The Derivative - Researching the Risks of Return Stacking with Corey Hoffstein & Rodrigo Gordillo

Starting point is 00:00:00 Thanks for listening to The Derivative. This podcast is provided for informational purposes only and should not be relied upon as legal, business, investment, or tax advice. All opinions expressed by podcast participants are solely their own opinions and do not necessarily reflect the opinions of RCM Alternatives, their affiliates, or companies featured. Due to industry regulations, participants on this podcast are instructed not to make specific trade recommendations nor reference past or potential profits, and listeners are reminded that managed futures, commodity trading, and other alternative investments are complex and carry a risk

Starting point is 00:00:35 of substantial losses. As such, they are not suitable for all investors. Welcome to The Derivative by RCM Alternatives, where we dive into what makes alternative investments go, analyze the strategies of unique hedge fund managers, and chat with interesting guests from across the investment world. Investors and advisors are finding comfort in moving away from government or sovereign bonds and buying junk bonds and private credit and VC, things that feel they're going to replace their bond position with these bond-like products that act like bonds on the way up, but act like equities on the way

Starting point is 00:01:11 down. So the fragility aspect is that a lot of people have a false sense of comfort in their new bond portfolio that in fact is highly pro-cyclical. So when the trigger does happen and there is a correction, their bond portfolio all of a sudden loses as much as their equity portfolio. And there's a tendency to exacerbate the drawdown. So this reaching for yield is reaching for yield in an asset class that is all the same bet. It's what I call equity market investing in drag. We want to make sure that we want to emphasize and try to incentivize investors and advisors. There's a better way. You can still keep your balance. You can still keep that

Starting point is 00:01:52 offsetting sovereign bond portfolio when things go wrong while also finding ways of increasing possible return stacking in a thoughtful way given the current availability of products out there. Hello, everybody. We're stacking two guests on the pod today. See what I did there? Yeah. Both of which have been on previous episodes of The Derivative talking their own separate strategies and firms. But now we've got them together to talk through a recent research piece collaboration. So without further ado, please welcome Corey Hofstein, CIO and co-founder of Newfound Research and perhaps better known these days for his irreverent takes on the Pirates of Finance

Starting point is 00:02:43 YouTube channel. And Rodrigo Gordillo, President and Portfolio Manager of Resolve Asset Management, SEZC, and host of the not as irreverent, but equally as interesting Resolve Riffs Friday live stream. So I want to do something a little fun here. I always like Corey's pod intro from afar. So Corey, could you be a little guest pod intro for us on ours here? Absolutely. Jeff, are you ready? I'm ready. Rodrigo, are you ready? I'm ready. All right. Three, two, one. Let's jam. Let's jam. Love it. That's how it works. There's no more magic than that. It's just the let's jam love it that's how come on love there's no more magic than that it's just the uh let's jam let's go jam that's it you're you're uh i always thought you had the what's the piano

Starting point is 00:03:34 thing the metronome i thought you had a metronome to time those numbers oh you want i should probably get one i wonder if i went back and actually counted how much my three two ones were like you know naturally in in like some sort of metronome count they seem very like it's a recording that they're so timed so from afar listening from afar um so we've had you both on before we'll put those episodes in the show notes for anyone who wants to get your backgrounds and backstories how you got in the business, et cetera, et cetera. So we'll skip those intros and backgrounds. But I will ask, since we did those previous recordings, you both sort of ended up in the Caymans. So is that all rainbows and lollipops?

Starting point is 00:04:16 Or how's it been? What's it been like? Before we continue, Jeff, let's just make something clear. The Caymanians do not appreciate being called the Caymans. OK, like throwback to the firm. It's called the Cayman Islands. And out of the three islands, we are in the Grand Cayman. So just, you know, I don't want to get you into trouble with the community here. That's fine. I got into a lot of Twitter trouble last night saying Crocs aren't cool anymore.

Starting point is 00:04:42 And so not the Caymans, Grand cayman and the cayman islands got it so how has it been being in the cayman islands and more specifically grand cayman well it was i think you know that mike came here in 2019 november 2019 and uh we always had a business uh line here through some of our hedge funds. He's been living here for a couple of years, but we decided to move and I decided to move my family here in the middle of the pandemic. Because I saw how there was no masking in Cayman. And we were about to go and take the kids to school in Toronto. So when I saw that happening, I'm like, well, if I have a shot at bringing my kids to school

Starting point is 00:05:27 without having to mask, it'd be amazing. And so I gave my wife five days to pack up and came over here in July 2020. Of course, my family didn't speak to me for a few weeks, but I think we spent a year without having to mask up, the kids going to school business as usual. I think it's possibly the only place in the world that has that. And along the way, I've spoken to everybody and try to convince people to come on over and join us in this free space. And the only one who listened was Corey Hosting.

Starting point is 00:06:00 And he's been here once or twice already. Yeah, I was in Venice Beach, California during the pandemic. Ended up going to Boston. I had a family member who was having some health concerns. And while in Boston for most of the summer, you had riots in LA. You had COVID. You had fire. Pictures of Venice Beach were pretty clear that the homeless population had doubled or tripled in size.

Starting point is 00:06:26 And my wife and I were saying, well, why don't we think about doing that cliche thing where we just pick up and move and go to Montana or something like that? And the gentleman at Resolve said, well, hold on. The Cayman Islands are doing this interesting program called the Global Citizens Visa, where if you can work remotely, they'll let you come, stay in Cayman, work remotely, and you can stay for a year and then possibly renew for a second. So I was lucky enough to get accepted to the program. My wife and I moved here in January. We were able to stay January through May when we had to go back for a wedding and then stayed in the US for the better part of the summer, just got back to Cayman. I will say as an American, it's been both amazing and eye

Starting point is 00:07:13 opening, amazing in the sense that while the rest of the United States was shut down earlier this year, everything was open here, which was phenomenal. It was like going back to pre-COVID times, but even better because you're living on a beautiful Caribbean island with no tourists. So it was like having paradise to yourself. It really was amazing and special. But now the island's starting to get a couple of breakout cases in the community. And you can tell that from a psychological perspective, it really doesn't feel like the island is ready to acknowledge that COVID is coming here. And correct me if I'm wrong, Rodrigo, they just kicked their reopening plans from, I think it's supposed to be October 14th

Starting point is 00:07:51 to next year. They just decided to scrap it entirely because they had eight cases. They were going to open up. They were trying to get, one of the benefits is that compliance on vaccination has been great. We're almost, I think the eligible population with double jabs is at 79%. But they want to get the full population to 80% and open up on October the 14th. That was their plan. The full population, I think we're at 71,

Starting point is 00:08:19 one of the highest in the world. And the countries that have opened up at 75 and up seem to be just fine so that denmark is wide open no mass no distancing and they're fully vaccinated i think spain and portugal or a couple others they didn't quite get there and there were these breakout cases and so they got terrified pushed it over to january and uh and unfortunately for the first time in a year are asking us to mask up and for the kids to mask up so as my wife was dropping off the kids this morning to school there was like you said people

Starting point is 00:08:51 aren't prepared there were one of her best friends turned around and started crying on her shoulder because she couldn't bear the sight of her daughter having to wear a mask so it's just complete this this connection to the rest of the world right yeah my daughter's been in a mess for two years now every day at school so it's like come on you can do a week or two i know we can and it might be just a couple of weeks they nip these eight cases in the bud um and uh wait till the 80 vaccination before they truly open up so it might just be a couple of weeks more back to normal who knows we'll see all right uh well i want to come. I want to get on the Aerofoil, the board. Have you tried that out, Corey?

Starting point is 00:09:27 I have. Learning was a painful experience. But once you get up and going, and these guys are great teachers, it is a blast. Yeah. We'll put a link to that. I think that's one of the mutual fund owners is involved in that company. We'll put it in the show notes. What's it called rodrigo the the uh company's called lift and that's their e-foil line so electric foil boards with a little

Starting point is 00:09:53 trigger you get to surf around in calm waters and try a few tricks it's a lot of fun all right uh let's get on to the paper unless everyone everyone came to listen to the Grand Cayman Advertising Association. So on to the paper, you release return stacking strategies for overcoming a low return environment. Who wants to give the elevator pitch on what you set out to accomplish there and kind of what your findings were? Then we'll dig in. Well, I'll start off maybe just setting the table here for why we wrote the paper. So one of the things that a lot of firms have been publishing on is that going forward, return expectations for most asset classes are significantly depressed compared to historical levels. Now, I should note that this is something that a lot of firms have been saying for five plus years. Equity valuations are high and we can't expect

Starting point is 00:10:58 7%, 8% returns going forward. They're more depressed to maybe 5% or 4% in real terms. That hasn't materialized as much, but it doesn't necessarily mean that there isn't, you know, again, a significant drawdown around the corner that could bring those numbers back down. When we often talk about expected average long run returns, it's not that you're going to see that number print every year. It's a, you year. It's going to take a decade, two decades to get that average annualized return. So on the equity side, we have higher than average valuations. The expectation is that growth rates don't necessarily justify those valuations. And therefore, we have to lower our return expectations. On the other hand, bonds, it's a much easier equation. When you buy a bond and you hold it to maturity, that starting yield to maturity is going to be, by definition, the return you get. And so when we look at treasuries today, when we look at investment grade corporates, we're talking about 1%, 2%, 3% nominal returns. In real returns, you're talking about

Starting point is 00:12:07 zero, if not negative, depending on where you are in the duration and credit spectrum. And so the risk that we've seen is a lot of investors and advisors are actually starting to move out along the risk curve. They're saying the traditional 60-40 portfolio, 40% of it is no longer an attractive return profile. And so we need to start either taking more equity risk, more systematic risk. We need to start taking more credit risk or more liquidity risk. And what's particularly interesting to me is that this anecdotal evidence is actually backed up by a few studies, behavioral studies that have been done as to how investors would actually respond when risk-free interest rates go down. So there was this great study that came out a few

Starting point is 00:12:57 years ago by two authors, Ma and Zylstra, who showed that if you were to give investors a choice between investing in risky assets or risk-free assets, when interest rates are around 5%, they would put about 60% in risky assets, actually around 56%. If you were to take that risk-free rate and bring it down to zero, the number climbs dramatically between 70% and 75% to that risky asset. And the point is here that investor behavior is to try to achieve that higher long run return that they need for retirement reasons or pensions need to meet future liabilities. And what they're doing is instead of simply accepting lower returns, saving more, contributing more to their pension, they are taking more and more risk. provided was that we believe investors can achieve higher expected returns in a much more resilient fashion, not by taking on more concentrated risk within their portfolio, but through the thoughtful

Starting point is 00:14:14 application of leverage. And wisely didn't put leverage in the title because that scares people, but we'll get into that in a second. A quick thought came to my mind, as you said, that isn't it a little bit self-correcting, right? So if 75% of people move into riskier assets, that's going to drive up those riskier assets and it's going to kind of self-correct the lower yield environment. But at what cost, I guess, is the other side of that. And the other piece to think about here that might complicate matters further is in investors moving from those less risky to risky assets, they can actually increase the price of those risky assets, which drives up the realized returns, which might create that sort of momentum fear missing out effect or give investors greater confidence that yes,

Starting point is 00:15:04 they can actually move into those riskier assets. There was a wonderful paper published last year. The thrust of the paper was that when investors move from bonds to equities, it actually has an impact on total equity market valuation. If you take a dollar and sell your bonds and buy broad equity market exposure, that $1 drives up total equity market cap by about $5. There's this inelasticity factor. And so if investors en masse are saying we need riskier assets to achieve that higher return and start selling bonds to buy equities, that in and of itself could be the thing

Starting point is 00:15:45 driving short-term equity returns that much higher, making investors feel like they're getting that higher level of return, but may indeed be inviting greater fragility into the market. All right. I'll add to the greater fragility aspect of this discussion in that investors aren't necessarily just eschewing bonds to buy more equities, but there is investors and advisors are finding comfort in moving away from government or sovereign bonds and buying junk bonds and private credit and VC, things that feel they're going to replace their bond position with these bond-like products that act like bonds on the way up, but act like equities on the way down. So the fragility aspect is that a lot of people have a false sense of comfort in their

Starting point is 00:16:30 new bond portfolio that in fact is highly pro-cyclical. So when the trigger does happen and there is a correction, their bond portfolio all of a sudden loses as much as their equity portfolio and there's a tendency to exacerbate the drawdown. So this reaching for yield is reaching for yield in an asset class that is all the same bet. It's what I call equity market investing in drag. We want to emphasize and try to incentivize investors and advisors. There's a better way. You can still keep your balance. You can still keep that offsetting sovereign bond portfolio when things go wrong, while also finding ways of increasing possible return stacking in a thoughtful way, given the current availability of products out there. So you hit on the return stacking. Corey kind of outlined the problem. So the solution is stacking these returns.

Starting point is 00:17:26 I mentioned that it was leverage or Corey said it was leverage. So tie that together. What is stacking versus leverage? It's just another side of the coin. Yeah, so we kind of ease the reader into the concept of return stacking. Of course, you know, this is nothing new, right? This idea of capital efficiency or stacking returns, as we're calling it, is something as old as when leverage was available to institutional investors. The big difference here is that it hasn't been available to retail investors until recently, right? So the way we ease people in is we say, look, you're a 60-40 investor, right? Most of the investors that we know still have this fear of missing out, this idea of wanting to participate, especially in domestic markets,

Starting point is 00:18:12 right? So we start with the 60-40 portfolio. And then we find a new product that came out a couple years ago, the Wisdom Tree. I always get this ticker wrong, Corey, but NSTX? NTSX. NTSX. So what is wisdom trees? Novel approach is that they, what they did is they grabbed the balance portfolio. That's 60, 40 portfolio. And they levered it up 1.5 times. So what you're in essence getting is you're, if you buy that ETF, you're getting 90% equity and you're getting 60% bonds, right?

Starting point is 00:18:46 That's 150% exposure. So in a sense, people could see that and say, well, I can get extra exposure to get extra return. But the other way you could do this in order to stack unique return streams is you can say, I'm going to buy 67 cents on the dollar of this ETF. And now I have $33 in cash that I can play with, right? And so when you invest 33 in cash, 67 in the ETF, what you end up getting is pretty much the exact same return

Starting point is 00:19:17 as you would from buying the Vanguard balance portfolio with 100 cents on the dollar, right? So you now have created excess portfolio real estate that one could use. That 33 cents, right? You can leave it in cash. So one thing that Corey discussed early on is that advisors that are waiting to buy the dip because they think it's frothy, but can't afford to not stay invested and have the tracking error bias pop in, is they can buy this 67 cents on the dollar, this, not have any tracking error. And when the market goes down, they can back up the truck and buy some more of whatever they think

Starting point is 00:19:57 is undervalued, right? So that's one approach of stacking returns. What we mentioned in the paper is something that has been done by PIMCO for a couple of decades, which is, well, what if we grab that excess real estate and buy a short-term ladder corporate bond portfolio? So after the cost of borrow, you still get a little bit of a 1% or 2% return to stack on top of that. So all of a sudden you're getting, let's say the 60-40 is annualizing at 7%, you're now stacking 1% or 2% on top of that with taking very minimal risk on the corporate bond level.

Starting point is 00:20:34 So I think you can then extrapolate from that, right? You choose your poison, but there are new ways with these types of products that were only available to institutional investors. Now for retail investors where they're getting access to leverage and very, very cheap leverage, institutional quality leverage by simply buying an exchange traded fund. Right. So that's kind of the beginning of it. And we can expand on that as to how we how we would use the access portfolio real estate. And a key point is here, you're not paying for the leverage per se. We can dig into that, right? But you're not a hedge fund that's going to a prime broker and saying,

Starting point is 00:21:10 hey, I need $10 million of cash. We'll agree on some LIBOR XYZ. And then I'm going to deploy that because I think I can make more money than I'm borrowing it for. So here it's the products they're using inside of these products. That's a double product phrase there. Sorry, here it's the products they're using inside of these products. That's a double product phrase there, sorry, but it's the products they're using inside of there that are causing that leverage. So who wants to explain how that works, right? It's just futures. Yeah. So in NTSX, for example, they're taking 90% of the portfolio and buying S&P 500 exposure, and then they're leaving 10% in cash, which they use as collateral to buy a ladder of treasury futures. And because the treasury futures market is so liquid and so

Starting point is 00:21:54 competitive, you get a very attractive financing rate that you're effectively able to use 10% of your money to create 60% notional exposure. but the borrowing cost of doing so is very, very thin, LIBOR plus a little versus if I were to try to do it as an individual investor, my borrowing rates might be in the hundreds of basis points. So we're able to take advantage of these incredibly liquid, highly competitive markets to get really attractive financing rates on core beta exposures. I think one of the things we've seen in the past is this idea of what used to be called among institutions, portable alpha, where you buy the beta and then you overlay alternatives via derivatives or long self-financingshort portfolios. And that can be potentially

Starting point is 00:22:47 very expensive from a borrow perspective. With the model we're talking about here, by using leverage and derivatives to get access to the core beta, and those core betas are very, very liquid and available in exchange-trad traded derivatives. The actual financing cost of achieving this leverage is pretty small. But that's all embedded. There's no actual finance cost, right? You're not- Right. It's embedded in the return of the futures themselves. Exactly. And so how do you view that with rates at zero? It's essentially, right? It's right now in the environment. Right now it's pretty new.

Starting point is 00:23:26 Yeah. And AQR put out a paper when they were looking at, it was about risk parity and the financing costs of using futures contracts in order to do this. And in the footnotes, it showed that we're looking at LIBOR between one month and three months, right? So even when rates were high, the type of leverage expense that you're getting in these products is less than what you would get by going out to your broker dealer or even to

Starting point is 00:23:53 the prime broker often. It tends to be even less expensive for institutions to do it through the derivative than to go out and do a straight borrow. But it's confusing to me even that the rates these bonds pay, it's often less than LIBOR. It could be less than LIBOR, right? So it's like, how does that work? But it's because the notional size of it is so much larger, right? So anyone want to dig into that hole or should we pass that by?

Starting point is 00:24:21 I feel like we've covered it. Yeah. I feel like we've covered it. Yeah, I think one of the, I just want to kind of get into one of the major reasons why I thought this was interesting to begin with is that it's not like advisors and investors that are reaching for yield aren't afraid of low returns in the next 10 years. It's just that FOMO is winning over, right? And so there's a small group of advisors and investors that have felt that they've gotten burnt by reducing their 60-40 exposure to make room for alternative strategies that are non-correlated, like trend-following CTAs or global macro or market neutral, whatever they're trying to use to diversify in case something goes wrong has really not paid off because over the last

Starting point is 00:25:13 decade, a lot of these strategies have done single digit returns while equities and bonds, especially in the US have done high single digits or double digits. And so this is where people feel burnt by diversifying. Diversification has not paid off. So what you end up getting is a lot of single digit returns that reduce and bring down your overall returns. And there's a fear that if this continues, you're not going to be able to capture it. And so all of a sudden though, when you have this extra 33% real estate, adding an extra one to 2% return, that single digit return that you hated because it was dragging your portfolio down, now you're stacking it on top of what you would earn anyway. And all of a sudden it becomes attractive. So I think that has been the biggest

Starting point is 00:26:06 attractor of adding alternatives in the last 10 years. It's that single digit return. But again, if you're stacking it, it's a massive advantage, right? So this is kind of like now we started getting into, okay, what can you do with that portfolio real estate? I think it's important to add things that are going to benefit the traditional balance portfolio in case we deal with a low return environment for equities, in case we deal with a high inflation environment, when equities and bonds tend to correlate quite, quite aggressively. And,

Starting point is 00:26:36 and putting things in there that have an orthogonal bet that might save you from a decade, a lost decade, like we saw from 2000 to 2010. So that's where the next step is. That makes sense to take that 33 cents and do more equities, right? Then you're just adding leverage for the sake of higher returns, higher risk. Which has so far been the biggest,

Starting point is 00:26:58 for people that may have misread the paper, it's been the biggest objection. All you're doing is just adding more risk to your portfolio. I think that's an important distinction here. We're not recommending that people go ahead and lever up an equity position or their Bitcoin. We are recommending that they use things that are non-correlated so that you can benefit from some protection in certain types of strategies. And in case that core portfolio doesn't do well, you have an alternative return stream that may do better. And that's a key thing. It has to be non-correlated in our view.

Starting point is 00:27:38 So I want to dig into a few things. One, the difference between just doing a 2x ETF, like explain that, right? Because they're 2x on tomorrow's return, not the long-term return. So there's tons of papers out there on that dynamic, but that's not what we're talking about, right? You're not just doing a 2x return. Who wants to dig into that? I can dive into that. So there are all these ETFs out there that do provide daily return leverage, right? So a two times daily S&P 500 fund or a negative two times S&P 500 fund. And they do provide you leverage, but that leverage is resetting on a daily basis. And so what's going to happen is

Starting point is 00:28:21 you're going to get sort of amplified volatility drag, that if the market sort of just goes sideways, that's a position that can burn you significantly because you're sort of constantly rebalancing into the position versus something like NTSX that's giving you 90% equity plus 60% treasuries, so 150% notional exposure, is managing that position much like you would the drift in a 60-40. So when the relative weights between stocks and bonds drift plus or minus, say, 5%, they're rebalancing the entire portfolio. So it's not going to give you 1.5 times on a daily basis. This is just more a macro level notional allocation that they're managing like you would your standard 60-40 to make sure there isn't too much drift. So there is some difference. That said, I know there's a lot of people who are

Starting point is 00:29:19 negative on these levered daily products and they they are very expensive, and that's something to keep in mind. But I have in the past worked with these products in a way to achieve return stacking, and they can be used to achieve the same sort of concept. I just think there's much more efficient vehicles available today that we don't have to use those sort of two times, three times daily levered products anymore. So you guys have both been doing this for years already inside your own products. Did you consider it as leverage or you just consider it as capital efficiency? Right. And what do those two terms mean to you? So we've been doing it, I guess,

Starting point is 00:30:12 going on two and a half years within our fund was something I talked about personally in a Barron's article probably four and a half years ago saying this is something we should be moving towards. And then it just operationally took a while to get up and running within an existing mutual fund structure for us, unfortunately. But the way I sort of separate those two terms is like, what is leverage and what is capital efficiency is we are using leverage, right? We are putting aside some collateral. We have an equity portfolio that we then overlay with an actively managed US treasury strategy. That US treasury strategy we implement with futures. And so we're using leverage to overlay, stack those strategy returns on top of our equity portfolio. What that can do for investors is

Starting point is 00:30:54 provide capital efficiency. So if over the long term, we assume our equity portfolio is going to give you, excuse me, our fund is going to give you on average 75% exposure to equities plus 75% exposure to bonds, call it a 50-50 portfolio levered up 1.5 times. What that means is an investor can allocate, call it 5% from stocks, 5% from bonds, put that 10% in our fund, and it frees up another 5% of their portfolio that they can hold in cash or allocate elsewhere. That action of having more than 100% exposure within our fund is what provides the capital efficiency for them to be able to do something with that cash. So we are using leverage to create capital efficiency for investors. Both inside and outside of your fund, right? Like inside of the fund, there's capital efficiency where you can invest in this. But to your point just now, you could also say, hey, Mr. Investor,

Starting point is 00:32:00 you don't need to give me all $1 million, give me X, and you can put the rest in, you know, do whatever else you're going to do with your portfolio. Exactly. And that's what we encourage, right? I think all too often, right, you talked about that line item risk. I think what investors really need to be doing is looking at their portfolio more holistically, looking at sort of the net exposure that they're achieving. Because when you are talking about these funds that incorporate leverage, most of the time they are giving you more than a dollar of exposure for every dollar invested. And the one figure seven in the paper was the kind of the average of these products was about

Starting point is 00:32:38 one and a half to two and a half in terms of the notional level they have? I think that's right. Yeah. And then where's the upper bound to that, right? It can't be 15x, right? Because you have to put up a futures margin. What are the practices? So there were some rules that have recently changed. This fall, there were new published rules around the allowed levels of leverage within a 40-act vehicle. So historically, what we have seen is notional leverage typically taps out at 2%, 3%. Because the guidelines were around total notional levels, the new guidance around the amount of leverage you're allowed to have within a fund is based on value at risk. So why does that matter? Well, if I lever up

Starting point is 00:33:27 20-year US treasuries three times, that's a very different risk profile than levering up two-year US treasuries three times. And the prior rules sort of treated them as equivalent risk on the amount of notional exposure you're allowed to have. The new rules would say, no, we're going to actually look at this on a risk basis. You have to maintain certain value at risk thresholds. You have to prove you're not going to exceed those thresholds. And those are somewhat based on statistical estimates. So we can get into whether that's a flawed line of thinking or not. But the basic idea is you could see seven, eight times leverage for very low vol instruments and only one or two times leverage for higher vol instruments. So I would expect over the coming years, what's going to matter less is the true notional exposure and more about

Starting point is 00:34:17 the risk exposure. And then we still have the rules though, that the grown in the ground commodities and whatnot need to be segmented off, put in a K-man blocker. We won't get too into the weeds there, but you also have a physical limitation to how much bad income you can have in a 40-act fund, right? Yeah, that's an income tax thing for sure. And then that 25% limits how much leverage you can use in there. So, yeah, for sure there is. But again, I think one of the key aspects of the piece is that we're not asking people to take an immense amount of leverage. In fact, we're simply addressing something that one of the most famous investors out

Starting point is 00:35:00 there has done for his whole career. Like Warren Buffett has achieved his alpha in many respects by picking good, high quality stocks. So he runs a quality portfolio, but then uses the money available to him in his insurance pot to lever it up 1.6 times, right? So AQR came out with a paper, I think, that showed that, right? So that's a reasonable amount of leverage. And it's even more reasonable if you diversify it across different asset classes and return streams. I think PIMCO also did this decades and decades ago by having portfolios that do 100% equity

Starting point is 00:35:42 and then 100% managed bond portfolio. And that's called structural alpha, right? Because you can get excess returns by being able to stack on different return streams that are not correlated to the other 50%. So there's moderate leverage that you can apply in order to capture that. You don't need to capture 10% excess returns and take undue risk. We're trying to increase returns for investors in a thoughtful way by adding one, two, three, four, maybe percentage points with reasonable leverage. And I think really quickly, I think

Starting point is 00:36:17 one of the ways to think about this is go back to sort of the basic example of that NTSX portfolio plus something else. I think there's a lot of investors that if I said, hey, I can get you a 60-40 plus, I don't want to say guaranteed because nothing is guaranteed, but a 10-year annualized alpha of 60 basis points a year, a lot of investors would say, well, that's really attractive. That's the sort of thing that's actually achievable if you put, call it two-thirds of your portfolio in NTSX plus one-third in short-term high-quality investment-grade corporate bonds. And so yes, technically your portfolio is 1.33 times lever. The total notional exposure

Starting point is 00:36:59 you have for every dollar you have in your portfolio is $1.33. But that extra 33 cents is in very short-term, high-quality bonds that might be giving you 2% a year. And so at a 33% allocation, you might be clipping 60 basis points. And that could be really attractive as a proposition to investors. And of course, there's other things you can add if you want to increase your risk, and we would argue you should be doing it with diversifying exposures. But Rodrigo mentioned what PIMCO has been doing. That's the style of thing they've been doing forever. And as long as you can overcome that financing rate with the types of active bonds that they're managing, they would argue there's a lot more

Starting point is 00:37:40 alpha in bonds than there are in picking stocks. Right. And that's their stocks plus ETF or mutual fund. I'm not sure which it is, right? Like they've been running that SMA, I think since the 1980s and they launched funds in the 2000s. And then, so I want to touch on the products you guys think make that diversifier. I'll first bring up a quick point on your point, Corey. To me, it's the reverse of that too, right? Like I'm much more willing to take a 7% loss in my alternative if I've gotten the full 20, 30% in the S&Ps, right? If I remove the return of the alts from paper eric crittenden of standpoint he calls it line item risk which i'm sure he didn't coin a lot of people say that but

Starting point is 00:38:52 right i've lived this for the last 15 years of hey great managed futures product you're invested it's averaged four percent annual return over the last five years because guess what there were no trends that's a line item that the people hate to see. And that, to your point earlier, Corey, that four percent might be up 12, down 12, up six, right? So that down 12, they're like, why is this thing in here? It's not doing anything. So I guess my question is, are we really that dumb as investors that we can't, right, that we need it to be packaged and bundled into this thing. So we don't see that line item and we keep what's good for us. That's the spoonful of sugar method.

Starting point is 00:39:30 I don't think I'll use the word dumb, Jeff, I think Kahneman and Tversky has done a lot of work on we're just you know, we have behavioral flaws that require us to deal with the world of math and numbers in a very different way. Like, you know, we're seeing a lot of irrationality with COVID and we've seen a lot of irrationality with markets. And so I think what, you know, there's always this balance in my view between optimal mathematics and the utility curve of the average investor. And that utility curve will depend, this emotional side needs to be taken into account. And I think we interviewed Crittenden a couple of weeks back where we discussed what is our job as educators in the financial world? Is our job to ram something that most people can't understand in a mathematical way and

Starting point is 00:40:24 shame them for not being able to do it? Or is our job to find the optimal balance between behavioral and mathematics and optimality that leads the ultimate investor to stay invested long-term, right? So I think what Eric learned in his career was that he tried to provide the best medicine that he could for advisors and investors to tack it on to their basic portfolio, showing them that it will be better long term. And that's exactly what happened. But few people could stick to it. is that he's mixed some basic beta, SPY, I think 50% of that, and added 100% CTA on top to provide a line item that is more palatable. And it's working. It has worked really, really well for companies like Milburn and a lot of other funds that are coming out of the woodworks after

Starting point is 00:41:19 this piece that I'm like, by the way, I've been doing that, but I haven't been telling anybody because I don't want to say the word leverage. Right. So these firms are explicitly talking about it. That's why we were able to find them for the piece. And that includes Corey's fund and my fund, you know, in ways that that allow investors to feel comfortable and are more likely to hold on to it long term. I think that's perfectly reasonable, given that we are all humans. My worry is twofold on that. Everyone seems to be having S&P as that core, right? And it's just kind of like, to your point, the FOMO and we're all going to miss out, but is that everyone rushing into that door,

Starting point is 00:41:59 does that mean it's ever likely to close on all of us? And where we really need to be is in foreign equities or something like that. So some of the products that we put out there include global equities as well. Right. So, yes, indeed, it's we're a bit flooded with SPY, but it's still the largest market in the world. So it's not terrible. You can you can do a lot worse. Right. And with the largest global companies. Right. So coming back to the products you guys do a lot worse. Right. And with the largest global companies, right? So coming back to the products that you guys do. So you both have had a trend following routes, uh, commodity routes,

Starting point is 00:42:31 um, and now have started to delve into convexity a little bit or volatility side. So talk about how those pieces fit into the puzzle and, you know, coming back to the non-correlated and the rebalancing effects there. Yeah, I think the, one of the issues that will, people will have in mind when they're listening to this is that you're asking me to put 66% of my portfolio in a single line item in a single company. Are you out of your mind? Right? Line item risk, talking about, again, that behavioral side of things, it doesn't matter what's inside of it. It is a big deal.

Starting point is 00:43:06 And I don't think we're going to change a lot of hearts and minds by asking them to put in two-thirds of their money into a single product. And so what we did is we said, okay, well, let's find as many capital-efficient funds out there, funds that we know use that leverage, as you mentioned, anywhere between 1.25x to 2.5x, and hit a couple of pain points. Pain point number one is tracking error, and pain point number two is multiple line items, right? Can we put together a portfolio that addresses both of those things and gives you what you want, but with a little bit of

Starting point is 00:43:43 medicine on top, right? And so it was as simple as grabbing those line items. And we started putting in, we started with like 15, 15, 15. We just kind of did a basic ratio. And the funds that we ended up choosing to be part of this had exposures to asset classes and strategies that enough research has been put in to know that they're likely to remain lowly correlated. They have a tendency to be offsetting during market scenarios. And this ends up being CTAs, trend following CTAs and global macro. Now, the difference between those two is that CTAs tend to focus exclusively on trend or have a big, big weighting, just pure trend. And global macro tends to use the same futures contract. So investing commodities long

Starting point is 00:44:30 and short, equities long and short, bonds long and short, currencies long and short. But in the global macro space, you're also looking at signals for mean reversion, seasonality, value and the like. And it has trend as well. So a little bit of trend in there as well. So another key aspect of having those in there is that the vast majority, as it's not, it shouldn't be surprising, the vast majority of publicly available mutual funds and ETFs that offer derivatives

Starting point is 00:44:58 happen to be stacking derivatives on these types of strategies because it's just, it's in the wheelhouse, right? Right. So what we did is we put together a series of publicly available funds, our funds, and a bunch of other funds that have been around for a bit, and put them together in such a way where when you added up the 15%, 15%, 12.5%, 12.5%, 10%, whatever it is, you x-rayed those portfolios,

Starting point is 00:45:28 what you'll find is that we can put together a portfolio that roughly has 60% exposure to equities, roughly has 40% exposure to bonds, roughly has 30% exposure to CTAs, and roughly has 30% exposure to global macro. Now, there's a kicker there as well that a lot of these funds now offer tail protection on top, right? So we show that, I think, in table one, where there is a bit of tail protection because one of the key concerns with leverage is that, yes, everything is non-correlated,

Starting point is 00:45:59 including CTAs and global macro, until they are, right? There is nothing to say when you are zero correlated that there may be periods where everything momentarily correlates to one. CTAs and global macro until they are. There is nothing to say when you're zero correlated that there may be periods where everything momentarily correlates to one. So having a prudent amount of tail protection in case that happens is useful. Now, we couldn't model that because it's really tough to model this type of convexity. And so what we did is we grabbed, we said, okay, these funds give this exposure. Now let's go to indices that we know have daily data and see what that stacked portfolio would have had.

Starting point is 00:46:31 So we're getting your balanced portfolio for $0.01 on the dollar, $0.30 to CTA, $0.30 to global macro. And that was, we can find the SOC Gen Index. We used global macro from Goldman Sachs Index. And we went back as far as they went, which is around 2000. So we can get daily granularity, see what type of worst drawdown or worst volatility we would see from those portfolios. And what we found is that everything that we expected, we are allocating to the stacked strategies that are expected because that's their job to provide positive returns most years. Right.

Starting point is 00:47:08 And that's exactly what they've done. The portfolio, the stacked return portfolio ended up doing better than just a balanced portfolio in 18 out of 21 years that we tested. Right. So it's not guaranteed that they're always going to be positive, but their job is to be positive most of the time. And more importantly, I think, is everybody feels like you're doing that and therefore you're stacking an extra 60% of units of volatility to the portfolio. I can't do that to my portfolio or my client's portfolio. And the reality is when you're dealing with lowly correlated asset classes,

Starting point is 00:47:46 that's not necessarily the case. I think the increase in volatility was just under 1% annualized average. And more importantly, even without the tail protection, using daily granularity, we show a chart that the drawdowns of the stack portfolio

Starting point is 00:48:01 with that extra 60% exposure were either lower or the same as a 60-40 portfolio. So again, you're addressing multiple line items, that behavioral flaw is handled. You're addressing a tracking error, that one's handled. And in terms of risk, I think that's the tough part that we're going to have to continue to educate on, that we're not stacking returns on top of, stacking risk on top of the 60-40 risk. It's almost like... Is it that, Corey? Sorry, real quick.

Starting point is 00:48:33 I'm just saying it's like the old CME graphic of why manage futures in the efficient frontier, and it actually increases return, reduces risk via standard deviation. It's like the physical embodiment of that, of like, here, these are actual products, built it, it does this, it moves you up and to the left on the efficient frontier. I mean, this whole concept, before we even talk about the alternatives, I mean, let's just go to maybe the largest hedge fund in the world, Bridgewater. Risk parity is this concept. They are stacking returns of different economically diversifying asset classes. And so the question is, if you have a risk parity portfolio, that's, you know, the total notional leverage is 300, 350%. Is that necessarily riskier than a 100%

Starting point is 00:49:20 equity portfolio? I would argue probably not if they have sort of the same volatility level, because you have much greater economic diversification within that risk parity portfolio. What we were looking to do with the stacking portfolio was not just say, how can we introduce economically diversifying asset class exposures, but structurally uncorrelated investment strategies, strategies. I love managed futures because when we look at it mechanically, it's really replicating that option-like payoff. When you compare, say, a managed futures portfolio to a risk parity portfolio, it basically looks like a risk parity portfolio that you bought a straddle on, that you've got this embedded sort of call option exposure to put option. And so the average return might be a little lower,

Starting point is 00:50:10 but when we look at the return profile of managed futures, it's very sort of muted on the downside with these big explosive upsides. And so to us, that was the right type of exposure to stack on top of the 60-40 because you never got that huge risk necessarily a big downside tracking error to that base 60-40. If you were to say just stack gold on top of the 60-40, you wouldn't necessarily have that. Rodrigo did this exercise and I think, and correct me if I'm wrong, Rodrigo, 1990 through 1995, gold had such a bad drawdown that if you had stacked it on top of a 60-40, it really ruined the core 60-40 returns. And so again, what we were really trying to focus on was alternatives that were more absolute return in nature. That all said, right, in a rapid deleveraging cycle, in a crisis, right,

Starting point is 00:51:04 correlations go to one. And that's where we think investors should potentially look towards products that have embedded convexity or tail risk protection of some capacity that are providing this capital efficiency. And I think institutions can get even more creative. They can work with banks to structure highly convex OTC option exposures that are based upon conditional joint drawdowns. So I want to put option on the S&P that only knocks in when bonds are also down or when commodities are also down. And that sort of exposure is going to be much, much cheaper because it's conditional, but it really hedges the core risk of this style of portfolio, which is a rapid increase in correlations.

Starting point is 00:51:52 Right. And by structural, I can't remember the term you used, structural diversification, right? We're talking structural managed futures can go short, will go short. So, right, if all these markets are selling off in a environment, this big correlations go to one, everything's selling off together. They can't go short on the same hand. It might take them three months to go short. So you could have this really long period of, of similar correlation. And then on the convexity side, structural diversification, we're talking you own puts. They structurally by, pay out when the market goes down. Yeah.

Starting point is 00:52:27 And I think there is absolutely nothing wrong with using this concept to create some sort of all-weather portfolio, whether it's the cockroach portfolio, risk parity, or the permanent portfolio in any way. This piece was about dealing with the tracking error bias. I personally, for my personal portfolio, I don't have any tracking error. I'm at the altar of risk parity all day. I'll take a 50% drawdown from gold because I don't care about me tracking differently from the S&P or the 60-40 because I also know when gold's going down, something else in the portfolio is going up. I like an idiosyncratic

Starting point is 00:53:11 return stream and we have been applying risk parity at 6 volatility, 12 volatility, 16% volatility, 20% volatility my whole career using this leverage. By tracking it, you mean relative performance, right? Relative performance. Yeah, exactly. It's got very little to do with U.S. equities, and I've learned to deal with it. And a subset of advisors we work with, even with Corey and I work with,

Starting point is 00:53:39 are okay with that and are embracing that concept, right? But the truth is that the vast majority of investors and advisors still haven't gotten there and would be better off emotionally to do this type of getting your beta and then stacking. And one of the other benefits, ultimately, I think you mentioned, Jeff, is that you're stacking something that can go long and short, but it's also dominated by commodity risk, right? So what people may not know that have only invested in the last 30 years is that in the 70s, your CC40 portfolio wasn't as protective, right? You had bonds and equities go down together as inflation went through the roof. Now, everybody's talking about

Starting point is 00:54:17 inflation. Is it going to happen? It's not going to happen. A lot of people are really worried about inflation because of the amount of liquidity pumped into the system by central banks. If that were to happen, if some sort of a multiple areas of inflation were to come, there is a high likelihood that bonds and equities lose money at the same time in higher correlation. And by having managed futures that have the ability to go long commodities and a global macro that have the ability to go long commodities, it also provides that extra hedge in case your 60-40 ends up doing really, really poorly. So I think that's another reason why I really like the CTA for somebody that wants to minimize tracking there. If you want to use this concept to do an all-weather portfolio, more power to you. It's a great

Starting point is 00:55:02 concept as well, and you can do it. You just have to play around with the positions available. I'm going to put a link to one of my old blog posts in the show notes of the picture from space that proves why commodities are non-correlated. And it was a freak snowstorm in the Dakotas or Wyoming in June or July, and the cattle hadn't grown their winter coats. So it literally wiped out like 60,000 cattle and the price of cattle spiked for three, four weeks and trend followers got in. So it's like, that's what we mean by this. It's a totally different ballgame. They don't care about what the CEO's tweeting or what the economy's doing. There's structural, physical things that are going on in

Starting point is 00:55:42 the world that affect those prices, which is counter to your point in an inflationary 70s environment. That is more, hey, no, it's because there's money chasing us. Sorry, Corey, cut you off maybe. No. And again, we're focusing here on managed futures, but I do think it's such a beautiful position to incorporate. And I know how many advisors have been frustrated in incorporating it, right? When you look at your traditional 60-40 and you have to make a decision of where you're cutting risk from to include a 10%, 12% allocation to managed futures, not only are you creating that line item risk that clients are going to complain when managed futures are down three years in a row and failing to keep up with equities.

Starting point is 00:56:32 But is that position even going to be large enough to have a meaningful impact on your 60-40 when markets are going down? Potentially not. I think. Usually not. Yeah. Usually not. 5% I'll touch it. Super high vol managed future strategy, which when we're talking about the 40 Act funds, they're really not. And so I think, again, where return stacking can be really effective is you get that 60-40,

Starting point is 00:56:51 and then there's the opportunity to introduce. And again, for me, the key term I like to really focus on is mechanically diversifying exposures. Trend following at its core is, is very similar to the Delta replication profile of a straddle. And so as markets start going down, it's going to start increasing the shorts as markets are going up, it's going to increase its longs. And so it's not a perfect option replication, right? There's gap risk and all the sort of mean reversion that can occur that can make it not perfectly replicate that structural option position. But on average, again, it really does create that sort of very convex return profile that I think makes it very attractive to stack on top of a 60-40. All the things that make it frustrating as a standalone when you have to take it out of a 60-40 are what make it

Starting point is 00:57:46 super attractive when you add it on top of a 60-40. And because we're a managed future show here, essentially, I got to dig into that a little bit. So I've been saying on this pod, right, that long period, my running joke is my son's 12. We've been in drawdown his whole life and managed futures, right? Like, but the firms that survived have gone longer term. They've added long-term bias and they've added equity exposure. This is very generalizing, but right. If you did those three things, your performance was much better over the last 10 years. So you guys are actually in there writing code and, you know touching the the lever so in your managed futures right have you done that and how does that fit into the concept of it's

Starting point is 00:58:31 mechanically going to be you know right if i take that smile and i shift it and it only works on the on the downside now or it works less on the downside i don't know if there's a question in there but go ahead well i think i can speak to that because we do run a Managed Futures book and have done it for many years. And we saw that trend, right? So that was Managed Futures managers trying to survive without really saying out loud that that's what they were doing was adding beta. And we could see it in the numbers, right? And so from our perspective, you know, Corey with Newfound and Resolve co-launched an index

Starting point is 00:59:13 that, what is it called? The Newfound Resolve Robust Momentum Index. And the whole concept there is to use an ensemble approach of multiple trend signals, anywhere from short-term to long-term, because we don't know which trends are going to be the best over the future. So in spite of us recognizing that trend, short-term, mid-term trend wasn't working,

Starting point is 00:59:39 we wanted to provide a pure exposure to the managed futures. And if we wanted to add beta, we wanted to do it explicitly, right? So we have our hedge funds that do it without beta that have a zero beta exposure, but we also have our mutual fund that has explicit risk parity beta exposure with the systematic global macro on top. And it's in the brochure. We're explicit about it. We don't want to hide it. And we could justify that because it is behaviorally correct and it'll allow investors to stick to it longer term. What's insidious about the industry and a lot of managers

Starting point is 01:00:19 that have taken the other route, which is we're not really telling you what we're going to do, but anybody who's in the business observes that they are doing this behind the scenes without making an explicit decision. So I think all those things are true. And what you want to do is know what you're getting in whatever product you're getting, how much beta, how much pure trend or global macro, and then you can make a thoughtful decision. Corey, anything to add? Yeah, I mean, I think what we have seen is that broad CTAs have lengthened out.

Starting point is 01:00:54 They have included equities. But when you look under the hood of a lot of CTAs, at the end of the day, the total notional exposure to equity still remains pretty small, particularly in a crisis, because their volatility is scaling these positions. So a lot of people assume that it's equities that really saved the day, short equities in 2008 or short equities in March, 2020. And the actual return decomposition shows that equities really haven't done anything. It was bonds and a couple of select commodities. Bonds, currencies. Right. And currencies. And so I think there's this idea that there's increasing equity beta.

Starting point is 01:01:30 I don't see it in the return stream. And I think a lot of it has to do with the position size is pretty de minimis. I think if we look at, say, the SOC Gen CTA index here, you're joking that your career has largely been in a drawdown. A lot of people would say the post-2008 environment maybe wasn't the most attractive. That said, if we look at the actual returns from 2008 through today, and I was just pulling this up really quickly, the max drawdown of the CTA index has been 16%. And the index is up 25% over that period. So when you start talking about adding returns on top, and we're gonna have a 30% exposure to CTAs, well, now all of a sudden, your drawdown is something like, instead of 16%, your max drawdown you'd be adding on is just 5%, you know, 5.3%. And you're adding an extra

Starting point is 01:02:28 8%, 9% total return to your portfolio over that decade. And the benefit has been that the drawdown came at very uncorrelated periods to when equities had a drawdown. So yes, that 2010 to 2013 period was very ugly for managed futures, but then there was just this absolute catastrophic rocket ship in performance from 14 and 15, which was very uncorrelated with what equities were doing. So I think, again, when we talk about even a period that has been ostensibly bad for CTAs, as an overlay, I still think it's very attractive. And I think I did some, I can't remember what, I think it was 2000 to 2010. It might've been 2000 to 2021. I can't remember, but I did S&P versus the Stockton CTA index, wildly varying yearly bar charts, annualized return, identical. And I think that's figure one in the piece where we drew it out with a pencil.

Starting point is 01:03:29 But it's like you have your 60-40 outperforming and your alt doing half the return in year one, same thing in year two, same thing in year three. You fire your alternative manager. Year four, you have your 60-40 losing money, your alt making money, and then your annualized return being identical, but nobody stuck to it, right? So I think, you know, that's a diversification is insanely painful. Yeah, and I call that the problem with alphas, it lacks beta, right? So you can't go to the cocktail party and be like, Oh, yeah, the market's down. But what are we going to do? And yeah,

Starting point is 01:04:03 they're gonna, the economy will turn around, we we'll get right there's like that safety in numbers and we're all in this together if you're the only guy you know in the uh managed futures mutual fund you're like what am i doing i feel like an idiot i'm getting out right before it goes on to make the highs so moving on you guys mentioned this in the paper um and i saw some tweets around it like there's a feeling all we're doing here is stacking fees right so we're increasing the cost of all this exposure so uh how do you how do you talk about that how do you go you want to jump in this or you want me to? I can talk about it. I think we are in an environment right now where I think a misinterpretation of regulatory guidance has led investment advisors to lean towards offering pure beta at very, very small beef.

Starting point is 01:05:03 So if you're not offering a portfolio that has an expense ratio of less than 15 basis points, the regulators are coming after you, right? But in reality, the interpretation is if you are finding managers that charge more, you have to make a case for why that's good for the client. And the way we outline the report and the funds that we put together, we ended up deciding, like, we just kind of found the blended fee. And the blended fee came in at around 1.29%, right? So the question is, how do you justify charging, going from 15 basis points to 1.29% for your

Starting point is 01:05:39 clients? And there's a few things that you need to, that we point out in the paper. The first thing is that you are paying 1.29% for an exposure of 160%, right? So the cost per unit of exposure is not that much. It may be double what you get from just being in beta, right? You're getting levered exposure to beta and levered exposure to CTA. The other thing is that what are you getting in beta, right? You're getting levered exposure to beta and levered exposure to CTA. The other thing is that when, what are you getting for that, right? Is the CTA and the global macro side of things, is that an easy thing to get exposure to? And is it an easy thing to get exposure to in a levered way? No, these are complex funds that will that require a lot of work, a big team,

Starting point is 01:06:27 and impeccable execution and, and high quality partners, right? So you're gonna have to pay for that diversification. The question is whether it benefits you by stacking and it benefits you from diversification. The answer to both of those is yes. The other thing is that you're getting access to leverage at an institutional quality level. We talked about the cost of leverage from using derivatives versus if you had to do it yourself, let's go to the cheapest broker out there, interactive brokers, where you're going to grab your portfolio, try to replicate it, and then lever it up, you're still paying significantly more, even with a large portfolio than you would from using and taking advantage of buying mutual funds and ETFs that are managing millions of dollars and getting the best rates, right? So you get a much, much lower cost of borrow. And the other thing that is key and often not talked about and that you're rebalancing over and over,

Starting point is 01:07:47 even if those asset classes return zero, but they're different than they're volatile, you can expect a rebalancing premium from pure noise, pure entropy, anywhere between 1% and 4%, depending on the environment. So that's money from nothing. And if you're an investor, if you're an advisor, and you are trying to rebalance yourself, you're getting retail transaction costs. And yes, I know, supposedly robbing hood and all of those don't have any fees whatsoever. But I think anybody who looks under the hood realizes that somebody is getting paid and that the fills that they're getting in those zero transaction broker dealers are actually just as high as anywhere else. You just don't see it. Right. So you're truly getting institutional quality, leveraged institutional quality,

Starting point is 01:08:35 rebalancing with low costs that so you're capturing rebalancing premium, you're capturing cheap leverage, you're getting a fee per unit of exposure that's much lower, and ultimately a better result for the client. So all those things kind of add up to is the fee worth it? Yeah, we think it is. And we showed it in the backtest of that report as well. Anything to add, Corey, that I missed anything? Yeah, the only thing I'll add there is, you know, you mentioned you can buy the Vanguard balanced fund for something like 15 basis points. The reality is I've never met an advisor that actually allocates to all Vanguard products. Not to say Vanguard and BlackRock products aren't used, but I think the portfolios I tend to see tend to have a blended expense ratio north of 40 basis points, somewhere between 40 and 60.

Starting point is 01:09:23 And so when you start talking about this portfolio with an average blended expense of call it 1.2 to 1.3 versus 50 to 60, now you're talking about a fee differential of 60 to 70 basis points. And the core question then becomes, is that worth it for the potential rebalancing premium, for the potential 60% extra exposure you get to CTA and global macro and their diversifying return on top, do you think that can overcome the extra 60 basis point hurdle? I think it absolutely can. But I think that's an important judgment call that every advisor or investor considering allocating to this style of portfolio should make sure they do the math on. And you're almost at the same point if you have the non-levered 60-40 ETF and the managed futures, right? If you add one of those products there, you're almost- Yeah. I mean, I think to the point of if you take, say, the average investment portfolio of an advisor who's doing active and passive

Starting point is 01:10:26 funds in their 50 or 60 basis points, and you take this portfolio, and they're only getting a dollar of exposure, and you take this portfolio, and you divide by the 1.6, I think this portfolio comes out about 80 basis points per dollar. And so it's really not that far off from a lot of the other portfolios that we traditionally see advisors and investors building. Got it. Yeah. And I'll add that it's something that's not on the report that we were asked to do after.

Starting point is 01:10:51 It's funny that we did this report, we launched it, we did the back test using indices. And then after the fact, we were like, oh, I wonder how the actual mutual fund portfolio did since the inception of the capital efficiency that all these funds have. So it was November 2020 is when everybody that we had on the list started running their capital efficiency. And what we found is that I think it was around 14% is what the balance fund did from November to whenever we did the internal back test, I think last week, was around 14 plus percent.

Starting point is 01:11:26 And the stack portfolio using these actual live mutual funds after transaction cost fees and the like was 19%. So you're looking at almost a 4% excess return with the same risk and highly correlated to 60- 40. So it's, it's all of a sudden now you have a true depiction of what you can get after all of those fees, transaction costs, cost of leverage and the like. It's, it's, it's pretty fantastic to see actually. Be interesting to see if some of those products increase their fee levels to, right. There's like an arbitrage there, right?

Starting point is 01:12:01 If I'm delivering 5% extra return, I should increase my fee. But we'll leave that for another podcast. Okay, we'll take that away. We'll let you guys know. And then lastly, I want to ask, okay, I'm doing stocks. I'm doing bonds. I'm doing commodity trading. It feels, and I think, Corey, I've been talking with Jason Buck about this, and you guys might've touched on it,

Starting point is 01:12:28 and Pirate's like, everything's at all-time highs, right? And it's like, if I do this right now, I'm getting into everything at all-time highs. So just how do you guys, even ignoring the paper, just do you feel like everything's at all-time highs? Is that a bad thing? Is it just normal? Why does it feel different this time? I did have this exact discussion with Jason Buck last week. And my comment to him is prices at all-time highs are not valuations at all-time highs necessarily. Beyond that, if you were to actually buy the S&P every time it made an all-time high, it's actually a very attractive return stream from a total return versus drawdown perspective. So I

Starting point is 01:13:05 think people are generally fearful of all-time highs, but I think it's not about the price you're paying. It's about the value you get. Now, arguably again, valuations are stretched in equities, valuations are stretched in fixed income. Commodities are a lot harder to judge as to what's value necessarily, what's the right price to be paying for anything. But again, we think these are the core building blocks of the portfolio anyway. Investors need to try to outrun inflation. Really, it's very dangerous to just outright sit on the sidelines. So it's more about building that maximally robust portfolio that can try to capture the most amount of upside return per unit of risk or unit of drawdown. And it's going to probably include some assets that are overvalued and hopefully include

Starting point is 01:13:52 some assets that are undervalued and on balance average out to a very attractive return stream. Another way to ask that would be, what if I'm like, you know what, stocks are too high right now. I'm just going to add the commodity piece. And then I'm going to add this piece. Then I'll wait for a drawdown and add stocks. Not recommended by either of you, I'm sure. I'm in the camp that nobody can foresee the future. And that's why I love risk parity.

Starting point is 01:14:23 The most I can do is try with a team to perceive where the markets are going to be in the next five to 10 days. We're using very, very short-term tactical models. But to try to sit here and say, I know where the S&P or bonds or anything is going to be a year from now, I am no expert in that. I haven't seen anybody that is really good at it over and over again. And so I lean back on, if you don't like equities, just don't overweight them. And by overweight, I mean a different weighting than the risk parity portfolio. Or I even, I'm starting to come around with overweight them, but have enough tail, like the stuff that the guys at Mutiny are doing. So I can get behind that. But in terms of whether it's overvalued or not,

Starting point is 01:15:05 I've been saying it's overvalued since 2010. Clearly, it has not been great. But, you know, it could be around the corner. The good thing about this is that you can have your cake and eat it too. You can make the bet on your 60-40. And if it goes well, then you're stacking returns on top of returns. Now, if it goes poorly over the next decade,

Starting point is 01:15:30 we expect, we've done the math internally, we think it's going to be around 2.5% to 3% for a balanced portfolio return long-term given valuation metrics. And we're not the only ones that think that way. But if all of a sudden you run into a decade like that, stacking 2% to 3 three to four, I think the historical numbers are three to 4% of excess return stacking actually may save your retirement

Starting point is 01:15:55 or it may save your clients from firing you, right? So in both ways, it's a valuable concept to consider. It's just that. And it's essentially what advisors do right now anyway, right? Like, hey, we need a little bit of all this stuff to create this holistic approach. And it's just saying, hey, this is also low. We need to up it a little. My other, try and get you guys to say something wrong

Starting point is 01:16:19 would be, I don't want the bonds. I want to do everything except the bonds. Bonds scare me. I'm getting, you know, the whole line about risk-free or return-free risk. Why keep the bonds in there? Why target the 60-40? Just for that relative performance and tracking it? Yeah, I think that is a key part of it. Just the reality of the way investors and advisors in particular are allocating today is that they have these global asset allocation policy portfolios that they tend to stick to. The 60-40 portfolio has worked extraordinarily well for the last 30 or 40 years. And I think

Starting point is 01:17:00 it's hard from a cultural perspective to be meaningfully different than that for an advisor. I think it's probably difficult from a business perspective for an advisor to be meaningfully different than that. What we put in this paper was not necessarily meant as a prescriptive solution. We're not saying buy this model. It is meant as an example. And so if someone doesn't want bonds or wants to under allocate to bonds, they can simply mess with the weights of these different products that are now available to reduce that sort of x-ray through bond exposure. And so I would say that anyone who

Starting point is 01:17:36 has that view, whether it's structural or tactical, they can embed that within their portfolio. Really what we were trying to show was there's a lot of advisors we work with that are sensitive to what a 60-40 portfolio has done and are concerned about reducing exposure to a 60-40 to introduce diversifying alternatives. These products allow you to maintain that core beta maintain that 60 40 exposure and introduce and stack those alternatives on top and so again just an example not prescriptive yeah i agree with everything cory said in terms of not being prescriptive i also want to answer your question about bonds because you know this is a conversation that drives me nuts that you know um

Starting point is 01:18:24 bonds what's the point? The yields are so low. There's no value. It's not even going to be as protective as it was in the past. It's not protective. And I've been hearing this for two years or more. And if you look at the best performing asset classes in Q1 2020, US treasuries are number one.

Starting point is 01:18:49 So all of a sudden, yields went to 75 basis points, I think, at the bottom. And it feels like, okay, well, it's not going to be there. But then we go all the way back to 2015 with German bonds, right? So I wrote a piece, a very small piece, I did a video where we show treasuries at 75 basis points at the time in March 2020. And then I go back to when German bonds were at 75 basis points. And I am sure investment advisors in Germany were saying, what's the point of owning German bonds at 75 basis points? I'm going to get it out of my portfolio. Well, it turns out much to my original point about predicting the future that between 2015

Starting point is 01:19:21 and 2020, March 2020, German bonds went from 75 basis points and yields to negative 0.5. That led to an annualized rate of return if you held the German bond 10 year, just under 5%. So you missed out on 5%, number one, because you thought what you thought. And you missed out on the diversification benefit that came with holding German bonds with equity. So the 60-40 outperformed German equities during that period. So I'm not convinced that treasuries will not continue to be protective in a negative growth shock. I'm also not convinced that we can't have negative yields. I think they will always be structurally non-correlated.

Starting point is 01:20:03 I think there is a place in the portfolio. And Corey has written about how you can kind of dissect the types of returns you're going to get from a bond portfolio based on the current yield. So if it's 1.5% over the next 10 years, we should expect that. Well, if you're stacking returns on top of returns, 1.5% is still better than zero and no diversification. So I think it's not what you, what's the saying that Mark Twain says? It's not what you don't know that gets you into trouble. It's what you know for sure that just ain't so. I think that falls into that cap.

Starting point is 01:20:43 I strongly believe in the continued diversification of treasuries. Now, if the shock is an inflationary shock, there's a likelihood that you're going to have bonds and equities move in tandem. But that's why you want the commodities in there, or a commodity sort of strategy. The last thing I'll add to that is that when I was talking earlier about the sort of very written in stone return of fixed income, what I didn't mention was that if you are maintaining sort of a constant maturity or constant duration profile for your fixed income, it means you're going to be rolling your portfolio, right? You might be buying at 10 years and selling when it's nine years. And so what that potentially does in

Starting point is 01:21:25 a return, in a yield curve environment that is steeper, is that not only are you going to get the yield from your bond, but you're also going to get some potential roll return. And so when we look at the yield curve today, a lot of people say, wow, yields are really low. But when you look at the total potential carry, which is going to be the yield plus that roll return of the 10-year rolling to say the nine year, it's actually some of the highest yields we've seen in the last decade. And so I think from a total return perspective, bonds are just as attractive as they were at a much lower sort of nominal level as they were in probably 2016, 2017. I love it. Can I just also deal with the classic objection just because I know it's going to come at me on Twitter? Yes, I know. I know that in

Starting point is 01:22:20 March, there was a time where everything went down together, including gold and treasuries. Okay. But for the most, the vast majority of days, it acted as an offset. There is a point where we're no longer dealing with a growth shock, but we're dealing with a liquidity event, a liquidity shock. That means that the margin clerks are out there asking for money from everybody and everybody will look at their winners and sell those and that in in march and in 08 and in every major crisis ends up being the biggest winners being treasuries and gold so for that a little tail production might not be so bad right and that's why but it's momentary for that quarter like january 1st to the end of that quarter it was still net protective and beneficial in terms of diversity.

Starting point is 01:23:10 I thought you're two things. One, I think you say booned if you're in the biz, not, not bunned. But, and two, I thought you're going to go with the Mark Twain quote of October is one of the more peculiarly dangerous months for stocks. The others are January, March, February, June. I think he lists them all, which is a good one. Any other quick thoughts or we'll move on to some quick favorites as we do to end the pod? The only thing I'll add is we published the paper. We're working on a website right now that'll have additional material, podcasts we've been on. I know Rodrigo is working on some interesting stuff behind the scenes about potentially being able to publish an index related to the model we developed in the paper. So hopefully we can get that out the door if people want to track that over time.

Starting point is 01:23:57 So stay tuned. I think there's going to be some additional resources as well as another potentially more institutionally focused version of this paper for pensions coming out sort of in Q4. And I'll say that we are, because it is not prescriptive, I want to emphasize that. What's been great is since we wrote the paper, we're collaborating with advisor teams to find the right stacking approach for them. And our doors are wide open to collaborate with anybody out there that wants to see what we can do together. Love it. How is it collaborating together? You've done it before on the index and whatnot, but how is it writing a paper together?

Starting point is 01:24:35 God, we fight like cats and dogs. Corey's like, why, why would you ever use those words? That's not how the English language works. I loved everything about the paper, except for the fact that Rodrigo's name came before mine. I don't. Hofstein G, man. I don't know.

Starting point is 01:24:53 It was actually quite, it was much better than what I expected it to be, especially given the slashing and dashing that happened on both sides once in a while. You know, when you're going and editing somebody else's stuff and saying i think this will work like you you finish and there was one night where like this is a good piece everybody loves it we're going i go to sleep i wake up in the morning and i have this eureka moment and i'm like i slashed a couple of pages and sent it to cory and i was thinking he was gonna lose his mind but he's like oh no

Starting point is 01:25:20 that actually worked and then when we finalized and tweaked that, we were really, really happy with it. Send it to Adam for editing. And it was just like redlined. Like it was mostly grammar, right? But it was one of those, we both responded like, my God, he just budgeted the piece. Took it away 10 minutes later. I'm like, oh my, that's significantly better.

Starting point is 01:25:39 So it was touch and go, but the result every single time was magnificent. And so great to work with Corey on it. It's been great. Years ago, I think we mentioned Resolve in a blog post, and I got an email from Adam that was like six grammatical changes. Oh, my. Like, I'm not sure that was requested, but thank you.

Starting point is 01:25:58 I spent, I'm not kidding you, 20 minutes with Adam on a single line for a flyer that was going to go out for a stack and returns event and came out. Just going back and forth. I'm like, this feels better. He's like, grammatically incorrect, my friend. Take it off. What does this mean? He starts talking to me about gram returns.

Starting point is 01:26:17 I'm like, I'm an ESL student. I can't. You do what you want. Favorites to finish it out. Corey, favorite Pirates episode so far? Might be like picking amongst your children. That's a tough one. I think some of the ones we did last spring were a lot more fun. When I was on the road all summer, I didn't have as much opportunity to do some editing. So I think some of the ones we did around crypto cash and carry trades were some of the fun ones. Awesome. Rod, favorite, resolve rifts, which was a tough one again.

Starting point is 01:26:53 I always love the ones that we do with Chris Schindler. Because when you talk with somebody who's speaking your language, but also was doing it 10 years before you were and before anybody was all this risk parity, you know, portable alpha factor investing. I mean, those are, are definitely my favorite. I also liked the, the one we did on right in March or April on trying to predict the future where everybody took a side of what was going to happen. And then the conclusion was nobody knows anything, but the narratives are very compelling. That was pretty good.

Starting point is 01:27:28 Was anybody right? I think it's called the pandemic portfolio episode on Riffs. Did anyone have 80%? Everybody was wrong. Well, we talked like the reason the markets went up were dead wrong. But one of them was markets go up. It's just how we got there was just brutally incorrect.

Starting point is 01:27:48 Favorite Caymanian food. Is that how i say that caymanian caymanian the conch curry baby yeah right cory the conch curry one of the things that's been surprising to me is if you said what is caymanian food i don't know if i've got a good grasp on it there's a there's a lot of curries but it's not. I don't know if I've got a good grasp on it. There's a lot of curries, but it's not like, I don't know if that, there's nothing truly native to this island, I guess. I mean, the fish is unbelievable, but the curries here are fantastic. The conch curry is great. No, I call it conch, but you say conch. You're probably right. I feel like every restaurant I go to and I try to order it they correct me i go conch which

Starting point is 01:28:25 is how i would have said it being from new england and they say no it's conch and then i say conch somewhere and they say no it's conch so it goes both ways um and then you've both done your star wars characters before so we'll switch it up favorite marvel character i'm gonna go with thor oh my god no i'm gonna go that's why i went first that's why i went first thor's big hammer i guess i'll be your hulk the hulk to your hulk to your uh thor there we go oh to your thor um nobody wanted ragnarok the raccoon um oh yeah he's pretty good yeah yeah that's a good one i think i would i will say I think I would I'm not a big comic book guy so I'm going purely based on the movies I probably would have changed my answer

Starting point is 01:29:10 if it weren't for the most recent Thor Ragnarok movie I don't think prior Thor iterations were all that interesting but man Taika Waititi is a genius yeah and then I think he's directing the new is he doing Dune or is he doing

Starting point is 01:29:26 someone's doing the guy who did ragnarok's doing something that's upcoming i can't remember um you guys are both or that's more adam that's pumped for dune right yeah um all right guys thanks we'll put links to the paper and all your good stuff uh in notes, and we'll talk to you soon. Thanks, Jeff. Appreciate it. Appreciate the time. All right, guys. The Derivative is brought to you by CME Group. CME Group is the world's leading and most diverse futures and options exchange. For more information and educational resources about futures and options,

Starting point is 01:29:59 visit cmegroup.com. You've been listening to The Derivative. Links from this episode will be in the episode description of this channel. Follow us on Twitter at rcmalts and visit our website to read our blog or subscribe to our newsletter at rcmalts.com. If you liked our show, introduce a friend and show them how to subscribe. And be sure to leave comments. We'd love to hear from you.

The Derivative - Researching the Risks of Return Stacking with Corey Hoffstein & Rodrigo Gordillo

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