a little bit of return and what's incredibly powerful about this concept. And this was.
sort of mind breaking was that the alpha, if we can call it alpha, that was being generated, the excess return above the S& P 500 of this program, was not coming from the asset that investors were trying to get exposure to. It wasn't coming from the beta. It wasn't coming from security selection within equities. It was coming from where PIMCO thought they had skill, security selection in bonds. And they were able to port that alpha on top of the S& P 500 beta that investors wanted.
And thus, the concept of portable alpha was largely born. It was actually originally called transportable alpha, eventually shortened to portable alpha. And almost 10 or 15 years went by before institutions realized that this could be generalized far more than the way that PIMCO was doing it.
If you look at the concept more generically, basically what's happening is institutions will look at their portfolio and find areas of large swaths of beta that they have low conviction that active managers will be able to outperform that beta. And if they believe that that beta can be cheaply replicated using derivatives, such as say the S& P could be replicated by buying S& P 500 futures, then they're able to free up quite a bit of cash. that they can then allocate to other places.
And those other places for PIMCO was, well, we can pick short term bonds, but we can go far beyond allocating just short term bonds when we think about finding additional alpha sources. So again, let's break this down step by step.
Step one here, you are going and looking at your portfolio and saying, there are large allocations that I have that I don't have conviction that active management is going to generate alpha, particularly after fees or with any significant degree of certainty, and I believe that I can replicate this using derivatives. This is the view an institution would have. The institution will then go and try to replicate that passive portfolio.
So again, let's say the S& P 500, they might go to a bank and ask for a total return swap. They might go trade futures and get S& P 500 futures exposure. They could synthetically replicate it with options. There's a variety of available choices here, but the point is they're going to choose A derivative structure that effectively gives them leverage, much like, again, buying a house using a mortgage. They're able to get all the exposure of the S& P 500 without putting the cash up front.
Now, they'll hold a little bit of cash aside as cash collateral, but not nearly all the capital that you would need. So I want to dive in here, just peel back the onion one layer deeper, because I think, I think it's, it's worth it to really drive home how this is working. Let's say I was an institution and wanted a hundred million dollars of exposure to the S& P 500. One way I could get that exposure is I could just buy a hundred million dollars worth of an S& P 500 ETF.
I put this together a few weeks ago, so the numbers aren't perfect for today's market, but you know, if you're going to go buy the SPY ETF, you're basically buying 175, 000 shares of SPY to get a hundred million dollars of exposure. And you're done. And again, you're going to have the very physical presence of the S& P there. The other thing you could do is you could go and buy all the underlying components of the S& P 500.
Then you've got to manage the index additions and deletions over time and figure out what you want to do with the dividends, right? But again, it's more or less the same thing as buying this S& P 500 ETF. You're just managing the basket yourself. The third thing you could do is you could buy S& P 500 futures. Now, without diving too deep, the important part is today, every futures contract gives you the notional exposure of about 280, 000 worth of S& P 500, right?
And so for 100 million of exposure, it means you only have to buy 350 contracts. Now, if you go to CME, And ask how much margin you need to post for each contract. They'll say it's about 14, 000, right? So you have to put up 14, 000 in cash to get about 280, 000. of exposure the S& P 500. That's about 5 percent of the capital, right? That's like basically buying a house by putting 5 percent down. Similar ish concept.
But what that means now is that you've only had to put up about 5 million to get 100 million of exposure, and the other 95 million is now free. for you to do whatever you want. Now prudence would tell us we probably don't want to run our margin limits that tight, we want to have a nice liquidity buffer, but the point is through using the futures we get the exposure to the S& P 500, but we've now freed up all this cash that we can invest elsewhere.
And that elsewhere doesn't just have to be short term bonds the way PIMCO did it, that elsewhere could be long short equity strategies, it could be CTAs, it could be global macro strategies, it could be event driven strategies, it could be any source of alpha Or diversifier or asset class or strategy that you think is going to generate positive returns above cash over time.
Rod. One question that came up in this chart here is how safe is the safety buffer? Um, I don't know if you can expand on that. Obviously it's going to depend on the institution, but
yeah. So this is going to depend both on the institution and what you're porting on top of. And the alpha source. And I know that that's a lot, but if you are porting, say on top of the S& P 500, that underlying index is very volatile, right? That S& P 500 can drop 50%. And so you're going to want a much larger safety buffer to make sure you don't have any meaningful margin calls.
If you're porting on top of, you know, if your policy portfolio or strategic allocation has a big bond allocation, you could port on top of bonds. And require much, uh, much less of a safety buffer because bonds are just going to move less. I actually, uh, recently had a conversation with a very large, uh, public pension who's been doing portable alpha for a better part of a decade. And they said that they're, they internally only port on top of bonds for this very reason.
Um, they, they used to port on top of equities. They said it's harder to manage operationally for this margin and safety buffer. And so they choose to port on top of bonds. So that's one of the, you know, again, it's going to vary depending on what you're porting on top of. End of the day picture that really matters here is how this all comes together to generate a return, right? And what we get when we talk about the end picture is.
When you run the Portable Alpha program, you get that S& P 500 exposure and you add this alpha source on top. And this portfolio will outperform so long as that alpha source outperforms cash over the long run. Cash here being basically T bills. And so this is, for many people, a totally new way of thinking about generating outperformance, right? You don't need to beat the market. by finding a manager who can pick stocks better.
You can beat the market by structurally changing your portfolio to free up capital to invest in something that you just think is going to beat T bills over the long run. And suddenly that allows us to think about all sorts of different investing components as Lego building blocks in many ways, right? So what we've done here is we've taken the return for all these different asset classes and hedge fund strategies Whether it's gold or trend following or market neutral, long, short, relative value.
And we've said, what is their return been above T bills over the long run? That excess return is effectively the thing that through Portable Alpha we can try to stack on top of our portfolio. And then we can sort of mix and match as we see fit, right?
Maybe you're someone who believes in having a big allocation to gold in your portfolio, or maybe you like the idea of long short equity and matching it with a macro strategy, or trend following plus carry strategies, and you can choose both the size, And the combination of what you're stacking on top to try to match the active risk budget that you have, as well as meet your core objectives.
And so if we compare the old world way of thinking about trying to beat the market, right, to the new world approach, I think there is some substantial improvements in terms of the likelihood of generating outperformance. In the left half of this slide, what we show is the performance of top quartile U. S. large cap equity managers over the last decade. So these are managers, uh, who out, who are in the, again, top 25 percent of the category.
They generated, on average, about 120 basis points of excess returns. So the market returned about 11 and a half percent. They added about another 120 basis points on top of that. And that assumes again, you could rewind the clock a decade ago, identify that top someone in that top quartile or a basket of managers in that top quartile and stick with them over the next 10 years.
I want to compare that to the second graph, which just basically takes the S& P 500 U. S. large cap and stacks generic hedge fund category beta on top. Here I'm just using a generic Credit Suisse hedge fund index, minus that cash return.
And you can see without having to do anything special, without even trying to pick the best performing hedge fund managers, just saying give me generic hedge fund beta, you would have stacked 275 basis points on top of the S& P. Now we think you can be far more thoughtful than this, but again, the point here is do we have higher conviction in our ability to identify some long only equity manager that can actually generate alpha?
Or do we have higher conviction in our ability to identify a diversified collection of alternatives that are going to be able to beat cash over the long run? And I think that's profoundly powerful when it comes to thinking about generating outperformance in our own portfolios. Now, what's really interesting to me about Portable Alpha is it's always been this concept about beating the market. But more fundamentally, what Portable Alpha does is it solves what we would call this funding problem.
One of the things we've said at Return Stack Portfolio Solutions is that diversification has always been this process of addition through subtraction. Thank you. If you want to historically have added diversifiers to your portfolio, most investors had to sell down something else to make room. So as an example, on the far left, we have an investor's benchmark allocation. Typical, traditional 60 percent stocks, 40 percent bonds.
And let's say they wanted to add 20 percent in some alternative diversifiers, whether it's Some of the passive asset class like gold or an active investment strategy, the old world approach required them to sell down some of their stocks and some of their bonds to make room for that allocation. And the potential problem here is it creates a two form hurdle rate. First from performance perspective, those alternatives have to outperform the things that they replace.
to add value to the portfolio, right? So whatever you're selling, whatever you're buying effectively has to outperform whatever you've sold. Second is, in my opinion, creates an important behavioral hurdle, right? You're selling things that most clients are comfortable with.
Stocks and bonds, they tend to be cheaper, more transparent, uh, more tax efficient, and you're replacing it with alternatives that often they don't understand are higher cost, less tax efficient, and it creates, once again, this trade off of, of a behavioral hurdle rate that it makes it hard for the clients to stick with that alternative when it is inevitably going to underperform what you sold to make room.
The new world approach, that portable alpha, And what we more generically call return stacking, right? When it's not just about trying to pursue excess returns, but when it's also about how we can just generally think about structuring a portfolio, this new world approach solves this funding problem. by layering the alternative on top of the benchmark.
You no longer have to make room, you can just add it as an X, as an additional, uh, allocation, effectively expanding your canvas that you can, that you can paint with, paint on. So I want to go into a little bit of an example of how this is sort of played out historically. People who know me will know that I love Managed Futures Trend Following. It's where I've spent a The majority of my career and a ton of time in research.
And for those who don't know what Manfruture's trend following is, Manfruture's trend following is an active strategy that can go long and short, equity indices, bonds, currencies, and commodities. It typically uses trends.
to drive the signals when trends are positive it'll buy when trends are negative it'll sell and if you look at the category what you found historically is a really attractive return stream from a diversification perspective it's had very low correlation to stocks and bonds it has exhibited positive long term excess returns above the cash rate It's exhibited at least, you know, going back 20, 30 years, positive returns during large equity drawdowns and positive returns during inflationary
periods. It's a very dynamic strategy, very attractive. So the question is why don't more people have it in their portfolio? And I would argue it is this funding problem, right? We all agree in this industry that all else held equal, more diversification is better than less. But if we look at the average allocator's portfolio, it typically is just very stock and bond heavy. And it's in my opinion, because of this problem that to make room in a portfolio, you have to sell those stocks and bonds.
And that lead leads to incredible behavioral frictions. I want to, I want to use a chart to try to explain that. So in the early two thousands, investors would have loved alternatives, right? What this chart shows is the relative performance of, of a 50, 30, 20, 50 percent stocks, 30 percent bonds, 20 percent managed futures. Versus the benchmark 60 40. And so when the line's going up, that more diversified portfolio is outperforming. When the line is going down, it's underperforming.
And what you can see is that alternatives were great for the lost decade of equities, right? The 2000 to 2010 ish period was ultimately a lost equi a lost decade. And so selling your equities and selling your bonds to make room for a diversifier like Managed Futures that did well during that decade, clients loved it. And if you were around during that period, you'll remember everyone was investing in EM and commodities and making room for alternatives.
And then it was almost like the decade flipped over and you got the exact opposite story, which is U. S. stocks and bonds just went on this perpetual bid grind up and everything else underperformed. on a relative basis, right? And no surprise, alternatives were bad for the last decade of alternatives. So if you were selling stocks and bonds to make room for managed futures, this was a very painful experience.
And again, it creates this behavioral hurdle because clients aren't going to necessarily understand why they have them in the portfolio. And it's very hard for a client to stick with 10 years of underperformance versus something that's cheaper and more transparent and more tax efficient. And so, to me, it's no surprise that by the end of the 2010s, most investors were increasingly narrowly focused on U. S. equities and U. S. bonds.
And I just want to make something, I think, clear on this chart is that what we're not saying is that they had negative performance during this period. They just underperformed the 6040 to such an extent that by the end of the period, you would have, you know, you're, you're back to where you were had you started investing in 2000, right? So it's the relative performance that's a problem here. You're still, you know, they're still doing positively. They're just doing worse than a 6040.
Thank you.
And so this shows up, this behavioral issue shows up in the actual data. This table is from Morningstar, and what it's showing is the investment returns versus investor returns of different managed futures funds from 2019 through 2022. 2022 being a great year for managed futures. And the investment returns like, well, if you invested a dollar at the beginning, took it out at the end, what was your total return over the period? The investor returns actually track.
Dollars coming in and out of the fund and how the average investor performed. And what you find looking across the category is that the gap between what the investment realized and what the average dollar weighted investor realized was over 300 basis points. Right?
Suggesting that most investors ended up performance chasing this investment, getting, not being in when they needed to be, chasing good performance, and then ended up selling out after the run had already commenced and they started potentially losing money again. Again, timing diversification is very, very hard. You want to just have it perpetually embedded in your portfolio. But the old world way of making room makes it very hard to stick with from a behavioral perspective.
Contrast the new world way where we are stacking alternatives on top, right? So what we have here is the same graph as before, but now instead of the 50, 30, 20 relative to a 60, 40, we have the 60, 40, 20 relative to a 60, 40. And you can see the relative outperformance in the 2000s, not as strong, right? Because again, that was a lost decade for equity. So by selling equities and putting in managed futures, you got that full return gap. Here you still hold the equities in the 2000s.
But you do get the benefit of having those alternatives stacked on top. And then in the 2010s, when those alternatives largely went sideways and stocks and bonds went on to have sort of the highest Sharpe ratio ever for a 60 40 portfolio, you didn't necessarily lag behind because you had to make room in your portfolio and you had that big opportunity cost.
By stacking an alternative on top that largely went nowhere, you Your performance of the portfolio continued to keep up with the generic 60 40 and so you had potentially that diversifier in place for when 2022 came around and it was again going to prove its worth as a diversifier versus stocks and bonds.
And so both from a performance and a behavioral perspective, we think that this concept of stacking diversifiers on top of your portfolio rather than selling core stocks and bonds to make room is much more sustainable and additive from both the diversification and potential outperformance perspective. And so we call this more generic idea of Portable alpha return stacking, right?
The core idea here is that we are layering one investment on top of each other, achieving more than a dollar of exposure for every dollar invested. So as an example, uh, you could stack a hundred percent managed futures trend following on top of a hundred percent U. S. equity exposure. And what's really exciting today is that there are a number of funds that are available that allow you to implement this concept, whether you want to do return stacking.
For diversification or you want to pursue portable alpha for excess returns. This is now achievable to anyone, even if they don't have access to banks and total return swaps. Even if you can't manage derivatives, you can use mutual funds and ETFs to implement this concept. The first way is through what we call pre stacked. fund solutions. So here, these are funds that are going to give you simultaneous exposure.
When you invest a dollar, you're going to get a dollar of some core beta plus some exposure, alternative exposure layered on top. So in this example, uh, we have a 100 100 fund that's going to give you for every dollar invested a hundred percent exposure to bonds and then a hundred percent exposure to some alternative. And you can see that if you have your strategic, Call it 50 50 portfolio, 50 percent stocks, 50 percent bonds.
If you sell say 20 percent of those bonds and invest in this 100 100 fund, if we X ray through what we will get back is our strategic portfolio, the 50 50 plus a stack of that 20 percent alternative on top. From the investor's perspective, right? You're still allocating a hundred percent of your portfolio. You're just using a fund that implements that stack. And so these are pre stacked fund solutions of which there are a variety in the market today, both mutual funds and ETFs.
And this presumes that you're going to want to, you have a particular alternative you want to stack on top, and you can find a manager that is doing that in a pre stacked way. And you like the way they do it. The other option is what we call capital efficient solutions.
So these are going to be funds that give you simultaneous exposure to stocks and bonds, not because you want to stack more bonds on top of your portfolio, but because it allows you to get the same stock bond allocation with less capital deployed. So as an example, let's say there was a fund. That for every dollar you invest, you get a hundred percent exposure to equities and a hundred percent exposure to bonds.
If you were a 60 40 investor, 60 percent stocks, 40 percent bonds, you could sell 10 percent of your stocks, sell 10 percent of your bonds, and put 10 percent into this 100 100 portfolio. That 10 percent in the 100 100 portfolio would give you back 10 percent stocks and 10 percent bonds. And now you've freed up 10 percent of your portfolio.
If you put that 10 percent in T bills, these two portfolios will effectively return the same thing, but now you're free to invest that 10 percent however you want. You could invest it in a strategic diversifier like gold. You could invest it in an active investment strategy. You could run your own tactical views through that freed up 10%. And so long as that thing you invest in outperforms cash, you will have created outperformance versus your 60 40 benchmark, right?
No longer does the outperformance have to come from security selection in your stocks or security selection in your bonds. You can simply say I've stacked something on top that I think is going to outperform cash. And if it does, over your investment horizon, you will have outperformed your benchmark. So some really key takeaways here. One, portable alpha, or what we more generically call return stacking, allows investors to pursue alpha in alternatives without disrupting that core beta. Right?
Not just without disrupting, it allows you to go outside of the core beta to find those sources of alpha. Particularly those core betas that we think are hyper efficient, that it's just really hard to beat the market. We believe that there are some alternatives like managed futures, as an example, that can offer both a source of potential excess returns, as well as profound diversification versus a traditionally allocated 60 40 portfolio or just generic stock bond portfolio.
And so return stacking is a more generic concept. We believe can help mitigate the behavioral biases associated with diversification by solving that funding problem, right? Instead of having to make room in your portfolio, you can now stack these alternatives on top of your core allocation. And whether you choose to pursue this with pre stacked fund solutions, or capital efficient strategies, both offer practical ways for every investor today to implement return stacking as a concept.
So with that, I want to say thank you everyone for tuning in. Um, we're going to turn to some Q& A, but quickly before that, I just want to say if you have any questions about implementing the concepts of Portable Alpha or return stacking in your portfolio, you can go to returnstacked. com. Go to the contact page. You can either submit a question there if one comes up after the webinar, or you can schedule a time to meet with our team.
They're always happy and we'll loop all the PMs in if necessary if you want to do a deep dive. There's also a huge amount of content written about not only things you can potentially stack and the pros and cons of stacking them, but Things like what's the tax efficiency of stacking? Uh, what are the risks of stacking? Uh, what are the costs of stacking? Different ideas for how to make this work, both for diversification and outperformance. How does it work, uh, in a retirement context?
How does it work in a growth context? And so there's been a ton of articles written over the last decade. So if you are looking for particular insights, that is a great place to start. And with that Rod, I will turn it back to you for some Q and A.
Great job, Corey. That was fantastic. Very informative. Um, you know, I actually want to start with something that you said in connection to a bunch of questions that we've had, um, when you were discussing allocating to that stack, to those portable alpha stacks. The questions revolve around, you know, what is the best way to rebalance, uh, across and what is the best way to time when they're underperforming?
You know, how should one think about strategic asset allocation versus tactical asset allocation, if at all?
So a lot of the point of this stacking, right, is to avoid the tactical in many ways. So if we go back maybe a couple of slides to just the generic picture, old world versus new world, right, whatever we're stacking on top, hopefully we have a high confidence view that it will generate returns in excess of T bills over our investment horizon.
Maybe not in the short term, um, right, because anything can happen in the short term, but over whatever our investment horizon is, we think it's going to be additive to our portfolio. And so a lot of what we're trying to achieve here is avoiding the need to be tactical, right?
I don't have a view as to what managed futures are going to do over the next 3, 6, 12 months, but I have high conviction that over the next 20 years, they're going to generate a positive return and be a good diversifier to my stocks and bonds. And so I'm just going to layer them on top of my portfolio. This is exactly what I do in my PA, by the way, uh, so that I don't have to make that timing decision. That said, it doesn't preclude people from running tactical strategies, right?
We talked about this idea of using capital efficiency to free up room. You can, in theory, and I've met with advisors and allocators who do this, who say, when I have no view, I will just put that freed up 10 percent of cash in T bills, and I know I'm going to effectively get the same return as my 60 40. But man, I'm really worried about inflation over the next year. So I'm going to take some of that 10 percent and I'm going to put it in commodities as a, as a bit of a hedge.
Or I might put a little bit of crypto in there, right? 1%, 2 percent of the new crypto ETFs. And then when I, when I don't have that macroeconomic view, I can take it off again. And so you can use the, this concept to express tactical bets for sure, but when it comes to stacking the alternatives, in my view, a lot of what we focus on at ReturnStack Portfolio Solutions and with our ETF suite is strategic stacks.
Excellent. So let's, let's continue to go down that path of When you allocate these portable alphas and, and the risks that are involved because, you know, we talked about how PIMCO was around in the 1980s doing this, it became super popular. I think the number up to 2008 was that 25% of institutions were using some sort of portable alpha. Then we didn't hear about it for a decade plus what happened that took people's, uh, foot off the gas, if not completely off the gas.
Yeah. So I, I mentioned this idea of. That pension, right, that said they will never allocate portable alpha on top of the S& P because of the risk they always do out of the top bonds. That was a lesson hard learned in 2008. Doesn't mean it can't be done, by the way, but you need to be careful. So if we actually look at like the picture of portable alpha, right, where you're replacing some generic index with some derivative, and then you're buying an alpha source.
What happened in 2008 was, Multipart. One, there were people who were replacing equities with highly levered derivatives, right? S and p total return swaps that they weren't having enough margin or, or safety buffer, particularly in the case that markets went on to fall 50%, right? If, if markets fall 50% and you only have a 20% margin buffer, well you're gonna run outta capital and your position's gonna get closed on you.
So you need the ability to rebalance between whatever you're porting or stacking on top. Now a lot of what was being allocated to were hedge fund strategies and there was a two fold problem here. The first was that the alpha that was supposedly there was actually ended up being highly correlated to equity markets during this huge liquidity crunch.
It really wasn't diversifying alpha and it was really liquidity risk packaged up as alpha and then express the same losses that happened as the equity. So you were losing on your equities at the same time you were losing on your alpha. And then when these institutions went to redeem from that, uh, hedge fund, either that caused the losses to be greater, creating this liquidity spiral, right?
Or the hedge funds just outright gated the redemption, which meant they couldn't come up with the cash to meet the margin costs. The last part being, some of the counterparties, right, were banks that went bust, right? If your counterparty was Lehman and you had an S& P 500 total return swap, you were left hanging saying, I don't know where my exposure lies anymore. And so, operationally, it was a mess from a, from a, what was getting ported on top.
I think, candidly, things went a little too far. People didn't have enough scrutiny as to what was being added. They weren't balancing their liquidity needs appropriately. When you talk to people implementing Portable Alpha today, They are mostly focusing on liquid alternative strategies that they can redeem very easily. Things that they have a high confidence are going to be uncorrelated with stocks and bonds.
And they are trying to port on top of assets that they don't think can drop 50 percent in a year, right? They're porting on their lower duration treasury exposure, for example. And so there's much less risk of a margin call. So there were some hard lessons learned in 2008. I don't think it was a knock on the concept. I think it was a knock on how it was implemented.
And I'll add, uh, you know, PIMCO has been, again, doing this in some fashion since the 1980s, had zero problem in their implementation.
I was going to say that, I mean, it's the important evolution as well today. Maybe it's not an evolution because PIMCO has been doing it forever. Is that when you're looking at public products? You are getting, you have to be liquid, right? You are, you are required to have liquidity whether you're stacking nothing or stacking something.
And the ability to manage that safety buffer, margin buffer, isn't just about how much safety buffer do I have, but also can I redeem out of my alpha source so I can manage the risk as it happens. Uh, and then there's also the non recourse aspect of funds that make it even more attractive to the average investor. So, Corey, let's talk about, let's continue down the path of risk. Um, we have We're stacking, we're, we're levering. I'm going to say the word we haven't said.
I don't think I've said that word too much today, but we are levering. And when people in the ETF space and mutual fund space here of leverage, they hear about the two times S& P 500 ETFs, the three times bull. And then we get into things like, you know, the rebalancing, decay, the, the variance decay, the double the risk, double the exposure. How do we think about the differences between those two structures? So when
we talk about these pre stacked solutions, whether it's capital efficient or your pre stacked alternatives, how do they compare to your traditional 2x products? And I think what's really important to think about here is the embedded diversification that's happening when you are doing the stacking. So. Um, on this slide, what I have is, is the volatility of an S& P 500 fund, which has historically been around 15, 15 and a half, versus the volatility of a two times S& P 500 fund.
And no surprise, the two times S& P 500 fund basically has double the volatility, right? And so you end up with a very volatile product. If you were to take the S& P 500 and stack on top, say, generic trend following index, like the Stock Gen CTA index, You can't just add them together, right? The vol of the S& P 500 is about 15. 5. The long term vol of the Sock Gen Trend Index is about 14. You can't just say 15 plus 14 equals 29.
Because the way diversification works by being uncorrelated to each other, you actually see the diversification of the portfolio drop. This isn't new to anyone who invests, right? This is just the basic principle of diversification. So when you're doing this stacking, yes, an S& P plus. Say managed futures index type strategy will be more volatile than the S& P, but it's not necessarily going to be double the volatility, right?
Because a lot of what's being traded both long and short in that managed futures strategy is not equity exposure. It's bonds and currencies and commodities that may be doing totally independent things from what equity markets are doing. And so when we think of that, the thing that comes up all the time is both the risk of the product itself, but also that variance drag that everyone talks about. Well, that variance drag really comes from how volatile the product is.
And so when we go from the S& P to two times the S& P, yes, the return is twice as much. But your variance is four times as much, right? When we go from the S& P to S& P plus Managed Futures, your return is going to be S& P plus Managed Futures, but your vol isn't doubling the same way. And so you don't get nearly the same compounding, uh, variance drag risks that show up in a product. Or a concept like this, right? And this goes back to me.
I mean, even if we just go way back to the fundamentals of modern portfolio theory, modern portfolio theory always said find the most diversified portfolio, the max sharp portfolio, and lever it to your risk level, right? That's effectively what portable alpha and return stacking allow you to do. And the reason that works is because it allows you to really unlock those benefits of diversification in stacking these things on top.
Yeah, I mean, the, the way when you, when you said returns and, and, you know, it's four times the variance, really, it's the returns are the arithmetic returns, a simple addition, like, if you're doing years, you're just simply adding the years in a decade of the S& P, you get a number, but that number isn't what goes into your pocket. It isn't the compound return.
It is the variance that defines how much of that arithmetic return actually goes into your pocket and the bigger the variance, the less goes into your pocket. So. You know, in these concepts, when you're doubling the S& P and quadrupling the variance, you're getting less in your pocket than you think.
But when you're doing a, when you're stacking something that's diversified, your variance drag is significantly lower, and therefore the stacking, the actual return stacking, is expected to be higher, right? Now, um, what do you think about You know, that's the kind of top level topic. A lot of these, um, even the non correlated alpha sleeves that have nothing to do with the S& P 500 sometimes lose at the same time as the S& P or whatever beta you're using.
How should people think about how that's going to feel, um, short term and long term in terms of risk management?
Yeah, it's a really important question, right? Uncorrelated does not mean negatively correlated. Um, if we were to just stack something that's perfectly negatively correlated on top of the S& P. Uh, we shouldn't expect a return other than, you know, the risk free rate or else you've somehow maybe found an arbitrage, right? So, so the point is we have to take some risk.
Um, on average, on a, at a fund level, right, if you have the S& P 500 plus managed futures, that fund is going to be more volatile and the average drawdown is going to be bigger. Average per year. What you tend to find though, if you look at historical samples and simulations, is that the big drawdowns Are not as bad, right? You know, again, what zero correlation means is not when the S& P is down, this thing will be up.
It means when the S& P is down, it's a coin flip as to whether the whatever you're stacking on top is down or up. And if it's up, it's a coin flip as to whether this thing is down or up. It should be totally, you get no information about the direction this thing is moving based on what the S& P has done. So you get a slightly higher, um, vol. That said, again, it goes back to how you're spending your active risk budget, because this isn't really any different at the end of the day.
If you're, you know, say buying a value fund instead of stacking something on top of the S& P 500, well, you're still getting the S& P 500 and then you're getting all those active picks. And it's possible that the S& P goes down at the same time those active picks underperform, right? And so for me, you're getting much the same concept, but I get to choose how I spend my active risk budget and put it into things I have much higher conviction in.
So the um, when you look at the stacks and that active risk budget that you mentioned, I think a lot of questions around like how much, how much is a good stack? Like what should I be stacking at any given time? What's, what's uh, going to be useful or not? You talked a little bit about your active risk budget. Like how should people think about that amount?
Yeah. So, so really simple math. And then I'll tell you sort of some practical examples. Let's say you have something that has. 10 percent volatility that you want to stack on top of your portfolio. You have a 60 40 totally passive and you stack something that has 10 percent vol on top. For every 10 percent stack you add, you're creating 1 percent tracking error. So what does that mean?
That means within a given year, a 1 percent tracking error means you'll be mostly plus or minus 2 percent to your benchmark. That's the risk you're taking. And so what I say to people is, You know what you're stacking on top if you're putting managed futures and gold and you know other strategies typically that blend is going to look like 10%. And so if you put a 10 percent stack on top of your generic 6040 you're going to be plus or minus 2%. Does that feel good or does that not feel good?
You put a 20 percent stack on you're going to be plus or minus 4 percent right? Does that feel good? Does that not feel good? What we tend to find in practice and working with most allocators is that 10 percent is sort of the The minimum, unless you have a really high vol alternative that you're stacking on, 10 percent tends to be the minimum to make a difference. You start talking about getting north of 30 percent and clients really start to notice that their portfolio isn't behaving like.
Generic stock bond portfolio anymore. And so really we started to start to put limiters on it, like the 20 percent mark and say, you really have to be sure your clients are super well educated. I personally go well beyond that limit because this is where I like to spend all my active risk budget. And I really like the things that I stack on top, but I have high conviction. Conviction cannot be rented, right? If you're going to go that route, you really have to believe it.
And you have to believe if you're allocating on behalf of other people, whether it's your fund board or. Or your, you know, uh, clients, if you're, if you're an advisor, that they can actually stick with what you're doing. And we find sort of the best approach is somewhere around 10 to 20%, and don't do all that with one fund. Find three or four pre stacked solutions or things that you can stack on top so that none of them are catching the investor's eye from a line item risk perspective.
Awesome. Um, we're a minute in. I think there's one more important one I think we should try and cover quickly, which is how viable is return stacking when it's so expensive to borrow in a high interest rate environment?
Yeah, so this is a question we get all the time, which is, well, this idea must have been great in the 2010s when, you know, you were just stacking, uh, on a risk free rate that was effectively zero. And the answer is that we're always trying to stack excess returns, right? And so all we're trying to do is say, well, what is the return of an asset minus cash? And people say, well, cash is so much higher today. Surely the return of that asset has to be less.
And so I'll consider an example of an alternative. Let's say you were investing in a managed futures fund. Well, when you invest in that fund, you're going to give them a dollar and they're going to take that dollar and put it in T bills. And they're going to use that as collateral to run their managed futures trend following strategy. So it doesn't matter whether T bills are returning 0 or 5 or 10 or 15. The excess return is always the return of that active strategy.
So it doesn't matter if rates go up or down. And that's true whether these are what we call cash plus alternatives. So. Long short equity, uh, a lot of systematic macro strategies, managed futures, or whether they're not cash plus, most assets or all assets really are things that we talk about in excess returns. What is their return going to be in excess of T bills? And we generally assume every asset has a return in excess of T bills or else why would you bother investing in it?
Why wouldn't you just invest in cash? And so from that perspective, the actual level of T bills does not matter. Um, because all we're talking about is the excess returns. And again, this is something we have an article written about, uh, that probably explains it a lot better than I can in 30 seconds to a minute with some nice graphical pictures, but it's a question we receive all the time. And we think that this concept is just as important today.
As it was in a zero interest rate policy environment.
Great stuff, Corey. I appreciate the answers. I appreciate the time and effort you put into this presentation. As Corey alluded to, you know, any questions that you've had, we didn't answer. We have answered it on the website. So literally go to the insights. com. Search for it. We'll have either talked about it in the podcast or we have written about it. So, um, that is it for today. If anybody has any further questions, please do reach out to us.
Go to the contact us page on the website, type out your answer or book a meeting for us to chat. We'll be, uh, more than glad to get the team on it and help you out. Um, if you wanna, uh, look at the other assets, other areas to get more information, you know, Corey's Twitter account is always fantastic. See Hofstein at, uh, well, I guess, x. com now. Also, we're putting a bunch of stuff on LinkedIn. I'm at rodgordop. Um, And, uh, same thing on LinkedIn.
We have a podcast, uh, that we are pushing out every now and then called the Get Stacked Investment Podcast, where we've covered a lot of ground, a lot of contemporaneous things that have happened, uh, a little bit of what happened with different stacks in July. And so there's, there's a depth of knowledge there that people can, um, can dig into and, uh, you know, once you start taking the red pill on this stuff, it's, it's really tough to go back. So we've done our best to try to.
help you get all the way down the rabbit hole, get comfort so that you can benefit from the things that institutions have been benefiting for over 40 years. So with that, I'd like to thank everybody and hopefully we'll see you again soon in the next webinar.