A New Way to Tackle This Market Moment
A strategy called ‘return stacking’ can free up part of your portfolio.
3 min
When there’s nowhere to run, nowhere to hide, what do you do?
U.S. stocks aren’t far from their all-time highs, while the income investors can earn from bonds is a pittance. So investing in stocks feels risky, and bond yields are too thin to do you much good.
The obvious solution is to diversify: outside the U.S., outside of stocks and bonds, and into assets that can protect you from bear markets or an inflationary shock. To do that, you’d normally have to sell some stocks or bonds to free up cash.
That isn’t the only way to diversify, though. Some investors engage in a tactic they like to call “return stacking.”
An illustration of this odd-sounding approach is an exchange-traded fund, WisdomTree U.S. Efficient Core, with $676 million in assets and 0.2% in annual expenses. Since its launch just over three years ago, it has slightly outperformed the S&P 500, after fees, with a smoother ride.
The fund takes a novel approach to diversification. It keeps 90% of its assets in a portfolio of stocks highly similar to the S&P 500 index. It keeps 10% in cash and cash equivalents. It then uses that cash as collateral to buy futures contracts on U.S. Treasurys.
Those futures are a low-cost form of leverage, or borrowing. This gives investors more bang for their buck. For every dollar you invest, the fund provides $1.50 in exposure to stocks and bonds.
And here’s the crucial point: Of that $1.50, 90 cents (or 60%) goes into stocks and 60 cents (40%) into bonds.
That creates the functional equivalent of owning a so-called balanced fund, with about 60% in U.S. stocks and 40% in U.S. bonds, one-and-a-half times over.
It also creates flexibility for an investor.
Imagine you have $3,000. You could stash it all in a balanced fund. Or you could achieve the same result by putting just two-thirds of it in a fund like this. That’s because the fund leverages your money 1.5 to 1. So you can invest less and use the rest of it to buy other assets.
“You get the same exposure for less capital,” says Jeremy Schwartz, global head of research at WisdomTree Investments Inc. in New York, the Efficient Core fund’s sponsor. This way, you still have $1,000 left over, and “that cash option is valuable,” Mr. Schwartz says.
Corey Hoffstein, chief investment officer at Newfound Research LLC, an asset-management firm in Wellesley Hills, Mass., calls this “return stacking.”
On top of your $2,000 stack of stocks and bonds, you could put your remaining $1,000 into assets that could hedge their risks—a commodity fund, perhaps, or inflation-protected I bonds from the U.S. government.
Wait a minute. Isn’t leverage dangerous?
Long-Term Capital Management, Lehman Brothers and China Evergrande all imploded because they borrowed too much money at too high a cost. So did speculators in the crash of 1929 and the South Sea bubble of 1720.
Moderate amounts of cheap leverage, however, can raise returns without sending risks through the roof. That approach isn’t radical, reckless or even new.
In the 1950s, economist James Tobin, who would later win a Nobel Prize for his research, demonstrated that investors could raise their return not only by buying riskier securities, but also by buying safer securities using leverage.
In a 1996 article, Cliff Asness, co-founder of AQR Capital Management in Greenwich, Conn., found that between 1926 and 1993, a 60/40 portfolio bought with about 50% borrowed money would have lost less in its worst month than an unleveraged 100% stock portfolio did. Those results have held up since then.
The world’s most renowned investor, Warren Buffett, has long relied on float, or insurance premiums that come in before claims have to be paid out, to amplify Berkshire Hathaway’s returns. Mr. Buffett has used that low-cost leverage—“money we hold but don’t own”—to crank up the capital he can deploy. That has given Berkshire “quite an edge,” he has said, “over our competitors.”
At least five years ago, several people with Twitter accounts, including the anonymous @Nonrelatedsense and @econompic, along with Mr. Hoffstein, began chatting about how investors could leverage Treasury bonds to improve the efficiency of their portfolios.
The anonymous author of the @Nonrelatedsense account died in 2019, but his tweets helped inspire WisdomTree to create the ETF, says Mr. Schwartz. (Besides its U.S. fund, WisdomTree also offers versions that combine the same cash and futures exposure with either international or emerging-market stocks.)
Other firms, including Pimco, DoubleLine and Newton Investment Management, offer funds that may use futures to leverage portfolios of stocks and other assets, although they are held primarily by institutional investors.
“Return stacking” on top of this kind of leveraged fund makes good sense when you have a finite amount of money to put to work for the long run—perhaps in your individual retirement account, a Roth IRA or a gift to one of your kids or grandchildren.
Over long horizons, interest-rate fluctuations should wash out, compounding should have time to work and diversification can do magic. Then a little leverage can be your friend, not your enemy.
Copyright 2020, Dow Jones & Company, Inc. All Rights Reserved Worldwide. LEARN MORE
This stylish family home combines a classic palette and finishes with a flexible floorplan
Just 55 minutes from Sydney, make this your creative getaway located in the majestic Hawkesbury region.
The best course when stocks slide is for investors to stand pat, but ‘put’ options are one way to hedge against a drop and lock in some profits
5 min
The past five years have been good to stock-market investors. The S&P 500 index has climbed an annualised 12% during that period, outstripping the 9% annualised gain over the past 40 years. This year alone the index is up 6.9% as of April 26, tacking on to the 24% gain in 2023.
But signs are emerging that the stock market could be due for a breather. As of April 25, the S&P 500 went 133 trading days without a decline of at least 10%, according to PNC Institutional Asset Management. To be sure, that’s still short of the 172-day average since 1928. But the S&P 500 has jumped 24% in the past six months (about 180 days), which buttresses arguments for a correction.
What’s more, the multiyear ascent has arguably sent stocks to overvalued levels. The S&P 500’s forward price-to-earnings ratio—a gauge of market valuation based on earnings estimates for the next 12 months—registered 20 as of April 26, exceeding the five-year average of 19.1 and the 10-year average of 17.8, according to FactSet.
“A correction is certainly possible,” says Jack Ablin , chief investment officer at wealth-management firm Cresset Capital, pointing to the high valuations and the prospect that rate cuts will come later than expected thanks to inflation that has been higher than expected.
Given the danger of a stock-market correction, commonly defined as a 10% to 20% drop, how can investors guard the profits they have made in recent years?
Wait and see
Assuming you have a well-diversified portfolio and aren’t counting on the money from your stocks to finance an imminent expense, financial advisers say the best strategy is to hang tight.
Corrections generally don’t stick around long. Since 1985, declines between 10% and 20% for the S&P 500 have lasted only 97 days on average—three-plus months—according to a CFRA analysis of S&P data.
It then has taken the market an additional 101 days on average to recover the ground lost during the correction. So in about six months, investors tend to be back where they were before the correction.
“If there’s a shallow correction of 5% to 10%, we recommend riding it out,” says Karim Ahamed , an investment adviser at wealth-management firm Cerity Partners. “Eventually the market recovers. The idea of selling out and climbing back in is difficult to achieve. You’re more likely to stay on the sidelines with your losses crystallising.”
The S&P 500 did fall more than 5% in recent weeks, from March 28 to April 19.
Sell losers
Some people, though, simply find it impossible to do nothing if they fear a correction is looming. At the least, they want to protect the gains they have earned so far. What’s the most prudent way for them to reduce their market exposure?
Keep in mind that most actions you can take to guard your stock profits carry a cost. The easiest method, selling stocks, subjects you to capital-gains taxes unless you are selling from a tax-advantaged retirement account. That tax rate varies according to your income, but will likely be 15%.
One way to limit the burden is through tax-loss harvesting, says Amanda Agati , chief investment officer of PNC’s asset-management group. That is when you sell stocks at a loss, lowering your net capital gain. If you have any dogs in your portfolio—stocks with poor fundamentals—you can unload those.
If you do sell stocks, you could put the proceeds into a money-market fund for now, financial pros say. Many such funds yield 5% or more, far higher than rates over the past 15 years. Or if you want to increase the safety of your overall portfolio, you could put the money into safe government bonds. Three-year Treasury notes yield around 4.75%.
Play defence
If you are going to unload stocks, but don’t want to sell right away, you can put in a stop-limit sell order through your brokerage. That order can automatically sell your shares if they slide to a level you designate (they can go below it, too), protecting you from big drops.
Say you bought 100 shares of Tesla at $140, and they are now trading at $165. If you don’t want your profit to disappear in a downturn, you could enter a stop-limit sell order with your brokerage at $150 for some or all of your shares. Those shares can be sold if the price reaches $150, securing some of the gains.
You also might shift your holdings more toward defensive stocks, such as utilities and consumer-staple companies, which generally outperform during market downturns, says Michael Sheldon , executive director of wealth-management firm RDM Financial Group.
PNC’s Agati suggests an emphasis on quality stocks, those with high recurring revenues, strong and dependable profit margins, high cash flow and low debt. These stocks—such as AutoZone and Visa , she says—have lagged behind the leaders of the market’s surge over the past year.
Consider options
Advisers also suggest looking at “put” options to protect your stock gains. Puts give you the right but not the obligation to sell a security at a preset price by a preset deadline.
Note that we’re talking about a risk-reduction approach here, not the kind of risk-taking—to try to amplify returns— that has been rampant in the options market . The simplest strategy could be to purchase a put option on a market-index exchange-traded fund, such as one based on the S&P 500. You could buy puts on individual stocks rather than an index ETF, but that may get expensive and complicated as each option carries a purchase premium.
Here’s how the ETF strategy would work: First, buy an option that would let you sell the ETF at a price below the current one, protecting you from declines beneath that level. You wouldn’t have to sell the ETF, and you wouldn’t even have to own it. As the S&P 500 falls, the put option gains in value, and you can sell it.
Say on April 16 you wanted to protect 100 shares of SPDR S&P 500 ETF Trust (SPY) from a decline of more than 10%. With the ETF trading at $505 a share, you could buy an option that covers 100 shares for $1,050, or $10.50 a share. You’re paying a premium equal to 2% of your position.
The option’s expiration date is December, and its strike price is $455 a share, or 10% below the current value. The strike price is the price at which you could exercise the option. But generally you sell the option rather than exercising it, so you don’t have to dump any shares, especially if you don’t own them.
If the market doesn’t go down 10% by December, you let the option expire worthless, and you’re out the $1,050 you paid for it. If the market drops more than 10%, you can sell your option at a profit whenever you want until December.
While it might be more lucrative to sell it early, Ablin recommends holding until expiration if you’re using the option to protect your portfolio. “Think of it like homeowner insurance,” he says. “You pay a premium, like a deductible for insurance, and your coverage runs for a term.”
Keeping the option until expiration extends your coverage for the longest possible period.
By using options, you don’t have to sell any of your stocks, which are typically the best asset to generate strong long-term returns. “If you have the wherewithal to hold the S&P 500 for 10 years, your odds of making money are over 90%,” Ablin says.
Consumers are going to gravitate toward applications powered by the buzzy new technology, analyst Michael Wolf predicts
Just 55 minutes from Sydney, make this your creative getaway located in the majestic Hawkesbury region.
