Diversification 2.0: Mastering the Art of Portable Alpha
Oct 19, 2024
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Corey Hoffstein, Co-founder and CIO of Newfound Research, and Rodrigo Gordillo, President of ReSolve Asset Management, dive into the intriguing world of portable alpha and return stacking. They explain how this innovative approach can improve portfolio performance by layering strategies to outpace market returns. The duo also discusses the behavioral advantages of sticking with low-correlation diversifiers and how to manage risks effectively. Insightful methods for adapting to high-interest environments are shared, emphasizing the importance of maximizing excess returns.
Portable alpha, also known as return stacking, allows investors to enhance expected returns by layering non-core assets on established portfolios.
The strategy addresses the limitations of traditional diversification, enabling investors to introduce alternatives without significant allocation sacrifices.
Behavioral benefits of return stacking support clients in maintaining allocations to low-correlation diversifiers, thus improving long-term investment outcomes.
Deep dives
The Birth of Portable Alpha
The concept of portable alpha emerged from the realization that excess returns, above the S&P 500, could be attributed not to equities but rather to skilled bond selection. PIMCO developed this strategy in the 1980s, labeling it initially as 'transportable alpha.' By utilizing derivatives to gain exposure to equities while investing available cash in short-term bonds, they were able to generate returns exceeding those of the S&P 500. This innovative approach laid the foundation for investors to rethink traditional portfolio construction and the sources of potential alpha.
Shifting Focus in Portfolio Construction
The discussion emphasized the need to reevaluate equity allocation, particularly within the heavily weighted U.S. large-cap equities. Data indicated that less than 10% of active managers have consistently beaten their benchmarks over the past 15 years in this category, while managers focused on international small-cap equities boast a fourfold higher success rate. This discrepancy reflects a home equity bias among U.S. investors, often overshadowing potentially more fruitful alpha sources. Consequently, investors are encouraged to explore high conviction areas that could enhance diversification without sacrificing core stock and bond exposure.
Understanding the Funding Problem
Traditional diversification often requires selling existing allocations to incorporate alternatives, thus creating a 'two-form hurdle rate' on performance. Portable alpha, however, allows investors to add alternative investments on top of their core allocation without the need for substantive sacrifices in their established portfolio. This method not only expands potential asset classes but also alleviates behavioral biases associated with replacing conventional investments with less understood alternatives. The strategy encourages a shift in mindset that redefines how diversifiers fit within total portfolio construction.
Implementation Strategies for Portable Alpha
Two key methods for implementing return stacking include pre-stacked fund solutions and capital-efficient options. Pre-stacked funds allow simultaneous exposure to a core benchmark while layering alternatives on top, effectively providing dual benefits. Capital-efficient solutions let investors maintain desired stock and bond allocations while freeing up capital for targeted investments in alternative strategies. This flexibility permits both diversification and potential outperformance without disrupting the foundational structure of a portfolio.
Navigating Risks and Market Conditions
As the discussion concluded, participants acknowledged market fluctuations and the inherent risks of returning on capital in a high-interest environment. No matter the interest rates, the essence of return stacking remains focused on identifying and leveraging excess returns above cash investments. There is an acknowledgment that borrowing costs and potential margin calls should be strategically managed, particularly when stacking alternative strategies. As institutional strategies evolve and adapt, investors are again finding relevance in portable alpha as a mechanism for accessing diversified returns.
Portable alpha (or as we like to call it: Return Stacking) has become increasingly popular in the financial media (including recent notes from industry giants like BlackRock, Russell Investments, and AQR) but many advisors are left asking: What does portable alpha mean? How might it benefit clients? How can I implement it?
At Return Stacked Portfolio Solutions we have made it our mission to thoughtfully and transparently help allocate into a portable alpha framework for client portfolios.
Join us for this deep dive podcast with Corey Hoffstein, CIO of Newfound Research, and Rodrigo Gordillo, President and Portfolio Manager at ReSolve Asset Management Global, as we explore:
What 'Portable Alpha' is: Review of the history and theory of the concept.
Outperformance Potential: Portable alpha/return stacking allows allocators to stack asset classes/strategies with positive expected returns on top of core assets which can help improve the likelihood of outperforming the market.
Diversification Benefits: Using return stacking to stack low correlation strategies on top of the core portfolio can help reduce portfolio drawdowns, thus influencing likelihood of achieving financial plan goals.
Behavioral Benefits: Sticking with low-correlation diversifiers can be difficult for clients. Return stacking can improve the likelihood clients stick with diversifiers long enough for them to realize the benefits.
*ReSolve Global refers to ReSolve Asset Management SEZC (Cayman) which is registered with the Commodity Futures Trading Commission as a commodity trading advisor and commodity pool operator. This registration is administered through the National Futures Association (“NFA”). Further, ReSolve Global is a registered person with the Cayman Islands Monetary Authority.
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