Episode #368: Rodrigo Gordillo & Corey Hoffstein, “You Now Get To Have Your Beta Cake While Eating Your Alpha Too”
Guest: Corey Hoffstein is a co-founder of and Chief Investment Officer at Newfound Research. Founded in August 2008, Newfound Research is a quantitative asset management firm based out of Boston, MA.
Rodrigo Gordillo is President of and a Portfolio Manager at ReSolve Asset Management Global and has over 15 years of experience in investment management.
Date Recorded: 10/27/2021 | Run-Time: 1:15:17
Summary: In today’s episode, we’re talking about return stacking! Corey and Rodrigo joined forces to try and tackle the issue of how to generate returns in an environment with stretched equity and fixed income valuations. We hear how using a little bit of leverage to the traditional 60/40 portfolio can provide more than one dollar of exposure for every dollar invested. Our guests then walk us through what strategies investors can stack on top of their 60/40 portfolio, including global systematic macro, trend following, and tail hedging, and what that does to the risk/return profile.
Be sure to stick around until the end to hear stories about what life is like for people who have actually lived in an inflationary environment.
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Links from the Episode:
- 0:00 – Sponsor – Public.com
- 0:50 – Intro
- 1:50 – Welcome back to our guests, Rodrigo Gordillo and Corey Hoffstein
- 5:31 – What led to writing the Return Stacking paper
- 12:58 – Buying stocks and assets outside of their packaged offering; Engineering Targeted Returns and Risk (Bridgewater Associates)
- 17:02 – Sponsor – Public.com
- 18:25 – How experiencing hyperinflation can dissuade you from buying stocks
- 22:18 – Assets that can be added to a 60/40 portfolio to manage inflation risk
- 28:31 – Gain access to their index at live
- 33:08 – Managing your FOMO and understanding the advantage of leverage
- 37:42 – Return Stacking in the Wall Street Journal
- 42:02 – How commodities have exploded in recent years
- 46:37 – Common objections to leverage and why bonds aren’t as safe as you might think
- 51:24 – Feedback from investors and advisors about their paper
- 57:43 – What Rodrigo and Corey are thinking about as we wind down 2021
- 1:01:30 – Whether or not there’s retail investor interest in this product
- 1:02:17 – Things that have them most confused about markets today
- 1:05:01 – Wake surfing in Argentina and people storing their wealth in boats
- 1:08:21 – Storing your money in businesses; Axie Infinity podcast episode
- 1:10:07 – Learn more about Rodrigo and Corey; investresolve.com; thinknewfound.com; returnstacking.com; returnstacking.live; Resolve Riffs Podcast; Flirting With Models Podcast
Transcript of Episode 368:
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Disclaimer: Meb Faber is the co-founder and chief investment officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s funds on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information, visit cambriainvestments.com.
Meb: Hey, everybody, we have a special two-guest episode today with both the CIO and co-founder of Newfound Research and president and PM at ReSolve Asset Management. In today’s show, we’re talking about return stacking. What is that, you ask? Our guests joined forces to try and tackle the issue of how to generate some returns in an environment with low expected returns for traditional assets. We are using a little bit of leverage to the traditional 60/40 portfolio can provide more than $1 of exposure for every dollar invested. Our guests walk us through what strategies investors can stack on top of the 60/40 portfolio, including global systemic macro trend-following, tail hedging. And what does that do to the risk-return profile? Be sure to stick around to the end to hear stories about what life is like for people who have actually lived through an inflationary environment, which we may be entering or already in. Please enjoy this episode with Newfound Research’s Corey Hoffstein and ReSolve Asset Management’s Rodrigo Gordillo.
Meb: Welcome back, Rod and Corey.
Rodrigo: Glad to be here, man. Wish we were in California.
Corey: Yeah. I’m surprised you allowed me back after, I think, the last time that I brought a whole bottle of rum to your office that we drank together during the podcast. I thought that would be my first and only time.
Meb: Rum Jumbie. Well, we got a Cayman manage episode, so listeners, hopefully you can distinguish between these two handsome gentlemen. If not, you can watch us, one of the hundred people that watch us on YouTube and you can see I’m wearing even some Corey schwag. Thanks for the hat, Corey, even though you don’t own one. Pirates of Finance, shout out. What’s the vibe in Cayman, guys? When are we doing a Cayman FinTwit meetup? I need an excuse to come down there.
Rodrigo: It’s looking good, man. We’re finally…when was it, Corey? On Friday, maybe Thursday they announced the official opening of the borders. We’ve been closed down for about 18 months now, fully closed. If you wanted to come in, you had to do a 16-day quarantine. As of the 20th of November, people who are vaccinated can come in without quarantining. So, I think the island is back in business and we can start getting some visitors.
Meb: When are you guys going to host something?
Rodrigo: You are invited November 20th to do a podcast with us at the beach. How about that?
Meb: Is there a wing foil/Fintwit? Have you guys started wing-foiling yet? I heard that’s the new thing.
Rodrigo: I’m dying to videotape Corey on it. He hasn’t been on in the last couple of weeks, but we …
Corey: I was going to say, not the first time on, please.
Rodrigo: You know what I did this past weekend and it was really fun, it was just a full day of free diving and learning how to hold your breath and the breath work there. That was possibly the funnest thing I’ve done on the island thus far.
Meb: What’s your, like, time capacity? Can you do that for, like, a minute?
Rodrigo: We started at two minutes. After the breath work, we ended up being able to hold four minutes, me and my brother.
Corey: I’ve done breath work before.
Meb: You seem like a WIM Hoffer, Corey.
Rodrigo: Oh, yeah.
Corey: Well, four minutes sounds horrifying. But I was surprised being trained to the breath work how easy two minutes is. You think after 60 seconds you need air, your body does not need air. It is totally fine.
Rodrigo: And how you get the four minutes is you understand the three phases. So, there’s three equal phases in your breath-holding. First one is you feel like you can do it for five minutes, then you realize, “Okay. This is getting difficult, so I’ll just focus and then focus on heartbeat.” That’s equal amount of time as the first part, but it’s a bit more difficult. And then you start doing the…where your body is trying to breathe. You can do that without any negative consequences for another third of the time. So, once you internalize and you get into the rhythm of those forced breaths, you can make it last significantly longer than you think. So, when you’re doing a free dive for some spearing or lobster fishing, you can be down there…Like, my cue was, I’ll be down there until I start making that noise and my body starts trying to breathe, at which point I’ll take an easy time to go up and know that I can even last longer than that. It just lets you understand your limits a lot better.
Meb: And I feel like the next obvious extension is spearfishing. Have you guys done that yet? Is that big in the Caymans? I bet it is.
Rodrigo: I’ve done spearfishing scuba diving. There’s a fish called the lionfish that is open season for them because they take over and just eat everything in the coral reef. So, you can go down there and spearfish as much as you want there. And then lobster season starts December 4th. We’ll be doing a lot of that.
Meb: Let’s talk about markets. You guys put out a pretty killer new paper as you’re wont to do. This is sort of a Justice League team-up between ReSolve and Newfound called Return Stacking. Who came up with the title, by the way? A great title.
Corey: That was all Rodrigo.
Rodrigo: Yeah. And that’s what drove me to actually sit down and do it.
Meb: Were you just sitting there one day at the poker table just doing the, like, shuffling stacking and said, “I got an idea.”
Rodrigo: It was 15 years of trying to explain this concept to investors and banging my head against the wall, and then realizing that you just needed to change the language for people to have an aha moment.
Meb: This paper actually takes me back because there’s been a few times where you have an insight in investing, personally, I feel like, or professionally, where you learn a concept and it’s hard to see the world in the same way again, and I put this into that category of conceptual ideas. Let’s get deep. Let’s dig in. Talk to us about the inspiration, the origin story for this paper, and then we’ll go all the way down the rabbit hole.
Corey: The paper really begins for us, like, the inspiration is this idea of is the 60/40 portfolio really the right portfolio going forward? Now, before I even start going down that rabbit hole, I’m sure longtime listeners of yours, Meb, are probably tired of this conversation because at least for my entire career, which is now going on 14 years, the 60/40 portfolio has been dead 5 to 10 times. Markets have been “overvalued” since 2013. And if you listened to any advice about not holding the 60/40 portfolio, in hindsight, you look pretty foolish. Now, obviously, we’re not judging prospective ideas based on realized results because that’s just one path of history. But the reality is, going forward, a lot of the same facts that applied 5 years ago apply today and are perhaps considerably worse in terms of making the case for the 60/40 portfolio going forward.
So, I know, Meb, you talk a lot about equity market valuations, in particular, U.S. equity market valuations. I’m not going to hit on that one too much. I think there’s strong evidence that valuations are a terrific predictor of forward returns in equities, but there’s a lot of moving pieces there. Suffice it to say, markets look relatively expensive. But let’s leave that part of the portfolio alone for a second and talk specifically about the bonds because where there’s a lot of moving pieces with the equities, the math around the bonds is a lot more concrete. If we buy a bond today that’s yielding 2% and hold it to maturity, assuming it doesn’t default, our annualized return is going to be 2%. The yield is sort of the gravity there.
And so the math gets a little bit more complicated when you talk about bond indices, something like the Barclays aggregate where you have additions and deletions, you have reinvestment of coupons. So, there’s a little bit of turnover that’s going on. If you’re talking about, say, intermediate-term bond funds or treasury funds that are only holding a specific set of maturities, say, 7 to 10 years, the math gets a little bit rougher. But more or less your starting yield is a really terrific predictor of your forward returns. A really good rule of thumb here is that your starting yield is a good predictor over two times duration minus one year. So, if the Barclays aggregate duration today is, call it, 5 just for easy numbers and the current yield is around 2.25%, then we would say we would expect about a 2.25% return in nominal terms for the next 10 minus 1 years, so 9 years annualized. And it’s hard to escape that. I mean, we might get plus or minus 25 to 50 pips around that depending on what comes into the market, what goes out, if there’s any sort of credit risk embedded in there.
But the reality is, that’s a really strong predictor. And so when we look at that part of the portfolio and start to account for inflation and things like advisory fees and expense ratios of funds that we’re allocating to, suddenly we have a large proportion of the portfolio whose return is getting driven to zero if not being outright negative. And so the question we were really trying to face is, okay, we have this behavioral bias among investors to stick to the 60/40. We know the math of the 40 really doesn’t play out that well for investors. So, other than just telling them to save more, is there a way for us to rethink portfolio construction in an additive way that allows them to achieve higher returns without actually necessarily moving off of the 60/40 portfolio?
Rodrigo: I will add that. The additional thing that we saw was that the 40 was being characterized. It wasn’t any longer 40% sovereign fixed income. It became riskier corporates, which then became private credit, which then became preferred, which then became structured product. More and more, you start seeing the statement say this is fixed income, but when you look under the hood, it was just equity markets made to feel like it was fixed income. So, we started seeing portfolios that were just 100% equity in order to try to reach for that yield. So, we still have this idea that clients think they’re getting 60/40, they’re actually getting 100% equity. Why don’t we go back to a 60/40 for them, a real 60/40 with two non-correlated return streams and then if indeed both of those things are expensive, they’re going to be low returning over the next decade, how else can we stack on extra return streams through this return stacking process?
Meb: Well, why don’t you tell us?
Rodrigo: We look at this situation and we go back to our roots, right? This isn’t something that we just came up over the summer, neither for Newfound or ReSolve Asset Management. We’ve been applying this concept of return stacking from the beginning of our careers and it’s embedded in the mutual funds that we run. But for the average investor, it’s been impossible, really, to get exposure to this stacking concept, which is really adding unique return streams that are in a lever basis. So, instead of just being constrained to you got $100 and you can only spend $100 investing into different asset classes, in our space, especially in the future space, for every dollar that we get, we’re able to get more exposure, 150%, 200% exposure using futures contracts and derivatives.
That was an access point that was only available to institutions whereas, in the last two to three years, the thing that clicked was realizing that more and more products are coming out to market both from exchange-traded funds and a mutual fund perspective that have an embedded beta component and then also have an embedded alpha component above the 100 cents on the dollar. So, you could put together a series of public funds in a way that gave you some sort of basic beta exposure and the alpha exposure, get your lever portfolios, but for retail investors to finally have access to it. That was a realization, we were like, “Oh, my God, we can do something really neat here.” We started with a basic example if Corey wants to go through that.
Meb: I think a great way to frame it, the insight to me is when you think of, like, the unlock of what partially we’re getting out of this, it has a lot to do with y’all’s risk parity routes and just thinking about asset classes, in general, because people get scared, nervous, squeamish anytime the word leverage is used or futures is used. But if you take a step back and say, “Look, what’s the asset that everyone holds on their balance sheet?” Your house or real estate is probably a leveraged investment. If you look at buying equities, you know, those equities hold debt on their balance sheet, the stocks do.
And so trying to get out of this concept of thinking of an asset class as having to invest it at a pre-packaged offering, someone comes to you and says, “You got $100. You have to buy stocks with 100 bucks.” Well, no. You could buy $50 of stocks and keep $50 in cash and that fundamentally changes the appearance of that asset class, though nothing has really changed and vice versa, you know, levering it up and down. So, there’s no real reason to accept what has been pre-packaged and given to at the level that it is to me.
And so once you think about that and say, “I don’t have to accept stocks at 15% volatility. I could invest in them at 7%, at 30%.” Same with bonds. You don’t have to be at 10% or sub-10% volatility. They could be lower, they could be higher. Anyway, I’ll let you guys take it from there. But that insight…and we’ll add some show note links. Bridgewater has some old grey papers on this. I’m sure you guys do too. This concept of thinking of putting together the Lego pieces not as they came in the packaging from the store is a huge insight that I think changes the way you view, at least it did for me, everything in the investment world.
Corey: I think it’s an incredibly powerful insight because when people hear the word leverage, typically, it immediately turns them off to the concept, particularly if they haven’t worked with leverage. And to your point, anyone who owns equities actually typically encourages a bit of leverage in the companies. They typically want them to take out debt to invest in growth opportunities. Anyone who has a house, anyone who’s even borrowed for student loans is, in a sense, levered up their human capital. So, we’re not averse to leveraging all of our life. But on the other hand, the world’s most spectacular financial blow-ups typically have a component of leverage. The difference is that it’s highly concentrated leverage.
So, what we’re advocating here is not say, “We want you to be levered and to escape the gravity of bonds, we want you to lever up your equities two times and just hold twice as much equity,” because that might be catastrophic. The real magic here is in saying, but what if you hold something that is, say, 2 times equities, but only do it with 50% of your capital? Well, 50% of your capital times 2 times equities means you have 100% exposure to equities, but now we freed up another 50% of your cash to do interesting things with.
Now, we wouldn’t advocate that you allocate that to, say, something that’s highly correlated to equities or has highly correlated and high vol. But what if you took that 50% and just put it in, say, very short-duration, very high-quality corporate bonds? Well, now, in effect, what you’ve gotten is equity returns plus maybe a little bit of marginal return coming from credit spreads and term premium embedded in those bonds. And it’s not like you’re taking substantially more risk, even though you are technically 50% leveraged. And I think that’s the really important part. How much you’re levered on its own doesn’t tell you how risky your position is. It’s really about what are you doing with that capital?
So in the paper, we introduced this idea of, yeah, you could do something as simple as very short-term corporate bonds and just look for a little bit of marginal return, which, arguably, might be much more consistent than, say, trying to find an equity manager that can deliver you alpha or you could look at what are the real flaws potentially of a 60/40? When does it do poorly? And then can we use that freed up capital to allocate to something that could do really well in that environment? And so that’s where some, like, Rod’s risk parity roots really come in and we start introducing things like commodities or other sorts of alternatives that can do well there. I know both of you probably know exactly where I’m going with this, but it ties into the current inflation debate very strongly.
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Meb: So even an inflation debate is a hyperinflation debate according to Jack on Twitter. Rod, you actually have some personal experience. I think we talked about this last time you were on the show for the new listeners. You have a nice Twitter thread on the topic too.
Rodrigo: It informed exactly how I manage money from the beginning of my career. I’ve never picked a stock in my life. I’m born and raised in Peru and in 1989, inflation went from 20% to 7,200%. And we had all our family’s money in a Peruvian bank account in cash that went to zero purchasing power. At the same time, my next-door neighbor who was about to get evicted from his house because he couldn’t make the payments had a couple hundred under his mattress that was able to then use that to pay off his mortgage in full because the mortgage was in Peruvian soles. So, the debtors won and the savers lost all of their money.
That really was an important part of my formative years that when I was getting into the business and everybody was focused on trying to pick Amazon versus Apple, I could care less. I wanted to have a portfolio that survives everything, and that includes understanding inflation that we haven’t seen in 40 years in any real way in these markets, understanding inflation and recessions, and together, stagflation, understanding high growth and low growth and putting together a portfolio that creates a nice balance and protects different angles. Of course, the problem with putting that portfolio together, and I know you’ve done work on this, Meb, with your all-weather race with the permanent portfolio risk parity, I think, Muhammad Larian and somebody else. But the goal there is to just be as consistent as possible year in and year out.
When you’re not using leverage, you just find that it’s quite boring too. It’s steady, but it’s so well-diversified that your volatility goes way down and also your absolute returns go down. The way to think about it is, you might have a year where equities are up 20%, but if you’re well-diversified, you will have something else that’s down 10% and something else it’s only up single digits. And when you add it all up for that year, you’re drastically underperforming the best performing part of your portfolio. You put all those things together, you end up getting more steady returns, but no explosive returns. That’s when you can say, “Okay. Well, I’ve also reduced my drawdowns, my maximum losses.”
Think about ’08. ’08, markets lost 55%, U.S. equity markets. If you added bonds, you only lost like 30%-plus because bonds went up, U.S. Treasuries, when equities went down. So all of a sudden, okay, putting those two together, I’m okay with that. If I’m okay with a 50% drawdown, I just added bonds that have a 30% drawdown. What if I lever that up to the point where I get 50% drawdown again? Well, you just have the same risk as your equities. If you’re levering up, you’re getting excess returns with the same level of risk as equity. So, then you will add commodities like a CTA, your drawdown goes from 30% with your bonds and equities to, let’s say, 20% because they did well in a way.
Now, you can lever that up until your max drawdown levels are hit or your analyzed volatilities are hit. I think that the key interesting thing about diversification is that it reduces the big left tails, and also the right tails, and then increasing leverage allows you to increase the risk to the level that you’re comfortable with. And instead of having a lot of zigs and zags in your portfolio because you’re in a single asset class, by putting a bunch of them together, you’re having more smoother upward sloping lines more often.
Corey: I think the way you would actually put it, Rod, is leverage unlocks diversification, lets you eat Sharpe ratios.
Rodrigo: That’s right.
Corey: Often what we see with diversification is your Sharpe ratio goes up, your risk-adjusted returns go up, but that’s because your return went down less than your risk went down. Typically, you’re moving both of those down. Leverage allows you to get it back to a commensurate risk level and then enjoy those higher expected returns.
Meb: As we think about, kind of, these two levers of dialing up and dialing down leverage because you can also dial it down for those out there that are looking for something just super low vol, what do you think are the main things we can toss into this 60/40, the biggest additions to a traditional 60/40? What are the big things, do you think, should be included in the pot of soup?
Corey: Well, I’ll tell you what we did first initially, and that we ended up changing in the paper, is we said, “There is an inflation risk here. What is the 60/40?” If we’re starting there, we’re going to lever that up and free up some capital for ourselves to invest elsewhere, what is the risk the 60/40 has? And it’s probably that stagflation environment. And so what’s historically done well during those periods? Well, different types of commodities have historically done well. And so we looked at allocations of things like gold or copper or agriculture. And we got some really interesting feedback from an advisor who read an early draft of the paper, and I’ll let Rod talk about it, but it sort of changed some of our thinking around what would actually make a portfolio like this more palatable in practice?
Because what happens is, once you start to add that commodity exposure, well, then the 60/40 sort of becomes the risk parity adjacent. It’s not quite at risk parity yet, so that’s too much equity exposure versus bonds, but it becomes more risk parity adjacent, which has a big tracking error problem. And it’s a question then, as you know all too well, Meb, is, can people really stick with the portfolio long enough to realize the potential benefits? I’d love for you to share that conversation, Rod, because I thought that was very insightful.
Rodrigo: Yes. As you know, or anybody who knows our work, we are quants and we try to create optimal portfolios. So, from a mathematical perspective, what we want is to absolutely maximize your diversification benefits, have a very weird unorthodox weighting scheme where we’re not, like, the maniacs take over the asylum. And then once you have your maximum return per unit of risk, then lever it up to your level of volatility. And what that leads to is just a massive tracking error to whatever your home country bias is. My Peruvian clients in 2009 after we were up in 2008 were really mad at me because Peru did 169% that year, whereas our all-weather strategy was up another 9% for ’09. Up 7%, up 9%. So, that type of tracking error means that they wanted to fire me.
The optimal portfolio doesn’t jive with reality of people’s behavioral flaws and behavioral needs. And I think we as advisors to other advisors need to find a balance between optimal mathematics and behavioral optimality. This is great and all, but nobody is going to stick to a risk parity portfolio in my group of business. They like 60/40. I need to give them as close to 60/40 as I can. Is there any way to use this concept and complement it with something that I can stick to and actually would make my clients really happy?
And that was, to your question, Meb, what can we stack on top of the 60/40 that has the qualities of protection and non-correlation, but where 9 out of 10 years, that thing I’m stacking on top is going to be positive? If I just add long-only commodities, it turns out that commodities as a group are down 4 out of the 10 years. So, four years is sometimes huge, right? So, 4 of the 10 years, advisors are going to have to explain to the clients, this is what diversification means, and diversification works even when you don’t want it to. And that’s a passive approach. That’s what risk parity is.
So, the solution was to think of, we need to stack active management on top of the 60/40. We need to have a strategy that can be dynamic enough, get exposure to commodities, and all other asset classes in a way that they’re aiming to be positive 9 out of 10 years just like equities are positive 9 out of 10 years and bonds are positive 9 out of 10 years. We need to give them that same profile. And the answer to that, for us, was active CTAs and active systematic global macro. And it just so happened that these are ideal both from a diversification perspective, but from a return stacking perspective because they are already offering a lot of these products out there because futures are so easy to leverage with that there were already offerings where you’re getting, let’s say, 100% SPY and on top of that 100% CTA.
The product that we run is 100% risk parity, passive long-only commodities, equities, and bonds. On top of that is 100% systematic global macro in the future space. So, the difference between trend and systematic global macro is that systematic global macro trend plus seasonality plus value plus carry, it’s multi-strat. And when you put those on top, now we’re only having to apologize, hopefully, 1 out of 10 years. And the reason that the CTAs and the systematic global macro seem like, “Well, why wouldn’t I, instead of levering it up, just add it to my portfolio?” Well, it’s because, over the last 10 years, those strategies have done mid-single digits. They’ve been positive most years, but who wants to drag down the 12% annualized return the S&P has had with a mid-single-digit alternative strategy? Why am I doing this for? It seems absurd.
But all of a sudden when you don’t have to sacrifice, when you don’t have to make room in your portfolio, 60/40 portfolio for this alternative, when you are buying product that already gives you your beta and then stacks that single-digit return on top, you’re now getting to have your beta cake while eating your alpha too. And that alpha, even if it’s a 1%…after transaction costs and fees and taxes, even if it’s 1% above 60/40, it’s still useful, it’s still a killer. And so all of a sudden, the last 10 years have a mid-single-digit strategy stacked on top of your 60/40 becomes, “Oh, my God, now I get it. I understand the value of this and I can never go back.” And the key here has to be stacking things that are zigging when everything else is zagging and that are trying to make positive returns 9 out of 10 years so you don’t have to explain to your clients at the end of the year too much.
Meb: Oh, sad you guys didn’t have stack ETF out. I actually tried to reserve the symbol for you, but somebody has it. I don’t know if it’s you guys. I went STAK. I don’t know what a better symbol for this would be.
Meb: That’s not bad. Think about it, listeners, when we convince them to launch one. But you do have an index. And the cool thing about y’all’s work, other than the fact that it’s always gorgeous graphics, is you put out a lot of actual data. So, I’m looking at some return tables that go back over 20 years now, actually even more than that. What am I talking about? It goes back to the ’80s?
Rodrigo: Yeah, ’87, ’88.
Meb: Worse years sub 5%. I could handle that. Not many of them. Only like five down years, six down years. Where do people find this paper, by the way?
Corey: Returnstacking.com. And then if they want access to the live index, which takes the model we built in the paper and tracks that on an ongoing basis, it’s returnstacking.live. As quants, we like to use a backtest, despite all its faults, that can help us look at what would have happened historically and get some gauges, did this behave as expected? The way to do that is because, as Rod mentioned, a lot of the products that enable this today for a retail investor or a financial advisor didn’t come out for the last couple of years, we have to sort of proxy it using different asset classes, right? So, we knew in the model that we built, using all these different funds, that we got basically 60% equity exposure, 40% bonds, 30% CTA, 30% systematic global macro.
But what we were able to do was take indices for each of those asset allocations, build a theoretical asset allocation out of them and backtest it, adjusting for costs and that sort of stuff going back to the 1980s to give us a more realistic backtest. But then what we’ve done for the live index is say, “No, there’s actual products out today, mutual funds and ETFs that you can buy that when you buy them all together, it adds up to 100% of your notional capital and creates this 60/40, plus 30, plus 30-type exposure and we’re going to track that going forward on a live basis. And what we’ve seen is that since all those products really came out, I think last November was the starting point that all this could have been done in practice, we can see that it did what was expected, which was it got you 60/40 returns incredibly highly correlated. But because CTAs and global macro have had positive returns this year, it’s done 60/40 plus a bit. And I think it’s plus 400 pips.
Rodrigo: 4.72 as of yesterday.
Meb: That’s not bad.
Rodrigo: This is a crucial thing because often people read the paper and they’re like, “Oh, that’s an interesting theory.” But this was designed to be a practical paper. The way to think about it in figure 7 of the paper, you actually x-ray these products, product 1 through 10. These are actually live mutual funds that we couldn’t put the tickers up on the paper for compliance reasons. But what you see there is you see bar charts that go above 100% allocations. So, whenever you buy a product, let’s say the WisdomTree Core NTSX, I think it’s the ticker, you’re putting $100 in there, but you’re getting 90% equities, 60% bonds. If you buy Corey’s fund, it’s, on average…this is active equities and bonds, but on average, you’re getting 75% equity, 75% bond, and you’re getting a little tail or convexity layer on top.
And so we go through 10 products as an example of different allocations, different betas, different alphas. And all you have to do now is get a spreadsheet, iterate, if you know what these products do. And some of them advertise, some of them don’t. Some of them we had to, like, call them up and say, “What is your actual exposure?” so that we can make sure that we’re putting the right exposures together. But once you have that, go on your Excel sheet and say, “Okay. I want 80% equities and 20% bonds and then something else. Iterate until you find the allocation there. You want the level of leverage that you want. I could have easily gotten 200% leverage for this. I did 160% because that’s what Warren Buffett uses in his portfolio. A few people don’t realize that but they buy high-quality equities and then lever it up 1.6. That’s the key behind figure 7 is that you need to know what the products do, x-ray them, and then put them together in such a way where in this paper, I think the exact allocation, the exact percentages were 61.8% went to equity, 40.3% went to bonds, 28% went to managed futures, 29.3% went to global macro. And there you have around 160% exposure with a $100 investment.
Meb: Choosing for the standard investor, is that the target notional level that’s palatable? What’s the area that you think most people when you balance the FOMO of underperforming the S&P when it’s up 20 every single year or the challenge of being worried about leverage? What’s the right number for most?
Corey: I think this goes back to the idea that leverage has a number, it doesn’t really tell you how risky a portfolio is. If I create 160% notional exposure, but that extra 60% is in very short-term U.S. Treasury bonds, then it’s very different than me taking that extra 60% and putting it in stocks, right? So, I think what’s important here is, again, we’re first and foremost capturing that 60/40 profile that investors care so much about, and then we’re being very conscious about trying to proactively add diversifying asset classes or structurally uncorrelated return streams. If I were to take a hard left turn from a conversation that I think has been fairly investor-friendly and go perhaps a little bit more quantitative, what I would say is what we can actually look at from a theoretical basis is what sort of leverage for a well-diversified portfolio would, in theory, maximize our compounded growth rate?
And if we look historically at something like stocks, it’s actually over the last 20, 30, 40 years, which has been a really good period for U.S. equities, don’t get me wrong, you would have wanted to hold something like 1.2 times leverage. If you go further than that, you start to hurt your return. It sort of creates this hump. And there’s an optimal point of leverage. And when you’re to the left of that point, you take too little risk, right? Not enough leverage. You say, “Well, I underperformed my maximum compound growth rate because I didn’t take enough risk.” But if you fall to the right, if you over-lever, what ends up happening is you underperform your optimal growth rate because you took too much risk.
Now what happens is if you look at an all-stock portfolio, you get a hump that peaks around, say, 1.2, and then sharply falls off. And if you go too far, you can actually dramatically fall off. But once you start mixing in diversified asset classes, not only can you get a much higher leverage rate, so say a 60/40 portfolio, you might be able to safely lever up 200%. You also have, sort of, much more leeway in terms of how precise do you have to be to get to that optimal point? Because I think we’d all agree, we probably…while the math doesn’t differentiate whether we’re on the left or the right side of that peak, we probably want to fall on the left side. We probably want to fall on the didn’t quite take enough risk left some on the table to make sure we don’t accidentally go too far. When you start talking about an incredibly well-diversified portfolio of stocks, bonds, global macro, managed futures, and start levering that up, you can actually crank the leverage up to 400%, 500% before, historically, you would have fallen over that hump. So, from a safety perspective, 1.6 is actually historically on the very, very safe side.
But I think, again, going back to what can an investor really tolerate? That seems to be a level where the amount of tracking error added by CTAs and global macro doesn’t overwhelm what’s happening in the core 60/40. And on top of that, because global macro and CTA tends to have that absolute return style of they might lose, but when they lose, they lose just a little, and then when they gain they gain a lot. That very asymmetric call option-type profile makes it something that from a tolerability standpoint, investors tend to be able to stick with more as an overlay than, say, again, just raw commodity exposure.
Meb: So, what would you guys do, 300%, 400%?
Corey: This is actually something I do in my own portfolio and I’m trying to incorporate more and more. Again, it’s a question of I have it in my own fund that I manage, which I allocate a lot of my own assets too. I know, Meb, you harp on managers not doing that, but I have a lot of my own money in my own fund. Other than that, unless I want to go actively roll futures within my personal account, it does get a little hard. And while I have the means to do that, there’s compliance burden as an asset manager that makes doing that pretty hard. So, as new funds have come to market, I’ve been proactively dialing up how much I’m doing this. But again, a lot of these funds, I think we’ve had two or three come to market this year that are making this. So, a lot of this is very new, and so it’s a question of, “Okay. Well, we got a lot of taxable gains I got to consider as well. How do I transition this over time to really maximize this type of approach?”
Meb: I feel like this would be perfect for some sort of structure that locks people in whether it’s like an interval fund or some sort of forever fund idea. By the way, nice shout out in “The Journal” for you guys.
Corey: Thank you. Appreciate it.
Meb: We’ll add that to the show notes links too. The concept where…Yeah. You wanted to actually really dial this up to 200%, 300%, 400%-plus, but you have to be in some sort of structure that keeps you in it or incentivizes you to stay in it because, as we know, people are very fickle with things, particularly when they’re higher volatility. You know what I’d like to see in this paper, maybe a future version or an idea, also is like this concept of…This has been a big topic riffing back on the earlier part of the discussion about inflation over the past few years where people are starting to really think about what to do with their cash, historically, not just on your personal balance sheets. In my Bank of America, I was laughing because I looked it up and they’re like, “The interest you’ve earned this year is like 75 cents on your account.”
So, your personal balance sheet, trying to survive in a world of inflation that’s above zero, but let’s call it 2%, 3%, 4%-plus. You’ve seen the discussion happen a lot with treasuries for corporates. Now, oddly enough, that discussion is skewed towards crypto for some odd reason as if those are the only two choices. But to me, this is a really interesting application for your idea de-levered or de-stacked. I don’t know what you’d call the phrase. But where you actually say, “No, instead of 160% we’re going to take this down and have this portfolio but have a cash cushion as a part of it to get to ultimate purchasing power stability.” Is that something you guys have looked at, thought about, going to include in a new version?
Rodrigo: The de-stacking I think would be later on if we’re going to think about it because you’re right, the concept here is to say, “What’s the best portfolio for you? And then what risks do you want to take? You want more risk, use leverage. You want less risk, use less leverage.” The more diversified you are, the less risk you’re going to be taking already. Part of that being in cash is the fact that cash can keep up with increases in yields and there is some sort of inflation protection there. But what’s been interesting about writing this paper and having to look at the data is understanding the mechanics as to what is likely to be a good inflation hedge in the next 10 years.
And when you look at CTAs and global macro funds, the first thing that you’ll notice is that the universe is dominated by commodities. They trade everything. They trade equity, indices, they trade bond indices, currencies, and commodities, but their universe is mostly commodities. Just by pure fact of that dominating your allocation in a period where commodities are going to benefit from inflationary boom, that universe, that asset class of CTAs and managed futures is likely to outperform. And in fact, when you look at the data, you see exactly that. Look at the mid-naughts, for example. That period was an inflationary boom where you had global growth and massive inflation. During that period, the U.S. equity markets were doing a decent amount like 9%, 10% annualized, but commodities were doing 35% annualized. And the CTA indices and the CTA providers were having their best decade in a very, very long time. Again, you don’t even have to be a genius. You’re just trading more of the thing that’s going to do well in an inflationary environment.
I think commodities peaked in 2011 when inflation peaked in 2011. And then we went to a disinflationary boom period for basically U.S. equities and bonds. In that whole universe for CTAs, there were no winners. You were being chopped up in commodities. The annualized return of international equities are in the low single digits for that decade. And then you had U.S. equity markets and U.S. bonds crashing at like low double-digit returns. So, when you only have 2 out of the 70 asset classes you can trade killing it, and you survive by providing positive returns in a single-digit way, it’s a nice way for you to have…Okay. Let’s say there isn’t inflation, you’re still going to have that single-digit period because there is enough of the asset classes you care about, you’re participating in that.
But if it is inflationary, I think the benefits that you get from being in managed commodities is going to outweigh the benefits you’re going to get from having a cash cushion in my opinion. We weren’t really talking about inflation much when we launched this, but it’s now abundantly clear because everybody wants to talk to me about it, as I look at the data, I’m like, “Oh, yeah, we’ll be just fine. Like, risk stacking return concept in a high inflation environment is going to be pretty robust.”
Meb: I’d like to see you guys put together something on that. I know you have nothing else to do. But on that topic of almost, like, what’s the safest portfolio in the world on sort of a lower vol purchasing power basis, I think that would be a fun one to look at. This was a painful…Listen, you talked about this, Rod, because going back to one of Corey’s famous papers on timing luck, we…As listeners know, we come from a foreign background and had a great wheat harvest this year. And the rare times discretion creeps into my world, it always works against me 100% of the time. And so we had a great wheat harvest. But as a trend follower, I’m looking at the wheat chart and saying, “Son of a bitch, this thing is channel breakout, positive trend. I should just hold on to this wheat for a while and then watch it go to the moon.” And then one day I said, “You know, Meb, what are you doing? Why are you playing around with this farming situation? If you’re going to trade the wheat futures, just trade the wheat futures. Get rid of your crop.” So, I sold it at 6 bucks or ballpark, and it’s 8 now, like, two weeks later, like, literally it was, like, to the day, the next day.
Rodrigo: Yeah. But did you listen to yourself and just go long the wheat futures?
Meb: No. I said, “Why am I timing any of this? Just sell it.” Anytime discretion has ever entered my process, it’s been an absolute opposite. I need to just go straight up opposite on any discretionary idea I ever have. So, yes, I would be retired if I just bought a bunch of wheat futures because now they are just gapping up to the moon. So, this inflation commodities topic, it also gives me a lot of humor and joy because we’ve all been at this for a while. Listen, you talk about the financial crisis. I mean, that’s 13 years ago. Watching the institutional allocations of commodities, everyone all hot and bothered in the mid-2000s, commodities went bananas. And then watching the next decade as every institution slowly puked out all of their commodities exposure, like, one after another. “We can’t take anymore. That was stupid. I can’t believe I read that white paper. I’m out,” over the last four years. And of course, now, everything has its time.
Rodrigo: CTAs as well. Anything futures-based, which, again, it wasn’t necessarily because they suck and trends didn’t manifest in any meaningful way. They did in some asset classes, but commodities were just choppy and terrible. And having, as I mentioned earlier, a passive exposure to commodities, you’re going to be wrong 4 out of 10 years. CTAs at least got it right more often. I’m saying to people now, you don’t want passive commodity exposure. You want active commodities or you want somebody to be there to manage that so that you don’t get completely screwed up. That’s a great way to do it. And I think CTAs and passive commodities will be…10 years from now, everybody will jump on the bandwagon and I’ll be shorting it.
Corey: I was just going to add really quickly, I think one of the interesting notes here is there are people I’ve spoken to that do have to hold cash, though. People who wanted that part of their savings account to the side or wealthy individuals, high net worth individuals that I work with that do private investments, PE or angel investing, PE, in particular, where they’ll get capital calls and those capital calls very often coincide with equity market drawdowns. And so they want to keep this cash buffer, but during a bull market, that cash ends up being a drag in their portfolio. I think one of the interesting things that can be done with this return stacking concept is to say, “Yeah, the paper discusses how you could create 160% exposure.” But, again, you can dial that down to say 150% or 140% and keep 10% of your money in cash. Any financial advisor in the world will tell you keeping 10% of your money in cash is probably a horrible idea.
But if you’ve already made up the beta, you already have more than 100% exposure, then the cash is there, but there’s an asset allocation overlay that’s happening. And so the asset returns that you’re getting are going to be in excess of cash because you’re holding that cash to the side, but you do have that cash held aside now if you need to use it opportunistically. If you’re a value investor who’s waiting for the market to fall apart, well, you can have a 60/40 portfolio that’s levered up 1.5 times, keep 33% of your money in cash, and wait for the world to fall apart, and then go stock-picking. But along the way, you can maintain that 60/40 exposure on the way up. And so I think, again, what we were trying to hit on in this paper was how do you create a 60/40 with the return stacking on top? But I think there’s some really creative ways in which this concept can be used to solve investor problems.
Meb: It’s a big surprise to many investors. We do these Twitter polls that we love to publish because it often gives investors insights into something that they believe that’s wrong. And a classic one that is such a basic insight is the max drawdown of bonds on a real basis. And most people, they put all their money, their “safe money,” in cash or bonds. And then you realize that…you asked the question, “What was the max drawdown in history?” And most people think it’s 5% or less. And the answer is 50% for T-bills, and for government bonds…and then foreign government bonds, it’s 60% to 80%.
So, thinking about this safe portfolio, we did this chart years ago in one of our publications, but it’s easy to do. You basically just show this Sharpe optimal return stream, and then the effects of adding 10%, 20%, 30%, 40%, 50% cash. And it basically just takes, you know, the return stream and just pulls the line so that it gets smoother and nicer. And you can look at it on a real basis and basically prove…I can’t say prove in our world but demonstrate historically that the safest portfolio is actually one that has these other elements, not just cash. Now, cash may be a portion of it, I’m guessing that the right amount of cash with this portfolio is maybe a third, could even be half, I’m not sure, instead of optimizing on the Sharpe volatility and drawdown historical, but that’s just a guess. But it’s a beautiful chart because it shows you that inside of I don’t have to take any of this pre-packaged. I can dial it up and down.
Rodrigo: And some of the added benefits today on the stacking is you were one of the first one to look at tail protection as a great way to benefit from volatility and rebalance back into your traditional portfolio before it goes up. The first objection when you talk about leverage is everything’s uncorrelated until things hit the fan and all correlations go to one. Now, that’s not necessarily true. That’s been very, very clear with an equity portfolio. It’s not necessarily true from bonds and equities most of the time. The drawdowns that we’ve seen in ’08 and in 2000, and even in 2020, have been largely mitigated by a long position in treasuries, right? So, you can actually see that even treasuries and bonds have negative correlation in those big crashes.
Even then, when you look at Q2 2020, bonds made a lot of money, 10-year treasuries were doing double digits, equities were down. But there was a three to four-day period where they all went down again. Gold went down, commodities went down, treasuries went down, equities went down momentarily together. And yes, in those very small periods of time, all of a sudden, the diversification that made leverage feel like it wasn’t there becomes apparent. The convexity and tail protection should be something that people need to consider. In fact, we included in the paper as a reasonable thing to do to have some of that long volatility or long convexity to protect against precisely those worst parts of the market. We didn’t use it in the backtest because we can’t go back and do this type of stuff to 1987. So, what you see in the backtest is without tail protection, but you can imagine that it will play a big part if you’re able to include it. And the returnstacking.live, you’ll see half of the products, at least, there have some convexity to them just precisely for those concerns.
Corey: I think the full way to think about this, a really easy visualization for me is what we’re trying to achieve is what I would call a Z-shift. So, we start with our very traditional portfolio. If we’re thinking about a graph in our head that’s on the Y-axis as our expected return and the X-axis is our risk, traditional efficient frontier, we got that dot that is our traditional 60/40. And when we sell stocks and bonds to include diversification, typically we’re moving down to the left. We’re reducing risk quite a bit, but we’re also typically giving up a little return. And then we levered up. We make it capital efficient and we move up and to the right. And so we get up north, almost directly north of that traditional portfolio.
And then because we know that leverage can be risky and those very particular and very acute liquidity cascades will add some tail risk protection again, which will move us down into the left. We’ll give up a little bit of return and paying for that type of insurance premium on those puts or however you’re doing tail risk management. And then hopefully it moves us down to the left. And together, what you create is this Z-shaped pattern. Everything we’re trying to do here is to create this Z shift in our returns from a very traditional portfolio to one that’s taking advantage and really unlocking the benefits of diversification through capital efficiency.
Meb: What has been, sort of, the advisor/investor response to this paper? What’s the feedback been like? Are there any particular topics that people get hung up on, caught up on?
Corey: I’ll start by saying, I think we probably have a biased sample of advisors we’re talking to. Let’s just acknowledge that. Generally, it’s been very positive. I think, probably, what we discuss in this paper might still be too high octane for a lot of advisors to wholesale switch their clients to, but the nomenclature of return stacking, I think, is very appealing to them because it was hard for many to intuitively understand what leverage really was. And by using that name, return stacking, it really unlocks what we’re doing here. It’s going to be beneficial when everything in the portfolio is positive, right, because you’re just adding those together. And when everything in the portfolio is negative, it’s going to be to the detriment of the design. And so then it’s all about what can you really combine?
So, I think the feedback conceptually has been really positive. A lot of advisors we’re talking to are struggling with what to do with the 60/40. A lot of them will admit that they are pushing their clients up the risk spectrum. And this may be a different vector of risk that’s worth exploring. Instead of taking more concentration in equity risk, use a little bit of leverage to introduce better diversifies. And while they might perceive that leverage aspect as a risk, it might actually be less risky than taking a 60/40 client and putting them into a 90/10 portfolio.
So, the feedback has been really positive. Candidly, a lot of the funds are new that we discuss, and so the pushback is, “Hey, these are new funds. This isn’t Vanguard. This isn’t BlackRock.” My clients don’t know who this is, and so there’s an education hurdle to be had. But we’ve had a number of advisors start to seed models like this on their own platform so that they can start tracking them. They have clients that will have an appetite for this type of stuff, they’ll start putting some money in it, and then hopefully over the next couple of years, it’ll prove itself out and they can educate their clients over time. But there’s a spectrum, some that say, really interesting, “I’m never going to do this. There’s no way I can do it.” And then others that have wholesale already started moving clients into it.
Rodrigo: Yeah. It’s been interesting to see some have been like, “It’s done. I’m moving it over.” They started with an all-weather plus leverage, and then they’re like, “Oh, I see the value of giving clients 60/40 plus the stacking of alternatives, so I’m doing that as well.” And they’re wholesale changing. It was one of those where these were guys that were diehard tactical guys for 10 years. They believed in your stuff, Meb, and Corey’s stuff, and my stuff. And because it’s underperformed the S&P for so long, without telling us, they’ve been inching up closer to 60/40, giving the clients what they wanted. So, the moment that you gave them, “Hey, how about you get to have both?” advisors literally got up out of their chairs saying, “Urika. This is amazing. This is exactly what we’re doing because I believe in you guys, but I do want to keep my clients.” Now you can do both. There’s that group.
Then there’s a group that’s, “This is really interesting,” go to returnstacking.live and look at the list of funds and ETFs. They would all be considered alternative because they’re all using leverage and derivatives like. And so they’re like, “My compliance department just said that I’m putting together a portfolio of 100% alternatives. I mean, how am I going to do that?” And that requires education. As Corey alluded to, those advisors are creating a separate asset allocation sleeve. They are seeding it with investors that are high risk. They’re working with a compliance department to get them to understand what this is about. This is nothing new. Institutions have been doing this for decades. That’s how they get their steady, relatively high returns, especially the Canadian institutions that have been applying this for a couple of decades, and trying to educate the compliance while also showing them month after month, year after year, I keep telling them, three years from now, everybody’s going to want to transition to that. Your clients are going to be educated over time. And so don’t force anybody. Don’t change your business. Just have it available to them and transition into that over time if it makes sense. And then there are a handful that won’t.
Meb: It always seems like an important thing on the advisory side is coming up with the narrative to where they can act as the in-between with clients and still their best interest. We see a lot of people that will do this in a way where it’s, “Here’s our traditional 60/40, and then we’re going to do the alts bucket.” And they’ll just call it the alts bucket because they give them the knowledge that it’s going to be different, which I think helps people behave a little more when the 60 side is ripping and roaring that the other things may be zigging and zagging. That seems like, traditionally, a way that has been successful but not without its own challenges.
Corey: For me, what was pretty funny was after “The Wall Street Journal” article got published, it got picked up on the Bogleheads forum. And I always like to read the Bogleheads forum because, for a largely self-taught group, there is actually some really sophisticated understanding, but there’s also some very dogmatic behavior. And some of the feedback was, “Leverage is always bad. This is a horrible idea. They’re just trying to sell you an expensive product.”
Rodrigo: “What could possibly go wrong?” is a great one.
Corey: I understand that because historically all the greatest catastrophes have been concentrated leverage, but the core idea here is the exact opposite. So, if someone’s comparing, say, a 90% stock 10% bond portfolio versus a 60/40 portfolio that has another 60% of return stacking that’s diversified CTA and global macro, well, the latter may actually be far less risky, especially when we consider and go back to what we said earlier, that extra 30% equities they have embeds leverage within it. So, you might say, “Oh, it’s only 90% equities.” But that extra 30% exposure to equities is intrinsically levered itself because of the way the capital structure of those companies. I just think there’s this large misunderstanding around the use of leverage. And arguably, what the papers have documented over the last decade is that leverage aversion potentially creates an excess return potential. Now, I don’t want to lean into that and say there’s a premium to be had here through leverage that all your peers are ignoring. But I do think it’s a massively underutilized tool that is now becoming available to non-institutional investors because of the 1940 Act Products ETFs and mutual funds that have come to market.
Meb: Well, gentlemen, I love the paper. What else is on your brain as you guys sit there in the warm Caribbean sun drinking rum, hanging out on wing foils? What else are you guys thinking about as we wind down 2021?
Rodrigo: I’m just excited, man. I think a lot of us, Meb, you, me, Corey, my team, Mike Philbrick, Adam Butler, we got West Grant, we all came to market roughly around the same time. You actually inspired all of us to get into the business. So, you are the godfather of this movement.
Corey: Yeah. So, fuck you.
Meb: Yeah. Yeah. What a sad mistake that was.
Rodrigo: Well, the thing is that we survived and we did well. I think Active has, as I alluded to, just people believe in it, but have had a rough go at it because it hasn’t been as good as the S&P. I’m feeling a change here. I’m seeing the value that other advisors are seeing with Active finally. This year is a great indication of that. What I’m thinking about the most is that the next 10 to 15 years is going to be Active, Active Management doing what people would expect it to do, versus the Active Management that they thought was going to happen in the last 10 years and didn’t provide. I’m really excited about that.
Meb: Good. Corey?
Corey: Number one thing that’s been top of mind for me, so I’ll take Active in a slightly different way from Rod, because when I think of Active I think of Active stock picking, for example. And I think one of the things that’s been really top of mind for me for the last 12 months, beyond the whole liquidity cascades thesis that I published about, is this idea of structural alpha. Where can I look in my portfolio to try to find sources of incremental return that come from not better stock picking or picking better bonds or coming up with better signals, but from structurally reformatting my portfolio to be more efficient? And so this whole return stacking concept to me is structural alpha in many ways in play that I am able to use capital efficiency to introduce secondary diversifying sources of return.
And again, it doesn’t always have to be things like managed futures or global macro. If I can just free up some cash and put that cash into short-term corporate bonds, honestly, I’d rather have the S&P 500 overlaid with short-term corporate bonds than try to find a manager that’s going to generate 200 pips of alpha continuously over the next decade. That’s where a ton of my thought and focus has been both from working with advisors and constructing portfolios as well as within the fund I manage, going around piecemeal and going, “How can I redo this piece of the portfolio to create that structural alpha potentially?”
Rodrigo: But you guys, I don’t think, ever separately managed accounts, actually ran them for private wealth, right? Then you ran models and whatnot. But we have been running robo-advisor in the United States for a decade now. And what we do is what we’ve always done, this idea of risk parity strategies and adaptive asset allocation strategies at different levels of risk, anywhere from 6% volatility to 8% to 12% to 16%, and we don’t even publish it, but we have a 20% option for certain clients. It’s available to everybody as long as it’s not in a qualified account, which meant the vast majority of people that came to the robo were like, “Well, I guess I can’t get anything but 6% vol.” And it was true, up until this concept. What this allows us to do now is to provide investors, within their qualified accounts, access to that structural alpha that Corey has alluded to. Finally, not only the people that can save outside their qualified accounts are able to take advantage of higher returns and lower risk. Now you can do it inside those qualified accounts in a way that, again, did not exist three years ago. I’m really pumped about that.
Meb: Did you see the individuals implementing this ever? Is it mostly too much paygrade, you think? What’s the breakdown? Are people pretty receptive on individual side? Is it get it, don’t get it sort of concept?
Rodrigo: Generally, we attract very technically oriented people, generally, not just advisors, but individuals. And yes, I would say 50% of the emails I get are from individuals asking slight questions like, “I can’t seem to get access to this ticker in the index. Can you help me?” So, individuals are most definitely allocating directly to the returnstacking.live index, but advisors as well. It’s very accessible. It’s a short paper. Once you get the paper, it’s very intuitive. Once you go to the actual live index and see the allocations and the underlying exposures, it’s probably the most accessible thing ReSolve has ever printed, to be honest.
Meb: What’s got you guys worried? Confused? Anything? You guys been building up your NFT collection?
Corey: I don’t think I’m ever not confused about the markets, candidly. I think if I ever have clarity about the markets, that’s more concerning.
Meb: What’s got you most confused? What’s got you most scratching your head as you look around the world?
Corey: The thing that has me most scratching my head as a quant is that there is really no applicable dataset to say what asset should do well during inflation. Quants historically rely on data. We in the U.S. have N equals 1 sample in terms of inflationary regimes. We can start to look towards other countries for inflation and hyperinflation, but when you start to look at very localized economies, maybe that don’t have as much global influence, it becomes difficult to say how U.S. inflation or U.S. hyperinflation would knock on into assets around the world. So, as a quant, you’d have to take a step back and say, “If I’m trying to design an inflation resilient portfolio, first of all, what type of inflation are we talking about? Second of all, we’re really modelling on theory here, not modeling numerically.” That probably shouldn’t be a deeply unsettling concept, right? I think as quants, we’re probably over-reliant on numerical rather than analytical solutions, but it is definitely something that is different and I think a lot of quants are trying to figure out right now is our old models and our old ways of writing papers was all about the data. There’s no data.
Rodrigo: A direct hedge for inflation is asking me “What’s the best hedge?” Well, it depends. Is it going to be a demand-pull inflation, a supply push inflation? In fact, people are scratching their heads about how gold hasn’t performed in this time around. And it turns out that there is no perfect hedge, as you mentioned, not locally, Peruvian versus an American versus the European. Even if you look at the nine unique groups in the commodity space, they all jump at different times during the different inflationary regimes. Right? We saw lumber happen earlier last year. Now we’re seeing natural gas and energies. Gold has never really done much of anything. And people are like, “Well, I thought that was an inflation hedge.” It isn’t an inflation hedge, but sometimes it is.” In a perfect inflation hedge, even TIPS, not perfect, because you also have the risk that the governments have an incentive to publish a different type of CPI basket. You really have to attack this with a shotgun approach, I think, and it’s not going to be perfect. Going back to the commodity space and CTAs and all that seems to be an imperfect way to manage that situation.
Meb: I was down in Argentina years ago and did a Fintwit meet up down there and one of the locals said, “Do you want to go wake surfing?” And I said, “Obviously.” We went out on his boat. And my favorite quote was, he said, “Hey, is it okay with you? We’ve invited a bunch of girls to be on the boat. Is that going to be all right?” I said, “That’s okay, I guess.” And I didn’t tell him that I used to own a wake surfing boat. He brought a bunch of fresh-made empanadas. And it was really the perfect day because at the end, they said, “Meb, we’re going to give you all this instruction.” I said, “I think I can figure it out.” And so I pretended as if I had never wake surfed in my life. Anyway, magical day. Not the point of the story. The point of the story was, as we came in and out of the marina, I said, “My God, I’ve never seen so many amazing boats. I live in L.A., one of the wealthiest cities in the world, and this takes the cake.” I said, “Why are there so many giant boats here?” And he says, “Meb, think about it. Your country and your government is consistently a basket case and you have consistent inflation. Where are you going to put your money? So, a lot of people just buy things.”
Rodrigo: There’s no savings.
Meb: He’s like, despite the fact that boats are terrible investments and depreciate and are a huge cost, at least it’s something tangible. And that was an interesting insight to me. And it made me feel better about owning my worst investment of all time, which was a boat, but by far, by far, the best purchase I’ve ever made in my life. My God, a boat is so much fun.
Corey: Do we have time for a quick little anecdote on a related subject that you might find interesting?
Corey: All right. So, back in the mid-2000s, there was a massively multiplayer online game called “RoomScape.” Think of like “World of Warcraft” for people who might have heard of that, but like, way less technically sophisticated. And mid-2000s, this whole new population of players came into the game, refused to engage with anyone else. They were constantly doing, like, what were consider the labor tasks of mining for ore and smithing and fishing and all the stuff in-game that could earn you money. And if you tried to engage with them, they would say, “Hey, I don’t speak English. Please leave me alone.” No one had any idea where they came from. One day people log in and that entire population is gone. There was, like, 50% of the players in the game that totally disappeared. And so what became apparent was all of these players were actually from Venezuela and that Venezuela had a blackout. And so all of them disappeared.
And what people put together was that because this game was older, it didn’t require really modern PCs to run, so people in Venezuela could play the game. And because they were dealing with hyperinflation concerns, they realized that spending time doing digital labor to earn digital gold was a better preservation of wealth for them than actually trying to earn money in their local currency because even if they took a massive haircut, there was a black market where they could turn around and sell that digital gold for U.S. dollars. And even if they couldn’t do it immediately, it was stable enough relative to the U.S. dollar that it made more sense for them to spend their time playing the game doing that rather than try to actually labor in the real world. And so I bring that up only on this topic of how do you hedge local inflation? Well, there’s a perfect example that to an American probably can seem absolutely ridiculous, but is a totally rational action when you price it out.
Meb: There’s a modern version of that with the Axie Infinity game, which is, like, half the Philippines play and a lot of people earn entire livings and the government wants to tax it. There was a good podcast episode. We’ll put the show note links about that story, which is just such a 2021 story.
Rodrigo: In Peru, the idea of retirement in my father’s generation was just never a thing. Saving, right? No, what you did is you bought small businesses that you can continue to run until the day that you die. You don’t retire. My best friend’s family, the mom ran a printing business that she could easily bump up the prices as inflation went up. My other buddy had a bunch of soccer fields, small soccer fields that he would rent out in Northern Peru, put a bunch of cameras on. He was a lawyer by profession. Their retirement was always you had to run a cash-flowing business that had pricing power. That’s it. That was your retirement until the day that you die. You either ended it or somebody within your family would take it over. And it continues to be like that.
In Argentina, a lot of the people I know don’t even get paid in cash. They get paid in … is what they call them, these barters. My best friend’s wife’s father runs a bunch of magazines. And so he needs a dentist appointment. He’ll give some ad space to the dentist in order to have five sessions for his family a year. He wants to travel to the U.S., has a travel magazine. Gives airlines some space so that he can travel free, and hotels and so on. So, you find ways of dealing with “inflation.” It’s just living. It’s being able to purchase stuff and continue to have some sort of purchasing power. Certainly, the idea of cash in the bank as safety is absolutely absurd to the average Latin American.
Meb: This concept of being an owner, I’m trying to think of the right narrative to try to translate this to an entire generation of young investors about having to own things. And people get it with real estate, I think. I don’t know if they get it as much with stocks. I mean, obviously, starting a business and being an owner of that is the hardest part, but owning stocks or businesses is, like, one of the best ways. Gentlemen, we’ve been at this for a while. I’d love to keep you for the rest of the day. Anything else on your brain before I let you go you’re jonesin’ to chat about?
Rodrigo: No. Just go visit us at investresolve.com. Go to the research page there. We run a podcast every Friday called “ReSolve Riffs.” Come check us out there. We’re active on Twitter. You can just go to our website and see all our Twitter handles there. Returnstacking.com and returnstacking.live, take a look at those and we’re open to have conversations on it and expand on the idea whoever’s interested.
Meb: Corey, you got anything?
Corey: I’ll say, if you want to find out more about us, you can visit us at thinknewfound.com and listen to my podcast, “Flirting with Models,” which is seasonal. I can’t keep up with you guys. I don’t know how you do this weekly or bi-weekly. I’m more like eight a year. And then you can find me on Twitter, tweeting far too often, @CHoffstein.
Meb: What’s y’all’s favorite rum that you found now that you’ve been ensconced in the Caribbean lifestyle for a while? You got a favorite we can pass along?
Corey: Yeah. The problem, Meb, is I keep finding all these wonderful rum lockers, places that have exquisite collections of rum that by three deep I’ve forgotten the name of the first one. But the Cuban rums have been really fun. We don’t get a lot of the Cuban rums in the States.
Rodrigo: Flor de Caña I think is one of the big ones, right?
Corey: Yeah, Flor de Caña is definitely one of the big ones around here.
Rodrigo: Where is that from?
Corey: Yeah, that’s Nicaraguan.
Rodrigo: Oh, is it?
Corey: That’s Nicaraguan. Yeah. It’s not Cuban.
Meb: Well, gentlemen, I’m excited for the next Fintwit Grand Cayman meet up. Look forward to in early ’22. You guys organize it. We’ll make it happen. Thanks so much for joining us today.
Rodrigo: Yeah, man. Thanks for having us, Meb.
Corey: Well, Meb, thanks for having us.
Rodrigo: Fun as always.
Meb: Podcast listeners, we’ll post show notes to today’s conversation at mebfaber.com/podcast. If you love the show, if you hate it, shoot us feedback at firstname.lastname@example.org. We love to read the reviews. Please review us on iTunes and subscribe to the show anywhere good podcasts are found. Thanks for listening, friends, and good investing.