A New Way to Tackle This Market Moment

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.