Risk Parity Resources: Gordillo et al. (2021)

"Return Stacking: Strategies for Overcoming a Low Return Environment"

Not exactly RP, but adjacent to it. This is an industry white paper about one way to use leveraged funds to free up space in the portfolios to make them more balanced. Authors are influenced by Risk Parity principles, and provide ideas for implementation, even though they call it something else.

Read the original:

Return Stacking:
Strategies For Overcoming a Low Return Environment

You will need to put in your email address and assent to receiving more information. You can also read a copied and pasted version of the paper here, though the formatting is not as attractive.

Important Points for the RP Investor:

Investors these days are often faced with a dilemma: go for returns and take on concentrated risk, or diversify risk and expect lower returns. The trend is more towards the first option. In order to boost returns, most investors wind up “reaching for yield,” by concentrating allocations on riskier assets. Think of it like stacking coins higher and higher in a stack - the higher it gets, the greater the risk of toppling. The safer alternative would be to make a few smaller stacks, lowering the risk that one will topple, but then you’re are devoting more of your capital to lower-producing assets. Even though such investors acknowledge the risk of focusing on equities, the lower returns expected from a more risk-balanced portfolio are insufficient, leaving investors in a bind.

Consistent with the tenets of Modern Portfolio Theory, the authors Rodrigo Gordillo, Corey Hoffstein, and Adam Butler, introduce the term “Return Stacking,” as a way forward. Simply put, this is the strategic use of leverage to increase equity or bond exposure while saving room for greater investment in risk-balancing alternatives. For ReSolve, this means creating and selling funds to investment managers that use financial derivatives to up their exposure to stocks/bonds, and then actively manage the remaining capital allocations. The image here is of having multiple stacks of coins and using leverage to  bring them high enough to provide satisfactory returns:

"The use of derivatives to provide core beta exposures and free up capital is called 'capital efficiency.' The allocation of the residual capital to excess return sources we call Return Stacking" (page 4).

The beginning section of the paper lays out the case for how “return stacking” can provide a way out of the investor’s dilemma. Next, the authors present a few general approaches to stacking returns. On page 4, the authors go over one of the the simplest: use WisdomTree’s US Efficient Core ETF (NTSX), which uses leverage on Treasury futures to essentially achieve a 90/60 stock/bond allocation, then devote the portfolio real estate freed up by that leverage to invest in diversified asset classes. If instead of 60% of the portfolio in stocks, and 40% in bonds, one could instead devote 67% to NTSX (which is leveraged to mimic the returns of that 60/40), and then the remaining 33% to diverse assets such as commodities, real estate, investment-grade corporate bonds, or whatever. The returns from these asset classes in the space created by the use of leverage are “stacked” on top of the 60/40. On pages 6 through 10, the authors present more sophisticated examples of portfolios following their principles.

The authors introduce “Return Stacking” as a trademarked term, and describe it as a “novel investment concept, accessible to all investors, which is designed to seek higher returns with less risk.” Yet it isn’t that novel, though I understand the need to carve out space in the competitive investment industry. Really, it’s the same  ideas that Ray Dalio covered in his 2011 paper, “Engineering Targeted Returns and Risks.” You can read my full write-up of the paper here, but, basically, Dalio advocates using moderate leverage to create risk-balanced portfolios that still have the same total exposure to stocks and bonds. “Return Stacking” is also another way of describing what I call the second of the two paths for Risk Parity portfolios.

Two Paths of RP
RP approaches are diverse, but at a basic level, follow one of two paths. They are not necessarily risky nor safe, but do provide a framework to balance assets at different degrees of total risk.

The paper concludes with some summative thoughts on Return Stacking as a concept for widespread adoption. On page 10, they acknowledge the aversion many people have to using leverage, though they answers those fears well, noting that prudent use of leverage can lower risk, and anyway, leverage is used more commonly than most people realize, with mostly benign impact (leverage to  buy houses,  investing companies  which themselves are leveraged, etc.). On page 11, the authors note that a drawback of Return Stacking is higher fees for investors (true, the use of leverage through embedded leverage ETFs is much higher than with regular ETFs; the interest rate for margin loans  even higher, if you go that route). The authors counter that increased diversification, increased exposure, and rebalancing benefits make up for higher costs. They also claim that the higher returns are worth it, and provide evidence of how Return Stacking has beaten a traditional 60/40 over the past twenty years.

All things considered, probably worth a read for RP investors, especially those using or thinking about using leverage. While not mentioning Risk Parity by name very much, it nevertheless has a great deal of practical insight for RP investors. Also, easy to read and to the point.

Extra Resources

This paper’s authors are Rodrigo Gordillo, Corey Hoffstein, and Adam Butler. It was published by ReSolve Asset Management, a Canadian asset management group, and Newfound Research, a quantitative investment research firm out of Boston. Gordillo and Butler are with the former; Hoffstein with the latter.

This is the roughly the same group that produces a podcast called Gestalt University, which is pretty advanced and very much geared towards professional investment managers, but is still worth a listen if you’re hungry for more commentary on portfolio construction. Thai episode, in particular, is focused on this Return Stacking Paper (also available in podcast form):

Gordillo and Butler, along with ReSolve CEO Michael Philbrick, also wrote Adaptive Asset Allocation, which is at the top of my reading list:

Adaptive Asset Allocation: Dynamic Global Portfolios to Profit in Good Times - and Bad: Butler, Adam, Philbrick, Michael, Gordillo, Rodrigo: 9781119220350: Amazon.com: Books
Adaptive Asset Allocation: Dynamic Global Portfolios to Profit in Good Times - and Bad [Butler, Adam, Philbrick, Michael, Gordillo, Rodrigo] on Amazon.com. *FREE* shipping on qualifying offers. Adaptive Asset Allocation: Dynamic Global Portfolios to Profit in Good Times - and Bad