At WJ, perhaps our most important investment principle is that diversification works. That might seem obvious or even cliché, but we take it very seriously.
In a balanced portfolio, we blend traditional stock and bonds with a variety of diversifying strategies such as managed futures, reinsurance, tactical strategies, treasury futures, real estate, and more. None of these are chosen by accident, and their weight in each portfolio is very intentional, balancing the desire to hedge risk with the necessity to grow and keep clients invested in both good and bad periods. In essence, we often prioritize controlling risk over chasing returns.
However, there are times when maximizing return can, and should, be the only goal. If that is the case, broad diversification across different asset classes is less important. Instead, growth is. We’re developing a detailed series on when this will be the case, and we will be sharing that with you soon.
We currently have a growth-oriented benchmark called Equity Aggressive, though it’s always been a fringe portfolio that few clients have ever used, particularly due to the perception of many clients that being 100% in the stock market is just too risky for them. We believe that portfolio is underutilized, and more relevant to our clients than they might realize, so we set out to improve upon it in what we call “Enhanced Growth.”
But before we talk about Enhanced Growth, we need a quick lesson on a portfolio construction tool that allows us to “enhance” our portfolios.
Leveraging Capital Efficiency to Enhance Portfolios
The starting point of any growth oriented portfolio is stocks. Throughout history, stocks generally offer the highest return of any investment without going into either private assets (private equity, levered real estate, etc.), or taking an exceptional amount of risk (individual growth stocks, crypto, etc.)
However, there are other quality asset classes that generate positive returns over time and diversify against stock risk. The problem when building a portfolio is that if you buy these strategies, you have to sell stocks to make room for them. This means willingly accepting a lower return to reduce risk.
But what if that’s not necessarily the case. In the hedge fund world, for example, there is an old concept called portable alpha, which simply means using leverage to layer on exposure to additional strategies beyond what you can buy with your cash.
This has been used by large institutions and hedge funds for decades but has never been accessible to financial advisors or retail investors.
That all changed in October 2020, when the SEC adopted the 18f-4 derivatives rule. This created the regulatory framework that provides clear guidance on how fund companies could use derivatives. (side note: derivatives are a complicated topic beyond the scope of this post, but are mainly futures, swaps and options contracts that have embedded leverage to markets like stocks, commodities, interest rates, etc.)
When this rule was created, a few innovative firms immediately created strategies that had previously only been accessible to large institutions. We were quick to research and adopt many of these strategies into our portfolios, and they’ve had a major positive impact in both our overall returns, but also in the amount of diversification we’re able to incorporate into our portfolios to reduce risk.
The strategy has a few names. Portable alpha, as I mentioned above is one of the oldest, but more recently it’s come to be known as return stacking, or capital efficiency. Without getting too into the weeds on how they work (call us if you want that), these strategies allow you to get more than $1 worth of investment exposure for every $1 you invest. A simplified example for one of these funds is below:
Here you invest $1 in a capitally efficient fund, and you get both $1 of stock exposure and $1 of “extra” exposure. We say “extra” because its invested differently from fund to fund.
In a portfolio, we can sell some of our stock and buy the fund above. This simple example is shown step by step below:
Here we start out in a 50/50 stock/bond portfolio. We sell 20% of stock and buy the capitally efficient fund in the previous example. That fund gives us back that stock exposure we just sold, plus that “extra” exposure.
That “extra” can vary depending on our objective. We can hold cash if we want to wait for more opportunities. We can buy stock if we want to ramp up risk and return. Or we can buy bonds and alternatives if we want to diversify risk.
Leverage often gets a bad rap in finance, and for good reason. We’ve all heard stories of large hedge funds, or you know… banks, that have been overexposed to certain markets, and unraveled when the bet went against them. This is nothing like that.
Keep in mind two things. First, we can control the amount of leverage we use. In most portfolios, we target about 20% ($1.20 for every $1 invested). In contrast, if you buy a house with 20% down, you are 400% levered to the price of your home ($4 of debt for every $1 of invested).
Second, we can control what we buy with that leverage. Leveraging up to buy more stocks, and leveraging up to buy treasury bonds are two completely different things. In the former we are doubling down on our bet, while in the latter we are diversifying.
The end result is a portfolio that is able to benefit from the additional returns of the levered exposures, but without the added risk typically associated with leverage. In fact, historically, drawdowns (i.e., losses in down markets) are often less than they would have been without leverage due to the added diversification.
A final comment on leverage is that it isn’t free. Leverage is primarily achieved using futures contracts, and embedded in their price is the cost of leverage. Fortunately, these contracts are amongst the most liquid in the world, and that cost very closely approximates the rate of 1-3 month T-bills, which is very cheap. So, when we add something to that “extra” bucket, we are adding the excess returns above that cost.
Putting it into Practice
We’ve used the concept of targeted leverage to improve our balanced portfolios (conservative, moderate, aggressive) since it became available to us, and now will apply that to our all stock portfolio, formerly known as Equity Aggressive.
In the Enhanced Growth Portfolio, we will seek maintain an exposure of 100% stocks, while ADDING exposure to treasury bonds and various alternatives. Though “growth” is the core objective of this portfolio, diversification is still a major factor in its construction.
Because Enhanced Growth’s primary objective is maximizing return, it will use more leverage than our balanced models,but will still only use that leverage to buy diversifiers.
We believe this portfolio has a place in many of our client’s retirement plans, and we look forward to discussing it with you in the future. In the meantime, if you have questions about Enhanced Growth or any of the other concepts expressed above, we’d love to speak with you about it.
Upcoming Trades
We have some upcoming trades we wanted to notify you of. First, we will be transitioning all current Equity Aggressive investors to the Enhanced Growth portfolio mentioned above.
Second, we will be consolidating the two positions in the small cap equity bucket to one. These are small positions and there's no reason to have two funds there. We will sell Schwab Funadamental US Small Company (SFSNX) and buy Avantis US Small Cap Value ETF (AVUV) with the proceeds.
If you have any questions about these trades, please reach out to us.
WJ Interests is the largest fee-only firm in Fort Bend County located in Sugar Land, TX. We provide comprehensive wealth management services. Our vision is to ensure every client lives a fulfilling life by making the most of their financial resources.
Learn more about us: https://www.wjwealth.com/
PAST PERFORMANCE IS NOT A GUARANTEE OF CURRENT OR FUTURE RESULTS. Examples of historical information included in this presentation do not, nor are they intended to, constitute a promise of similar future results. Specific client portfolio allocations, risks and returns can and may deviate from these examples depending on accounts and types of investments available through each account. Future market views by WJ Interests, LLC may vary significantly from the historical examples presented herein and no one receiving this summary should assume that WJ Interests, LLC will be able to replicate successful views in the future.