[00:02:09] Corey Hoffstein: So return stacking, at its core, and I really appreciate the opportunity, and it’s always exciting to hear when someone else is talking about the work you’re doing, so I appreciate Logan talking about it.

[00:02:23] Corey Hoffstein: Return stacking is this idea that actually goes back to the 1980s. Pimco, one of the largest investment managers in the world, came up with this idea they called portable alpha. And it was really popular among institutions in the early 2000s and remains popular for large, sophisticated institutions in terms of how they implement their portfolios.

[00:02:46] Corey Hoffstein: But it’s not something that ever really came down to the retail financial advisor or individual retail level. My suspicion is that to implement it, it typically requires trading all sorts of derivatives, like futures and swaps, and a lot of that stuff is either too operationally difficult or too difficult from a compliance perspective.

[00:03:08] Corey Hoffstein: So it never really made its way down. That’s a little historical context, but I think what’s more important is why would you care about this? Why did I get interested in this? Well, for me, the firm that I manage at Newfound Research, we’re a quantitative investment manager, and we have a huge focus on diversification.

[00:03:31] Corey Hoffstein: What we try to bring to the market is diversifying alternative strategies, and one of the things that we saw in the 2000s is right after 2008, there was a large appetite for introducing alternative diversifiers. But what that ultimately means for most investors is if they hold stocks and bonds and they want to buy something like managed futures, they need to choose what to sell before they can buy.

[00:03:59] Corey Hoffstein: So they have to sell some stocks, sell some bonds, buy some managed futures. So you have this ultimate problem of what am I funding my position with? What am I selling to buy the alternative? And in doing that, in the 2000s, it was an incredibly frustrating period because it was one of the best periods of returns for a very traditional stock-bond portfolio.

[00:04:25] Corey Hoffstein: So early in the 2000s, post the 2008 crisis, people really wanted diversification. They started to introduce alternatives, and then as the decade waned on, those alternatives were a larger and larger drag on their portfolio compared to if they had just held stocks and bonds. So there was a lot of frustration.

[00:04:46] Corey Hoffstein: They liked the diversification, but they didn’t like the relative underperformance that they were realizing. What I saw was this opportunity with my collaborators on this. It was: if we could take this idea of portable alpha, which is, let me get my stock and bond position using some derivatives that are a lot more capital-efficient – I don’t need, if I want a hundred dollars of stocks, I don’t need to use a hundred dollars – I can use $10 and buy a futures contract to get that a hundred dollars of stock exposure. And I can use the remaining 90 to invest in alternatives. You don’t need to do that proportion, but just as an example.

[00:05:33] Corey Hoffstein: If we could package that up in a mutual fund or an ETF and create these building blocks for people, it would allow them to, instead of having to make this either-or decision about their core stocks and bonds and the alternatives they might want as diversifiers. It allows you to say “and.” It allows you to have your stocks and bonds and overlay your portfolio with these diversifying alternatives that we think can really help during environments like 2022, when stocks and bonds go down simultaneously.

[00:06:08] Rebecca Hotsko: And I want to get into some of the different products that are available. Because I think that’s one of the cool things was back a couple decades ago, there weren’t really any products where the average investor could implement it.

[00:06:19] Rebecca Hotsko: It was mostly just institutions that were capitalizing on this. And then firms like yourself got into it. And now there’s some ETFs that make it available for all of us, but for our listeners to make it very clear. What return stacking even is. Can you kind of explain it in simple terms, what it is and then how it works?

[00:06:38] Corey Hoffstein: Absolutely. In the simplest terms possible, return stacking is the idea of basically layering a new set of returns on top of your existing portfolio. So, we call it stacking because you’re trying to stack the returns of a hopefully second diversifying source of returns on top of what you already have; it’s sort of an A plus B equals C equation.

[00:07:01] Corey Hoffstein: The way it’s implemented, unfortunately, is kind of sophisticated. It requires using derivatives behind the scenes and that sort of stuff. But the real basic concept, the real potential benefit to investors is the opportunity to add a new diversifying source of returns on top of what they already have, hopefully enhancing long-term returns, increasing diversification, and helping reduce drawdowns.

[00:07:24] Rebecca Hotsko: So, the one really cool thing that I read about this strategy, and this is where it hit home for me, was that it was the Cliff Asness paper that talks about how if you are 100% equity, then you should be for a leverage strategy where it’s the leverage 60 40, I think his paper argued, because you actually get a higher return than the 100% equities but for lower risk. And so that just blew my mind honestly that something like that was possible, ’cause it almost seems like it’s a free lunch.

[00:08:02] Corey Hoffstein: Yeah. What Cliff, as the founder of a QR, wrote this paper called “Why Not a Hundred Percent Equities?”

[00:08:09] Corey Hoffstein: And it was in response to another article that had been written, talking about, “Well, why don’t institutions and endowments who have these very long dated goals, well, why don’t they just put a hundred percent of their money in equities? Why hold bonds? Why hold anything else?” And what Cliff pointed out is that, well, if we go back to Modern Portfolio Theory, what Modern Portfolio Theory tells us to do is find the most diversified portfolio.

[00:08:40] Corey Hoffstein: And lever it up, and Cliff showed that actually if you take a portfolio that looks very close to a 60-40 and lever it up 1.5 times, historically, you would’ve had a higher return and about the exact same risk as equities. And to your point, right, they call diversification the only free lunch in markets. It largely is. There’s no benefit really to foregoing diversification, but often you have to use leverage to really unlock those benefits, right?

[00:09:12] Corey Hoffstein: Most people would think a hundred percent equities. When you go to a 60-40, you’re de-risking your portfolio, right? You’re selling stocks to buy bonds that are less risky. The only way a 60-40 can compete, even though it’s more diversified, the only way it can compete with a hundred percent equities over the long run is by levering it back up to the same amount of risk.

[00:09:39] Corey Hoffstein: And, and Cliff found that that was about 1.5 times. Interestingly, a product launched that replicates exactly that from Wisdom Tree. It’s their US efficient core ETF (NTSX). I think it will launch in 2018. And Jeremy Schwartz, their director of research there, published a follow-on piece. So Cliff, I believe, wrote his initial piece in the early nineties.

[00:10:02] Corey Hoffstein: Jeremy then said, “Okay, let’s see if that’s held true for the last 30 years.” And lo and behold, it continued to hold true for the 30 years out of sample after Cliff had written his piece. So I think, right, diversification is one of those really evergreen ideas.

[00:10:22] Corey Hoffstein: 

[00:10:22] Rebecca Hotsko: I think it is remarkable to look back and backtest the different funds and actually prove to yourself that it works, and that this is something that now can be easily implemented by the average investor.

[00:10:36] Rebecca Hotsko: And so, I want to get into the different ways that someone could use this strategy to their benefit, because my understanding is there are a couple of ways that it can benefit a portfolio, and you can correct me if I’m wrong. One is to enhance returns, and the other is to diversify. So, could you talk about how each of those works?

[00:11:02] Corey Hoffstein: Yeah. And if we get lucky, hopefully we can do both at the same time, right? That’s the holy grail there. So we talked a little bit about replacing that 100% stock with the levered 60 40, so what we’ll call a 90 60. You take your 60 40, you’ll lever it up 1.5 times, you got 90% bonds, 60% stocks, excuse me. That portfolio over the long run seems to have a better return profile for the same amount of risk as all equities. And effectively what you’re doing, right, is you are layering those bond returns on top of an equity portfolio. So, right. So you could say you’re stacking bonds on top of equities, and for every dollar you invest, you’re getting a dollar 50 that keeps the same risk profile, but those extra bonds serve as a secondary diversifying source of returns that enhances the long-term return profile of that strategy.

[00:12:04] Corey Hoffstein: Now, it’s not without its risks, right? 1.5 times levered 60 40 portfolio did quite poorly in 2022, right when stocks and bonds went down at the same time. That’s not a great time to be leveraged stocks and bonds. So it’s not like this is a purely free lunch. There are risks. One of the things you can consider, though, is, well, how can I use this same concept to introduce a new diversifying asset class?

[00:12:35] Corey Hoffstein: So let’s go back to this levered 60-40 portfolio and wrap it in an ETF, right? NTSX is the ETF from WisdomTree that does this. Well, if I have a hundred dollars and I want to get the exposure of a 60-40, I could take 60 of my dollars and buy stocks and 40 of my dollars to buy bonds, right? The other thing I could do with the existence of this ETF is take $66 and buy NTSX.

[00:13:07] Corey Hoffstein: Let’s do the math here. NTSX gives you 90% stocks, 60% bonds. Well, 90% of 66 is $60 of stocks, 60% bonds in NTSX times $66 is 40% of bonds. So we took $66, put it in this ETF, and we got 60-40 exposure, but we have $33 left over of our hundred. So then the question is, well, what do you do with the $33? I don’t want to be prescriptive here. People can do whatever they want. I have certain views as to what you should do. But if we know, for example, stocks and bonds tend to go down at the same time during inflationary impulses, one of the questions we might ask is, well, can we buy something with that $33 that might do quite well during inflation?

[00:14:00] Corey Hoffstein: So I’m a large proponent of managed future strategies. These are strategies that trade equities, bonds, currencies, and commodities long and short, historically have done very well during inflationary impulses, a low correlation of stocks and bonds. On average, positive returns have done well during equity crises. I really like the strategy. So what we can do is maybe take that $33 and buy managed futures. And so what you’re left over with, if you do that two-thirds of your money in NT S X, and say one third in a managed future ETF, like DBMF, your net portfolio looks like 60% stocks, 40% bonds, and 33% managed futures.

[00:14:45] Corey Hoffstein: You have more than a hundred percent exposure. You have 133%, and what I would argue is ideally a more diversified portfolio than what you started with. Hopefully reducing drawdowns, reducing volatility, and potentially enhancing returns.

[00:14:59] Rebecca Hotsko: That was such a great explanation, and I’m wondering what about someone who already has a 100% equity portfolio.

[00:15:07] Rebecca Hotsko: They’re in their accumulation phase, so they don’t even have a 60-40 portfolio right now. How would they think about implementing a return stacking fund into their portfolio and what allocation should it maybe optimally have? 

[00:15:22] Corey Hoffstein: Right. So this is where you can look beyond just the 60,40.

[00:15:26] Corey Hoffstein: To go back to the first point, you could just sell some of your stocks and buy something like NTSX. And effectively, you have introduced bonds on top of your existing stocks. There are funds out there that provide you exposure to equities and layer managed futures on top. So there are two mutual funds, one from AbbVie Capital, one from Standpoint that give you exposure to equities and layer managed futures on top. There are funds from PIMCO that’ll give you, for every dollar you invest, a dollar of bonds and a dollar of equities.

[00:16:05] Corey Hoffstein: So there are all these funds now that you can mix and match and say, “I want to retain this underlying profile and layer some extra diversifying returns on top.” What I would suggest though is that if you are an aggressive investor pursuing growth, you might be better off actually not holding a hundred percent equities.

[00:16:28] Corey Hoffstein: You might be better off holding 80% equities, 20% bonds, and 20% managed futures. And it seems contradictory, but by actually reducing the equities to make room for other diversifying asset classes, you can actually move yourself ideally up into the left on that risk-return profile, get better internal portfolio diversification, not take that long-run risk of the, “Hey, there’s going to be a 50% drawdown at some point in holding this portfolio.”

[00:16:56] Corey Hoffstein: Hopefully more diversified without necessarily sacrificing the returns.

[00:17:00] Rebecca Hotsko: Yeah, so it could involve then selling a portion of your equities. Say someone’s just in a very simple ETF portfolio, and they would sell some of their stock exposure by some of the, like the NTSX or one of those products that are the leveraged 60-40, and then that would give them the diversifier.

[00:17:19] Rebecca Hotsko: Then from there, they could take that extra money and do something like commodities or some other diversifying asset. 

[00:17:26] Corey Hoffstein: Exactly, at the risk of getting in trouble with my compliance department, the fund we launched gives you for every dollar you put in, it’s a dollar of bonds plus a dollar managed future. So if you were 100% equity, what you might consider is, I’m going to sell 10 or 20% of that and put 10 or 20% into our ETF. What that would effectively do is leave you with 80 to 90% equities, the remainder in bonds, plus the equivalent amount of a managed futures overlay. So again, it’s about trying to incorporate more diversification and using leverage to unlock the benefits of that diversification. So you’re not necessarily just de-risking yourself, you’re maintaining the same risk level, and hopefully moving to a higher return.

[00:18:17] Rebecca Hotsko: That’s great and that’s super exciting that your ETF just launched. I was looking into it today before the interview, and there are a few other ETFs out there, so I wanted to get into this with you, the construction of them, because they’re all a bit different.

[00:18:31] Rebecca Hotsko: Some use more leverage than others. So I kind of wanted to go over some of the main ones with you. Talking about that and then also the bond future versus stock future component. Because to me, I didn’t understand why some funds would use bond futures versus others would use stock futures. Is one more optimal?

[00:18:50] Corey Hoffstein: Yeah, these are great questions. So there are a large — no, actually, compared to the grand scheme of things, there’s really not a large number of offerings in this space, but there are a couple of funds that have been launched that I think are particularly interesting. So let me try to give some high level.

[00:19:12] Corey Hoffstein: WisdomTree has a series of leveraged 60/40 portfolios. They have a US 60/40, so US equities plus treasuries, they have international equities plus treasuries, and emerging markets plus treasuries. They also have a portfolio that for every dollar you give them, they will give you 90 cents of US equity and 90 cents of gold. So for people who maybe want some gold exposure, that’s a way you can retain your equity and get some gold.

[00:19:43] Corey Hoffstein: I mentioned Standpoint and Abby, who each give you equities plus managed futures layered on top. I mentioned my fund that’ll give you bonds plus managed futures layered on top. Then there’s PIMCO that has a large series of these. What PIMCO does is they believe that they can generate alpha through bond security selection. So they’re going to buy a basket of bonds and then give you the equities by buying equity futures. For example, they might say, “Hey, we’re really good at buying bonds. We think we can beat the bond benchmark Barclay’s Ag. We’re going to actively buy that bond portfolio and then we’re going to buy S&P 500 futures or we’re going to buy Russell 2000 futures.” The bond portfolio might be a core bond portfolio, or they might have a version that’s, say, long-term corporate bonds. So they have a couple of different flavors of it, which sort of goes into your question of, “Okay, what are we using here? Are we buying bonds and overlaying with S&P futures? Are we buying equities and overlaying with treasury futures?” Like why does WisdomTree do it one way and PIMCO does it another?

[00:21:01] Corey Hoffstein: So there are two important answers here. First, the first point is PIMCO thinks they can add value in picking bonds, right?

[00:21:10] Corey Hoffstein: They think they can pick individual bonds, add some alpha. They have a great track record of doing it, so I’m not going to second guess them here. I’ll let other people do their evaluation. So to them, they’re saying the passive part we want to give you is in the equities. We want to be active in the bonds.

[00:21:34] Corey Hoffstein: Therefore, every dollar you give us, we have to spend that dollar buying bonds, and we’re going to give you S&P 500 futures exposure on top. Let’s pause there for a second and talk about the tax efficiency of that because it’s absolutely horrendous. You’re going to get ordinary income from the bonds, and then the S&P futures need to be rolled every single quarter, so you’re selling them and buying a new futures contract.

[00:22:03] Corey Hoffstein: Which is going to realize any capital gains and losses, those capital gains and losses are going to get taxed at what’s called 60/40 tax treatment, 60% long-term, 40% short-term. Which means if you’re buying this as a long-term buy and hold way, and to get equity exposure, you’re going to be taxed out the nose.

[00:22:24] Corey Hoffstein: This is a horrible way to get equity exposure. So what I would argue is if you’re going to do that, it really needs to be in a qualified account or you need to massively discount the returns for the taxes you’re paying because you’re going to pay a lot of taxes, right? Every year the market’s up, right? You’re basically paying 60/40 on that year’s gains.

[00:22:51] Corey Hoffstein: So it’s a lot of taxes to be realized. Let’s compare that to the Wisdom Tree. Wisdom Tree says, we’re not going to try to pick anything, we’re just going to be completely passive. Every dollar you give us, we’re going to buy 90 cents of equities, and they buy basically the 500 largest equities, and then we’re going to use the remaining 10 cents as collateral to buy 60 cents notional of treasury futures.

[00:23:19] Corey Hoffstein: Well, how does that differ? Well, first, it’s an ETF wrapper. I’m going to assume, hopefully your listeners know that ETFs are much more tax-efficient under certain conditions than mutual funds, but basically, by buying the stocks within the ETF wrapper, Wisdom Tree can manage that portfolio. So there’s hopefully zero capital gains realized on any of those equities.

[00:23:42] Corey Hoffstein: You basically defer all your capital gains until when you sell the ETF, at least on the equity side. On the bond side, okay, we’re getting these Treasury futures. How tax-efficient are those? Well, they also have 60-40 tax treatment and they’re going to roll four times a year. So any gains or tax at 60% long term, 40% short term. It doesn’t sound attractive until you realize the other opportunity, right, is that you would actually buy the Treasury bonds, in which case you’re getting taxed at the federal ordinary income rate, which is going to be higher than 60-40.

[00:24:22] Corey Hoffstein: So from a tax efficiency perspective, the Wisdom Tree product actually is arguably as tax efficient as you can get with equities and a much more tax-efficient way of buying Treasuries. So highly tax-efficient, but not trying to add any alpha. PIMCO, highly tax-inefficient, but because they think they can add some alpha, and so asset location is really going to matter.

[00:24:46] Corey Hoffstein: You have to sort of think, is this tax-efficient, is it not? One of the easiest ways you can just go to Morningstar on their website and look up the tax efficiency of the fund. If it’s not tax-efficient, if it’s got a big tax drag, it probably needs to go into one of your qualified accounts.

[00:25:09] Rebecca Hotsko: Okay. That was very helpful.

[00:25:10] Rebecca Hotsko: And then how does that compare to your ETF then? 

[00:25:14] Corey Hoffstein: Yeah, so our ETF, what we are aiming to do is for every dollar you give us, it’s called the Return Stacked Bonds and Managed Futures ETF, ticker RSBT. For every dollar you give us, we’re trying to give you a dollar of core fixed income exposure, plus a dollar of a managed futures strategy.

[00:25:36] Corey Hoffstein: To achieve that, we’re going to take a dollar and we’re going to buy about 50 cents of an Ag ETF and use another 50 cents of bond exposure through treasury futures. So, like Wisdom Tree, those treasury futures are probably more tax-efficient than if we were just buying treasuries. The Ag ETF is a pretty passive vehicle. We will end up passing on any ordinary income that comes from that ETF, but it should be about as tax-efficient on the bond side, if not slightly more than someone else’s existing bond exposure.

[00:26:13] Corey Hoffstein: Managed futures, on the other hand, has never been a tax-efficient strategy, right? This is an alternative strategy that’s trading commodities. It’s trading currencies. There are certain things we can do, way behind the scenes. For example, to trade commodities, we have to set up what’s called a Cayman blocker. The commodities are traded in that Cayman blocker. Any gains and losses get passed up as ordinary income, but it prevents the creation of a K-1.

[00:26:43] Corey Hoffstein: There’s all sorts of things we’re trying to do to create tax benefits, but to smooth out the ownership process. This is something almost every managed futures fund does, but at the end of the day, managed futures has never been a tax-efficient strategy. That said, let’s go back to that example of a 100% equity investor who sells some of their equity to buy a. This strategy? Well, maybe the 60-40 investor, ’cause then it’s at least equal. So, the 60-40 investor sells some bonds to buy our ETF. What I would say is if the 60-40 is like your cake, the managed futures part is like adding some icing. Yes, taxes will scrape some of that icing off, but there will still be icing there, right?

[00:27:34] Corey Hoffstein: Ideally. And so it’s one of those, even after taxes, hopefully you are left with a more diversified. Higher return portfolio than you would have been if you didn’t layer that on top. 

[00:27:46] Rebecca Hotsko: 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 their stock portfolio and just go in 100% this leveraged fund.

[00:27:59] Corey Hoffstein: 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, let’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, if 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? That’s something you can probably stick with and will probably still be very beneficial versus the un levered portfolio.

[00:29:47] Rebecca Hotsko: 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, uh, they just want to Yeah. Keep this long-term outlook.

[00:29:58] Rebecca Hotsko: Is this something that can be implemented with that, or would there be times where you get out of it completely? 

[00:30:06] Corey Hoffstein: 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.

[00:30:21] Corey Hoffstein: This is how I strategically allocate my portfolio. Actually, it 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 gotta work through.

[00:30:48] Corey Hoffstein: 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, and that’s a great strategic all-weather portfolio. You’re 33% levered. And arguably, it should, based on 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.

[00:31:26] Corey Hoffstein: 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 are different ways you can put this together, but I absolutely think it’s a way to reframe how you should be allocating strategically.

[00:31:45] Rebecca Hotsko: 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, if 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.

[00:32:03] Rebecca Hotsko: Sometimes it’s only a few months. And so that’s where I was kind of wondering like, are there any issues if you hold this fund for five years, are there any types of drag and performance or volatility or anything? 

[00:32:14] Corey Hoffstein: 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. When you do a three times levered fund, you basically have the equation: 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. So it’s not quite the same thing, but on sort of the same thread, one of the big push backs with leverage is that every financial catastrophe in the history of mankind has probably included leverage, right? People remember post-2008, all these investment brochures that said no leverage, no shorting, no derivatives. 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. I would never, ever, ever say it’s a good idea to say, “Hey, I’m a hundred percent equity investor. Let me use leverage to go 200% or 300%.” Using leverage to buy more of the same thing is usually a bad idea. Using leverage to buy something different that can diversify you in 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. 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 leverage strategies.

[00:34:55] Rebecca Hotsko: Okay. 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? 

[00:35:12] Corey Hoffstein: Yeah, I’m absolutely biased. You probably don’t want to ask the guy who does all the cooking, you know, who shouldn’t eat the meal.

[00:35:22] Corey Hoffstein: I obviously think this is a great idea for everyone. Again, the reality is for everyone, there are 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. If 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, right?

[00:35:51] Corey Hoffstein: 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.

[00:36:21] Corey Hoffstein: So 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, 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.

[00:36:56] Corey Hoffstein: 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? We don’t want to 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?

[00:37:29] Corey Hoffstein: So we want to be very conscious of what’s the appropriate risk level for each investor, not only 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.

[00:37:47] Rebecca Hotsko: And I guess to me, what’s so cool about this strategy is that in normal times, even if there’s a large draw down, if you use a leverage strategy like this, like historically you were better off in most cases, but it broke down recently.

[00:38:01] Rebecca Hotsko: And 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. 

[00:38:15] Corey Hoffstein: Yeah, when we say the funds did horribly, let’s be specific ’cause my fund wasn’t even around, but the funds that did horribly, right, were these levered stock and bond funds.

[00:38:27] Corey Hoffstein: So I’m going to pick on PIMCO ’cause 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. Every dollar you give them, they’re giving you a dollar of long duration bonds and equity.

[00:38:52] Corey Hoffstein: 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.

[00:39:14] Corey Hoffstein: Then 2022 comes around and stocks and bonds sell off simultaneously, and for every dollar you have invested, you are getting $2 of exposure. Long duration corporate bonds sold off just as hard as equities. So I think that portfolio, at one point last year, had a 50% drawdown, if not more. So full pause.

[00:39:36] Corey Hoffstein: 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’ve made a lot more money during the run-up, you would’ve lost a lot more money in 2022, but your risk profile was also higher.

[00:40:02] Corey Hoffstein: 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 in stocks and 50% of your money in bonds, and 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.

[00:40:30] Corey Hoffstein: 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, 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.

[00:41:10] Corey Hoffstein: So 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 the exact same amount as 50-50. 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.

[00:41:50] Corey Hoffstein: 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 right 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.

[00:42:16] Rebecca Hotsko: Right. 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 the strategy, I guess, relies or some of them rely on the fact that stocks and bonds are not perfectly correlated.

[00:42:35] Rebecca Hotsko: So what would happen in the world, I guess what could break this strategy is what I’m wondering. 

[00:42:42] Corey Hoffstein: So let’s go again to Wisdom Tree as an example, the 90-60 portfolio. Again, if you put a hundred percent of your money in that, you’ve got a 60-40 levered up 1.5 times. If stocks and bonds go down at the same time and go down significantly, you’re going to lose a lot of money.

[00:43:04] Corey Hoffstein: 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. The maybe second subtle part of your question is, is there something that could literally make this strategy blow up?

[00:43:27] Corey Hoffstein: Right? Could this be like XIV that inverse volatility ETF that literally imploded on a single day, right? Well, for that to happen, you have to think through that. You sort of needed it to all happen on a single day and your 90-60 portfolio would basically have to lose, if I’m doing my math correctly, I think it’s 66%.

[00:43:51] Corey Hoffstein: 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, ’cause 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.

[00:44:21] Corey Hoffstein: Because even if you have a really big drawdown one day, the portfolio’s 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. You 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. 

[00:44:49] Rebecca Hotsko: What are some risk management strategies or things that investors should do if they are implementing this strategy? 

[00:44:58] Corey Hoffstein: 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 Wisdom Tree example. If you’re a 60/40 investor, you put two-thirds of your money in this Wisdom Tree product to get effectively 60/40 exposure. And near that $33, dollars left over, and you put that $33 in stocks, you’re probably going to have a bad time. All 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 is how is it going to change your overall risk profile, and 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 it 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? 

[00:46:59] Rebecca Hotsko: 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.

[00:47:13] Rebecca Hotsko: And so would this be a bad time to get into a leverage strategy? Could it be a bad time if someone’s fearful that the market would go down more? 

[00:47:23] Corey Hoffstein: Yeah, so let’s maybe walk through two or three examples here. If you’re a hundred percent 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, right? 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. On 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 selloffs or inflationary bear markets, that might be a great time to use a little leverage, right? So again, it really comes back to what you’re implementing.

[00:48:25] Corey Hoffstein: 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. They 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.

[00:49:10] Corey Hoffstein: 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. So 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.

[00:50:00] Rebecca Hotsko: 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?

[00:50:09] Rebecca Hotsko: Is that an efficient way to get commodity exposure? 

[00:50:14] Corey Hoffstein: I’m actually, so the one that I’m aware of is the Wisdom Tree. I believe the ticker’s GDE, where it’s very dollar you give, it’s 90 cents of equities plus 90 cents of gold. The one I’m aware of. Yes, if you like commodities, I think that can be totally fine. If you are 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.

[00:51:02] Corey Hoffstein: 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. We use it as a very big umbrella term, but there are 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. When you look at 2022, the way inflation played out, the best trades were along the dollar in short bonds. It actually wasn’t even, I mean, you used a little bit of 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. And again, what I love is that folks like us and Wisdom Tree are bringing these building blocks to market so that people can build the portfolios they’re confident in.

[00:52:23] Rebecca Hotsko: 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? 

[00:52:37] Corey Hoffstein: 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 sixties, early seventies) where inflation crests at about 6%, comes back down, and 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, 16-17%. And that would just be brutal psychologically, economically, from a business planning perspective. That’s very difficult.

[00:53:19] Corey Hoffstein: Now there’s a large number of arguments as to why you saw sort of that three-wave inflation cycle in the seventies relating to the way monetary risk was managed, getting off the gold standard, understanding how fiscal and monetary policy work together, geopolitical instability. There are 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 hawkish higher for longer than I think a lot of people forecast, even with a lot of people feeling out of an earnings recession.

[00:54:09] Corey Hoffstein: 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 managed futures that I hold stocks and bonds. And then I try to use this concept of return stacking to overlay manage futures on top of my portfolio. 

[00:54:31] Rebecca Hotsko: 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?

[00:54:41] Corey Hoffstein: There is a phenomenal piece of literature written by Cliff Asness from AQR that’s called “Seven Lessons for Investing Big Money for the Long Run.” And he originally wrote it back in 2009. I found one copy on the internet of it. 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.

[00:55:08] Corey Hoffstein: 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; 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 get off and stuck in the land of esoterica.

[00:55:41] Corey Hoffstein: Like to just reground myself with these core principles and say, investing shouldn’t be that hard. Stick to these sort of core basic ideas. Get the big muscle movements right, and you’re going to be okay. To 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 has a track record as a tremendously successful investor. 

[00:56:09] Rebecca Hotsko: That is awesome. I’m definitely going to go search for that after this.

[00:56:13] Rebecca Hotsko: I love Cliff’s work, so thank you for sharing that. 

[00:56:16] Corey Hoffstein: My pleasure. I’ll make sure I send you a copy so that at least you can have it. 

[00:56:19] Rebecca Hotsko: And before I let you go today though, where can our listeners go to learn more about you, your work, and everything you do?

[00:56:26] Corey Hoffstein: Sure. So you can learn more about our ETF set, https://www.returnstackedetfs.com/ , and then you can find me mostly on Twitter @choffstein, where my wife would tell you I am there way too frequently.

[00:56:36] Rebecca Hotsko: That sounds great. I will make sure to include all of those in the show notes. I wanna thank you again for coming on today, Corey. 

[00:56:41] Corey Hoffstein: Thank you so much, Rebecca. 

[00:56:44] Rebecca Hotsko: 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, We Study Markets which goes out daily and will help you understand what’s going on in the markets in just a few minutes. So, with that all said, I will see you again next time. 

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