(Bloomberg) -- A leveraged strategy for diversifying investments that crashed spectacularly in the financial crisis is back. This time, the designers say they’ve ironed out the problems.
The offering, known as portable alpha since the 1980s but recently rechristened “return stacking,” has caught on in exchange-traded funds sold by Newfound Research and ReSolve Asset Management. Cash is creeping into the ETFs billed as one-stop shops for cross-asset diversification that use borrowed money and derivatives to amp up firepower.
An example is the Return Stacked US Stocks & Managed Futures ETF (ticker RSST), a fund launched in September. For every dollar invested, the fund is designed to give a dollar’s worth of exposure to US equities. Because some of that is achieved through leverage, there’s money left over to add — or stack — another bet on top, in its case a trend-following strategy.
While the math is thorny, the core principle is that if you package up enough uncorrelated bets, it’s no sin to use leverage to juice the overall return. Creators bill them not strictly as standalone products but building blocks in even larger portfolios, boiling down multiple tasks of diversification to a single button click.
It’s the latest attempt by Wall Street to market sophisticated investment concepts to the masses. While portable alpha strategies have delivered solid risk-adjusted gains in good times, they burned pensions and endowments alike in 2008 when leveraged and illiquid wagers backfired.
Rodrigo Gordillo, president and portfolio manager of ReSolve, says the disastrous outcomes of the past were the result of too much leverage concentrated in too few bets. By stacking uncorrelated assets at a time when stocks and bonds are more inclined to move together, he expects the new breed of ETFs to better weather market rough patches.
“We focus on systematic macro as a sprinkling of tail protection and as a recognition that there’s a flaw in an equity-bond portfolio,” he said. “We want to increase stack returns, but we want to keep risk at bay. And you can do that if you’re stacking diverse things that are zigging when the underlying is zagging.”
Investors learned the benefit of spreading out bets during the summer equity rout. When the S&P 500 sank more than 8% for its worst correction since October, a plain cross-asset portfolio as tracked by the RPAR Risk Parity ETF (RPAR) lost only 1%, buttressed by gains from Treasuries. Yet since stocks started bouncing back, RPAR’s edge has been almost reversed.
While sound in theory, return stacking is not risk free. For one, leverage works both ways and margin borrowing will work against investors in a downtrend. Further, the stacked return is typically selected based on a historical relationship that may or may not last, particularly over shorter periods. Like other asset-allocation models, the benefit tends to manifest over longer stretches than retail investors may be willing to endure.
“Investors should view returns stacking and capital efficiency as tools to help make the inconsistent return profiles associated with portfolio diversifiers like managed futures and commodities more palatable and easier to live with,” said Michael Crook, chief investment officer at Mill Creek Capital Advisors. “But they have to understand the underlying composition of each fund in order to make sure they are using them correctly within a portfolio context.”
In less than a year, RSST has garnered $200 million assets. Along with three other funds, including one launched in May, total assets under the return-stacking umbrella now exceed $600 million.
Most of these funds hold either equities or fixed income as the core and seek stacked returns from dissimilar assets. For now, it’s often a strategy that makes bullish and bearish wagers via futures based on an asset’s price momentum. Picking from a pool of 27 diverse markets, ReSolve and Newfound try to duplicate the performance of a widely tracked index of trend-following trades.
The tactics don’t come cheap. RSST, for instance, has an expense ratio of about 1%, well above the average ETF. Still, in the eyes of the managers, that’s reasonable considering funds specializing in managed futures usually charge 1.7%.
ReSolve and Newfound plan to introduce two more funds this year with bonds working as the base in both cases. The stacked returns will originate from strategies focused on futures yield and merger arbitrage, respectively.
“The ambition ultimately is to make this a nine to twelve products suite,” said Corey Hoffstein, chief investment officer of Newfound. “It’s all about getting the Legos out the door and letting advisers pick and choose how to combine these building blocks.”
The introduction of return-stacked ETFs is occurring alongside a debate about whether diversified portfolios were ever the right prescription for buy-and-hold investors, an old claim that got a new airing in November when three researchers claimed a wrongheaded devotion to bonds had cost retirees trillions of dollars in lost profits over the last century.
Hoffstein and Gordillo’s products reflect the long-standing academic rebuttal to such arguments: that adding a dash of leverage to the mix is a reliable way to push a blended portfolio past just stocks on a risk-adjusted basis.
That idea was adopted in 2018 by WisdomTree Inc. in its leveraged version of the widely followed 60%-share, 40%-bond allocation, which was then labeled 90/60. The ETF, later renamed as WisdomTree US Efficient Core Fund (NTSX), beat the S&P 500 in the first three years before tumbling 27% during the pandemic bear market.
Behind NTSX’s bad year was a breakdown in the historic relationship where stocks and bonds tended to move in opposite directions. In 2022 when inflation raged, however, the two assets sold off together and leverage made things worse.
Stacked returns aren’t immune from drawdowns, either. Since RSST’s inception, the trend-following strategy has suffered losses amid swift market reversals. As a result, the fund is behind the S&P 500 by 8 percentage points.
Still, the approach may appeal to today’s diversified investors, who’ve had to sit and watch as gains in a handful of technology stocks made anything other than owning a simple S&P 500 ETF a distant second in terms of portfolio gains. RSST is up 16% in 2024, roughly in line with the S&P 500 and 5 percentage points ahead of the standard 60/40 blend of equities and bonds.
“It allows you to say ‘well you know what, trying to pick stocks that beat the market is really, really hard. Why don’t I just get the market beta and add an alternative strategy that I have higher confidence in?’” Hoffstein said. “A ton of people are doing this in the institutional space so this is not a novel concept. But in the ETF space, we’re really at the forefront.”
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