Corey Hoffstein: 00:09
The way I always frame it is strategy versus structure. The structure you choose to launch is really important for how well your strategy can work.
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Stefan Wagner: 00:39 Welcome to the Nalu Finance Podcast. I'm very excited. I'm having here today, Corey Hoffstein, who I've been actually following for quite a while. One of my absolute favorite podcasts I'm listening to is Flirting with Models, which I always enjoy when it comes. Today, I also want to talk a little bit about return stating and the strategy in implementing, but number one, welcome to the podcast.
Corey Hoffstein: 01:03 Thank you so much for having me. I appreciate you inviting me on. I appreciate you taking the time to listen to my podcast, Flirting with Models. Whenever that name comes up, I'm always like, people are going to search that and be wildly disappointed that there are really no models being flirted with. It is the nerdiest, most quantitative podcast you can listen to, but hopefully people get a kick out of the name at least.
Stefan Wagner: 01:28 I get a kick out of the name and a lot of them are really interesting. You have some interesting guests on it. Talking a little bit about coming to the idea of return stacking, how did the idea of return stacking evolve from sort of an institutional concept of portable alpha and what motivated it to make it more accessible to a broader audience?
Corey Hoffstein: 01:46 Yeah, so I'm gonna back way up and maybe just start with what is portable alpha because that really came first, I mean portable alpha started in the 1980s at I'll give credit to Pimco. There's a little bit of debate who really got it started. But what portable alpha tries to do is solve this core funding problem. What do I mean by that?
And I'll use a, I apologize for the international listeners, I'm going to use a US centric viewpoint here. But in the US, when you're talking about an institution, they typically have some sort of policy portfolio or strategic allocation that they start with, let's just call it the generic global 6040 portfolio.
And when they want to add anything to that, it requires them to take away something, right? If you want to add some interesting alternative or alpha strategy, it requires selling some stocks or bonds without a core block. That's just the traditional way of incorporating diversification or alpha.
And so that creates an extra source of tracking error. Not only do you have the tracking error of what you're adding, but you're having the tracking error from what you're subtracting and that creates A hurdle problem from a return perspective, right? Whatever you're selling, you need whatever you're adding to overcome as an added return hurdle rate. And then from a principal agent perspective, when you're talking about committees at these institutions and who's managing the portfolio, it also creates some behavioral friction.
And often they just say ok here you can have a little bucket that's called alternatives you can stick everything in there exactly so what ends up happening typically is the majority of the active risk budget ends up getting put into security selection right which is why you find that that's a very overcrowded. area and why things like the SPIVA report show you that most managers underperform their benchmarks in both equity and fixed income. Everyone's already fishing there. What portable alpha tries to do is it tries to separate alpha from beta. And it says, well, if we just want the beta, why don't we use capital efficient instruments like futures or swamps, where we only have to outlay a little bit of capital to get our full exposure in that, in that margin or collateral.
And then we can use the rest of the freed up capital to allocate to interesting alternatives. hopefully alpha or just pure diversifying alternative risk premium or betas. And when you put those two things together, what you end up with is the beta plus the additional returns stream stacked on top. Now, the original idea was to use this for pursuing alpha, right? So as a very simple example, imagine, you know, you believe that in small cap equities, it's very easy to find alpha. But your global 60-40 portfolio has a very small exposure to small cap equities. Well, what do you do? You could buy a small cap equity manager, short the Russell 2000, go long the S&P 500, and you now have S&P 500 exposure with the alpha of that small cap manager stacked on top.
And so that very much solves this funding problem. This has existed in the institutional space for decades. Again, going back to the 1980s, it got very, very popular in the mid-2000s, seen a recent resurgence in popularity among institutions. And it's because it gives a tremendous amount of flexibility in portfolio construction. It has some problems and risks, all things we can discuss, but it's been a very powerful concept for portfolio construction. have always operated in the wealth management space.
So we're an asset management firm who builds mutual funds and ETFs, and those mutual funds and ETFs are used by financial advisors. This concept of portable alpha was largely out of reach for financial advisors because they can't often manage derivatives on behalf of their clients, either from a capacity and scale perspective, an operational issue, a compliance issue, a regulatory issue.
And so as we were trying to get advisors to adopt alternatives as a diversifier in their portfolio, we kept running across this funding problem. And so in the late 2010s, around 2017, we sort of looked towards this institutional space and said, oh, this portable alpha solution is really interesting. What if we took it and put it into a sort of a turnkey vehicle? So we take the beta, some interesting alpha, stack them together and put it all within a single ticker zed solution. And instead of calling a portable alpha we're gonna call it return stacking one because I think portable alpha is sort of impenetrable to the average person as to what it means.
And two the things that we're stacking together aren't necessarily alphas right gold is really interesting diversifier that people want to have. Selling stocks and bonds to make room for gold introduces all the same problems I talked about before: what if we could stack. gold on top of a portfolio, right? It's an alternative beta. And so we more generically called it return stacking. All credit goes to my colleague, Rodrigo Gordillo, who came up with that phrase. And ultimately, that's the problem we're trying to solve for the wealth advisory space, which is how do people get access to diversifying alternatives and alpha sources and solve this funding problem that creates these two real frictions, both the return estimation friction and the behavioral friction from the clients who are allocating.
Stefan Wagner: 07:05 So when I think about the practical implementation, I guess you have to keep in mind here what the cost of funding is. And I guess in respect, the investor has to think about it that it only makes still sense to invest in, let's say, the beta that you still can't say, let's just say the S&P with spiders or futures or whatever. You actually have to outperform at least the funding. You have to make that logical thing. But are there other practical considerations you need to take into account when implementing return stacking?
Corey Hoffstein: 07:37 Yeah, there are a lot of practical considerations. This is a big question. We could probably spend the whole podcast talking about just this question. I'll try to keep it brief. So the funding point you bring up is very real, right? I think the… What people sort of miscalculate is they say low return environment low interest rate environments must be better for portable output than high interest rate environments The point I like to bring up is excess returns are always supposed to be on top of short-term rates So if you can get a funding rate that is close to t bills or so far Right, it shouldn't really matter.
So I often explain using example, right? managed futures as a strategy that goes long, typically trend following long, those futures contracts that have recently appreciated in price, short those futures contracts that have recently depreciated in price. But when you give a futures manager your money, they're going to take your dollar and put it 100% in T-bills. When they only need like 10 cents of that to really run the collateral, of the managed futures program. So what we simply say is, well, what if, when you give us the dollar, instead of just holding that extra 90 cents in T-bills, what if we put that 90 cents in the S&P 500? Right now you're going to basically get the S&P 500 plus managed futures stacked on top. All we've done is transform that lazy collateral with respect to the original Managed Futures mandate. Our cost of funding is just the T-bills we sold. So quite literally, it's just, in that case, T-bills.
Now, that's not true for every form of stacking, and you do need to consider what the implied cost of funding is. But if you are thoughtful, you can drive your cost of funding quite low. And it's typically around T-bills and or SOFR plus 30, 40 basis points. And so it can be done quite cost effectively. To your question, and again, I'll try to keep this answer short, I think the biggest thing, and this is especially true in the institutional space, is how you think about the portfolio construction when you're doing what I would call modular portable alpha, which is you have some beta, like the S&P 500. And you want to free up capital. And so you replicate that beta with, say, swaps or futures. Now you've freed up some capital and you go and you put it in a hedge fund. And at that point in time, you get the S&P 500 plus that hedge fund return stacked on top.
Stefan Wagner: 09:56 But you have different liquidity profile.
Corey Hoffstein: 09:59 You have this liquidity issue. And this is where Portable Alpha really got itself in trouble in 2008, which was, OK, we're stacking on the S&P 500, which suddenly goes into a massive drawdown. You get a margin call. You need to free up cash to feed your margin call to maintain your beta. You go over to the hedge fund and say, hey, I'd like some of my money back. The hedge fund says, well, first of all, we lost money at the same time. Second of all, no, you can't have your money back. We're gating you. And you have this liquidity mismatch that happens, and you have an operational issue.
And so that became a problem for a lot of institutions who adopted Portal Alpha before 2008. After 2008, a lot of institutions learned. They said, okay, we're going to port on top of very short-term bonds where we're less likely to get a more margin call on that beta. We're going to be a lot more thoughtful about the liquidity profile of who we're allocating to. But you've also seen this evolution of what we would call turnkey portable alpha, which is the hedge fund is saying, well, instead of having someone manage the beta and someone manage the alpha, why don't we manage both for you in a separate account. You choose whatever beta you want. We can completely customize to you. We'll do all the rebalancing internally. We'll make sure we don't have any issues.
And that'll solve the operational hurdle there. Again, you still have a liquidity mismatch. If your alpha that you're adding is a totally illiquid asset class, it doesn't solve the problem, right? But if you have a semi-liquid asset class, and you're not having to have multiple people operationally try to handle this, it can be somewhat of a solvent and unlock. And so you need to be thoughtful. So take a big step back. You just need to be thoughtful around you are using leverage. Leverage requires managing liquidity. And therefore, you need to be thoughtful about, you know, how much margin you're posting, the collateral, collateral management and what you're investing in. And do you have a big liquidity operational mismatch there?
Stefan Wagner: 11:59 Yeah. I mean, I have found always that leverage doesn't have to be bad. It's leverage usually blows up in your face when it has different liquidity profiles and they don't match on one side. How do you sort of deal with the behavioral aspects? And what I mean by that is that, maybe not so much over the last few months, but for a very long time, the market went up one way. And how do you get somebody sort of selling, I sell this exposure and instead I'll go into this new thing, return stacking, that hopefully I maintain some of the exposure. But how do you so psychologically get people over the line for that?
Corey Hoffstein: 12:35 You know, the behavioral part is actually, I would argue, one of the unlocks of return stacking. And it's because when we talk about return stacking, we are almost exclusively always talking about the turnkey approach. And when we talk about our own funds, if you give us $1, for example, one of our funds might give you $1 of S&P 500 plus $1 of Managed Futures. So when we talk to someone who, again, investors never begin with a blank piece of paper. They are always coming to us, whether it's an institution or a financial advisor, they're always coming with a starting policy portfolio. It's usually a strategic asset allocation. Some mixture of stocks and bonds and so if we were to say to them. Hey, we think you should have managed futures trend following as a diversifier in the traditional approach they were selling down stocks and bonds in the return stacking approach. We say sell some of your stocks and buy one of our funds that'll give you stocks plus managed futures, you get to keep your stocks and the managed futures get overlaid on top. So in a decade like the 2010s when managed futures go sideways, from a total portfolio return perspective, there's really no damage. You kept your beta and you were able to keep the managed futures there.
Now, that's not to say there isn't short-term noise added by the managed futures, right? But over the full period, you weren't having a huge opportunity cost of not being in Stocks. It cuts both ways a lot. People loved diversifiers in the 2000s when stocks went nowhere and diversifiers did incredibly well. You would have been keeping that beta and so not creating as much outperformance, but we think it's long-term more sustainable at the portfolio level. The second really key issue here is line item risk. This one is really big from a behavioral perspective.
And this happens when investors go through their portfolio and review the performance line item by line item, not thinking about the holistic composition. And this is something that happens very frequently with alternatives. Investors tend to understand stocks and bonds. They're liquid enough. They're low cost. They're fairly transparent. They're fairly tax efficient. Investors get them and understand them generically. If you put an alternative strategy in front of your average investor, they probably have no idea what it is. It's going to be higher costs, less transparent, less tax efficient.
And so it underperforms two or three years in a row, which by the way, is going to happen for any like 0.3, 0.4 sharp strategy. And they're going to look to throw in the towel because they, they don't have the conviction that the strategy works over the long run. And so you end up with all this performance chasing behavior in alternatives. When you look at the gap between investment and investor returns, alternative categories have one of the biggest gaps, suggesting there's a tremendous amount of performance chasing where people chase after returns are really good. They sell after returns are really bad. They just can't stick with it.
And so by shoving the beta and the alternative into the same ticker, that line item now sort of, dare I say, hides the alternative. And we think, right, there's some long-term benefits there between the constant rebalancing and the diversification benefits you get within that item. But part of it is the behavioral, you know, a spoonful of sugar helps the medicine go down. We're just kind of giving them what they want to see. They're not tracking too far from the things they're comfortable with. They get to be a little careful here.
So the caveat is right. If I take high vol trend following and I stack it next to equities. they're going to pair well from a, you're not going to really be able to tell on a day-to-day basis what's driving the returns. But man, the vol of that line might be really high. It might be like a 20 vol line item versus you stack managed futures on top of core bonds.
Well, core bonds have such a lower vol than managed futures. The managed futures are really going to be in the driver's seat day-to-day, but the overall volatility profile of that line item isn't going to be huge. So you can't just put things together. You still need to be thoughtful about overall sizing, overall vol of each product, what mixes well with each other. But these are some of the practical considerations of bringing these products to market to try to address some of the behavioral concerns around alternatives.
Stefan Wagner: 17:04 I like that word, line item risk. I like that, that's a good one. When it comes to product development, maybe you can take an example from your own offerings in a sense. How do you develop, and you touched a little bit already with what you mix and match, but how do you make sure you cater exactly for the investor risk? How do you approach it? Is it because a client says, this is what I need, or you research? How do you approach it?
Corey Hoffstein: 17:29 Yeah, I'd say there's a couple of considerations here, some on the investment side and some on the business side, quite frankly. On the investment side, one of the things we think through is obviously what strategies do we have conviction in and then what strategies do we think can be put into an ETF or mutual fund structure? Regulatory-wise, risk-wise, what do you like? Risk-wise, regulatory-wise, and liquidity-wise.
So I'll give you an example. And I'm going to keep using Managed Futures Trend Following as an example. It just sort of works here. I apologize to the listeners, but I'll use it as an example. For those familiar, again, with Managed Futures Trend Following, you're trading Commodities, bonds, currencies, and equity indices, and some interesting alternative indices all around the globe. And when you talk to a hedge fund that's doing this, they'll often give you hundreds of futures markets. Some of them incredibly esoteric, like trading power in France or apples in China, right? Yeah. When you talk about taking that strategy and putting it into an ETF, you have two problems. The first is that ETFs cannot be closed.
So you have a scalability problem, which is that you just, if money keeps flowing in, you just have to keep accepting it. You have a design choice as a manager. You can say, I'm going to trade very low-capacity things when my AUM is low and then change the strategy as my AUM gets big. Or I'm going to build a product that is as acting as if my AUM is really high, even when it's low. And therefore, I don't have style drift. And, and we think the preferred method is the second, we don't want investors getting a different product just because the AUM is higher. Right. So that's going to change what we can trade.
The second aspect is when you trade an ETF, the market makers are a really important part of the ecosystem. Right so when you go to buy a new ETF you're typically going to an exchange, you're not buying it from me the product sponsor you're buying it from a market maker who is then hedging their inventory so their ability to hedge that inventory. easily is going to define both the amount of liquidity that's on screen and the bid-ask spread. And so for a good client experience, you want to maximize that liquidity, which means, for example, we make the trade-off of only having futures in our funds that trade during US hours, predominantly during US hours.
Stefan Wagner: 20:01 Ah, I see. Okay.
Corey Hoffstein: 20:02 Right? If we have products that where all the liquidity is during Asian hours, it just makes it very hard for those market makers to make markets on our funds, right? And so there are some trade-offs there. Now, therefore, the way we will do our managed futures strategy might be different. in terms of how we run it versus what we do in a mutual fund where none of that is a consideration in the mutual fund that we manage we trade seventy plus markets and a whole bunch of spreads between futures because we don't have the scalability issues we can close the phone we don't have the market makers we can trade whatever hours we want.
Stefan Wagner: 20:35 So the vehicle and what you can do with it drives a lot what you can actually do inside.
Corey Hoffstein: 20:40 Yeah. The way I always frame it as strategy versus structure, right? The structure you choose to launch is really important for how well your strategy can work. And so that's a big consideration for us. So it's okay. What do we, what do we have conviction in can work? What do we think we can actually put into the structure? And then there's some thoughts around, um, tax efficiency. There are other regulatory and compliance issues that we need to consider, but those are, those are sort of some of the big ones.
Stefan Wagner: 21:09 And when you sort of decide to launch something or what strategy you might want to put in there, how much sort of current market conditions you take into account?
Corey Hoffstein: 21:18 We try to take as little as possible. I will say we have an unbelievable track record of launching at the exact wrong time. And it's not because we're trying to time the market at all, but I don't know what I did to anger the market gods. We launched a managed future strategy into March 2023, which is the largest five-day drawdown in Managed Futures funds in history, we then launched a merger ARB strategy into the slowest period for merger ARB other than 2020 in the last 25 years. We just have really good, I hate to say it, but if we're launching a new fund, it's probably time to get out of that asset class for at least six months.
Stefan Wagner: 22:05 A little bit more philosophical question, but when it comes to hedging, hedging often sort of feels like you're paying for insurance you hope you never use, but how do you help invest away the psychological and financial trade-offs of hedging in turbulent markets when it's particularly expensive to do so?
Corey Hoffstein: 22:29 Hedging makes more sense when you are somewhat, I don't want to say forced to be over your skis in terms of risk, right? But if you're increasing your risk more than you're comfortable, that's where hedging to me makes the most sense. When, when there's a true knockout event, if you're just investing your portfolio and there's no knockout event for you, I don't think you should be hedging. I think you should be diversifying. Truly, like if something really bad happens, will this disrupt your life?
And if so, you need to explicitly think about hedging that and or just taking less risk in your portfolio. But if you can't afford to take less risk, you need to take that risk. Then you need to think about the downside hedges that's appropriate for preventing you from basically going bankrupt.
Stefan Wagner: 23:17 Maybe a more philosophical question that little bit comes to, you know, Where do you draw, if you draw any, line between investing and betting?
Corey Hoffstein: 23:27 I love this question. This is a great philosophical question. It's blurred. It's definitely blurred. But I think I would typically say traditional investing I think it's more pure form capital creation, positive EV. And then the betting tends to be zero-sum games where someone's a winner and someone's a loser. And often, in the purest form of gambling, it's negative-sum games.
Stefan Wagner: 23:50 I love it. Three questions I always like to ask everybody pretty much at the end of the interview is, what is your personal definition of success? In investing, in career, in your life, whatever, however you want to approach it.
Corey Hoffstein: 24:06 My personal definition of success. Success to me is not the outcome, it's the effort. And so long as you put in best effort, it doesn't mean effort for effort's sake, right? You can just be spinning your wheels. But as long as you put in best effort, you know, there's a lot of randomness in life. And I don't want to say just because you failed, you weren't successful. Because I think as long as you put in a wholehearted effort into achieving what you're trying to achieve, to me that's success.
Stefan Wagner: 24:39 The other question I like to ask is what is currently on top of your music playlist? I don't know if you use Spotify or something else. What is it?
Corey Hoffstein: 24:49 I tend to take care of my son first thing in the morning. So I have been going through all these old bands from the late 90s and early 2000s that I was listening to when I was young. And that's just been a lot of fun. So I know I won't necessarily name names, but it's like a lot of these old high school early 2000s, you know, rock bands.
Stefan Wagner: 25:12 Okay, last question. For any listeners who want to follow your work or get in touch, what's the best way to connect with you?
Corey Hoffstein: 25:18 Yeah, so if you want to learn more about return stacking and the concepts of Portable Alpha, you can go to returnstacked.com. We have a whole insights section where we're writing what are hopefully very approachable blog posts that go as deep as you want to go. It's very surface level. You can go to flirtingwithmodels.com if you want to listen to some of the old podcast episodes I have. And then finally, I am on Twitter way too frequently. You can find me @choffstein, and I love to engage with folks on Twitter.
Stefan Wagner: 25:48 Excellent. Thank you very much, Corey.
Corey Hoffstein: 25:51 Real pleasure to be here. Thank you for having me.
