Return Stacking: The Best Portfolio Strategy You've Never Heard Of (Part 1, PSLDX)

Summary

• Return stacking allows you to get exposure to $1.00 of assets without putting up $1.00 in cash.
• This means you can build a more diversified portfolio than you could otherwise and get a higher return for the same level of risk.
• PSLDX is a fund you can use to execute this strategy with only a few clicks of a mouse.
• Other ETFs you can return stack with, which I will cover more in depth in future pieces.

YelenaYemchuk/iStock via Getty Images

Many of the greatest minds in finance freely published their work over the last century, available to read for anyone with an internet connection today. You might not know their names, but their work lays out the most efficient ways to beat the market. Fortunately for us, using classic finance theory to beat the market is far less labor-intensive than picking stocks.

Harry Markowitz introduced modern portfolio theory and the efficient frontier to the world in 1952, while John Kelly developed the Kelly Criterion in 1956. Ed Thorp published Beat the Dealer in 1966, popularizing counting cards in blackjack. Bill Gross read Thorp's work and went on to co-found PIMCO, applying the theory he learned at the blackjack tables in the financial markets. One thing that all of these individuals have in common is that their research and financial market investments were able to take advantage of return stacking.

What is return stacking?

The basic idea behind return stacking is that you don't need to tie up $1.00 to get $1.00 of exposure to any given asset. Futures generally let you get exposure to an asset for 5% or less in margin (at the cost of LIBOR or less, depending on the asset), leaving the rest of your capital free to invest elsewhere. I've written about futures extensively on this site, but many readers find them intimidating, so I'll share mutual funds and ETFs that will do everything behind the scenes for you – all you have to do is point and click.

Why does it matter that you don't need to tie up your money to get full exposure to an asset? Well, the idea is that you can use the excess money to diversify your portfolio and find returns elsewhere. For a basic example, if you're able to use return stacking on the S&P 500 (SPY) using futures, you can invest the remaining money in bonds (BND) and get the returns of both assets. Return stacking can also ensure you market exposure while freeing up capital to invest in preferred stocks, municipal bonds, individual stock picks, or commodities.

Return Stacking SPY + BND (blue) vs. S&P 500 (red)

Source: Portfolio Visualizer

Freeing up your capital would have allowed you to earn a higher absolute return, a higher risk-adjusted return, and a lower maximum drawdown in 2008. Leverage can be complicated to implement, but fortunately, there are products that will do this for you at a low cost, which I will cover throughout this month.

Return Stacking With PIMCO StocksPLUS Funds

PIMCO launched a product in 1986 called StocksPLUS. Most investors don't know what StocksPLUS is, but it's a strategy that allows you to get stock and bond exposure in one product. This strategy isn't too different from the one I detailed in "How I'd Invest $1 Million", one of my most popular pieces on Seeking Alpha. I've improved the strategy from the old article, and I'll share some ideas today for readers.

StocksPLUS works by building a bond portfolio, and then putting S&P 500 futures exposure on top. For example, if I have $1,000,000 to invest, I could get $1 million in bonds and also layer $1 million in S&P 500 futures with about 5% margin posted at the exchange. Stocks and bonds both tend to return higher than cash, and they're not correlated with each other historically, so the returns beat the market more often than not. The most popular product from PIMCO that uses this is StocksPLUS Long Duration (MUTF:PSLDX), which recently cut its management fee from over 1% to about 0.60% per year (thank Vanguard for this), making it a better product today than it has been in the past.

Source: Portfolio Visualizer

The returns have been great, due to three factors.

1. Stocks have had a positive return.
2. Bonds have had a positive return.
3. Stocks and bonds have been negatively correlated, meaning that the fund has been able to buy low and sell high by rebalancing.

From here, we can plug in some basic capital market assumptions to guesstimate the futures returns of PSLDX.

PSLDX has returned over 17% since inception. Some of this is luck, and some is due to skill on the part of the design of the fund. It's difficult to predict the future, but we can make an educated guess about what PSLDX will return in the future.

1. Stock return= 8.5% annually
2. Long duration bond returns minus PIMCO's management fees = 2.75% annually
3. Rebalancing bonus = 0 percent annually (I'll assume zero here to be conservative)
4. Financing cost = minus 0.25% annually

These combine for a roughly 11% expected return to PSLDX, which is lower than the historical returns, but higher than the market. Do note that this assumes cash rates are zero–financing costs will increase if interest rates rise. There's no guarantee that long-term bond yields will surge if cash rates rise, market participants might actually buy bonds if they expect a recession to follow interest rate hikes, so I don't make any assumptions about future bond prices from here. There are ways that PSLDX could return better than my expectations, for example, if the S&P continues to be unstoppable, PSLDX would have higher returns. The same would be true if the S&P does worse in the future.

Analysis & Criticism of PSLDX

Seeking Alpha author Left Banker recently published a nice essay on the merits of PSLDX and recommended holding it in a tax-advantaged account due to the potential tax implications. This is sound advice, but I'd like to expand on this here to show why I believe PSLDX is also a good investment in taxable accounts.

The main criticisms of PSLDX tend to fall into two camps.

1. The first camp says that increased taxes make PSLDX an unattractive investment even though it looks good initially (this group often extends tax arguments to any active investments).
2. The second camp says that rising rates will cause both stocks and bonds to crash (or at least go into simultaneous bear markets).

1. Taxes

Taxes are an important component of investing. As an investor, your goal should be to maximize your returns after tax. Many investors confuse this, in my view, with their goal being paying as little tax as possible. PSLDX uses S&P 500 futures for the stock component, the bond coupons are taxable as interest, and capital gains on the bonds are typically taxed as long-term capital gains. Futures benefit from section 1256 taxation, which means that gains are 60 percent long term and 40 percent short term, regardless of holding period.

I've tried to build a model in Excel to compare section 1256 taxes to holding SPY using some "if-then" algorithms, but things got really complicated really quickly. For example, SPY holders are taxed on dividends, which blunts some of the impact of deferring taxes. Section 1256 has a loss carryback provision, which means if you've paid taxes in years past, you get that money back if the market is subsequently down for a year! For example, what would a $100,000 tax refund in April 2009 be worth from a $1,000,000 investment? You'd have been able to buy at the exact bottom when you needed money the most. SPY also has management fees that need to be accounted for. Then there are state income taxes, and changes in both the Federal and state rates over time which made historical comparisons difficult.

A paper I like to reference from Northern Trust shows that section 1256 taxation is actually good compared with normal taxation, while investors tend to dramatically overestimate the benefit of tax deferral vs. the value of diversification. Other advisors have pointed out some holes in the theory that deferring taxes indefinitely is actually feasible for most investors. The tax disadvantage for holding a fund like PSLDX is hard to exactly pin down, but I believe it's less than 50 basis points annually over a market cycle for the futures component. This could even be a tax advantage when you account for loss carryback treatment in volatile years. Finally, the taxes on the bond component are on returns you wouldn't earn otherwise.

Taxes are fairly complicated, but the argument you should NOT make against funds like PSLDX is to compare the 17.3% return of PSLDX against the 10.5% return of SPY over the same period and apply federal and state taxes to PSLDX without also applying them to SPY. After all, if you want to spend the money you make in the market, you have to sell. I know that the buy, borrow, die strategy is currently en vogue, but it has costs in terms of interest and margin call risk that I don't like, as well as the risk that Congress simply changes the law before they realize much benefit from it.

PIMCO doesn't have good distribution relationships with every broker, but PSLDX is easily accessible through Vanguard, Etrade, and Interactive Brokers, the three brokers I was able to immediately check. Your trusted CPA is going to be the final word on anything you read on the internet, but I think the tax treatment of PSLDX isn't too bad from the analysis I've done.

2. Rising Rates

Another argument against PSLDX and similar investments is that interest rates will soon surge and that it will cause PSLDX to drop much more than stocks. This is a valid argument, but since PSLDX invests in high-quality bonds I would expect that the bond portion of the portfolio will arrive at the eventual return implied by the current pricing, even if rising rates mean that the path to get there isn't smooth.

The general rule of thumb is that if the duration of your portfolio is longer than your investment horizon, then rising rates will hurt you.

But if your investment horizon is longer than the duration of your portfolio, then a rate shock is actually beneficial in the long run, even if it makes you lose some money in the short run.

Interest Rate Shocks vs. Treasury Returns

Source: Alliance Bernstein

PSLDX has a lot of duration, by my last measure about 16 years. This is about the same as TLT, the most popular 30-year Treasury fund. But the beauty of return stacking is that while PSLDX has a lot of duration, duration is something that you can control at the portfolio level. If you invested all of your money in PSLDX, then rising rates would represent a big risk for you. But if you're able to take advantage of rising rates by rebalancing, then fluctuations in interest rates actually represent an opportunity for you to buy low and sell high. Stocks and bonds are both richly priced compared with historical metrics, but I much prefer the approach taken by PSLDX and similar funds to concentrating too much in the S&P 500 and risking a market like we saw in the early 2000s.

Conclusion

Return stacking allows you to get $1.00 of exposure to an asset for less than $1.00. This allows you to earn more return for the same risk, or to reduce the amount of risk you need to take to earn the same return. In future parts to this series, I intend to cover other return stacking funds such as NTSX and TYA, that expand on these ideas and allow you to be more diversified than you could be otherwise, and to explore some ways to reduce the risk for the strategy such as investing internationally, investing in preferred securities, and investing in commodities through low-cost funds like Vanguard's quantitative commodity fund (VCMDX), another return stacking fund.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.