The Power of Return Stacking: Eliminating Cash Drag

Introduction

As asset managers, our primary focus often centers on optimizing investment portfolios to generate returns. Yet, in the broader context of wealth management, it's crucial to consider the entire financial landscape of our clients. Cash reserves play a significant role in this equation. Many investors, including retirees, maintain cash reserves for short-term liquidity needs, comfort, and security. These cash holdings ensure that everyday expenses can be met, safeguarding short-term lifestyle needs, while investment portfolios work toward long-term wealth accumulation. However, the presence of substantial cash holdings can lead to a "cash drag" on long-term returns. In this article, we explore a concept called "return stacking" that offers a potential solution to this conundrum, allowing investors to harness the full potential of their wealth.

Case Study: Cash Reserves in Retirement

Retirement is a life-altering phase, promising newfound freedom and leisure. However, from a wealth management perspective, ensuring financial security in retirement requires balancing short-term comfort with long-term sustainability. Retirees often opt to maintain a portion of their wealth in cash, serving as a financial cushion for immediate expenses. This strategy offers peace of mind, providing retirees with a clear view of their financial situation and a means to cover unforeseen expenditures.

Nevertheless, this approach forces retirees to make a choice: either consistently diminish their investment portfolio to maintain a substantial cash buffer or keep cash reserves to a minimum, relying on investments to support their retirement. The article argues that this doesn't need to be an "either/or" scenario; it can be an "and." Return stacking provides a solution that allows investors to hold significant cash reserves while maintaining a fully invested wealth allocation.

How Return Stacking Changes the Conversation

At the core of the return stacking concept is a simple mathematical equation. The expected return of an entire wealth portfolio (E[Rw]) can be calculated as a weighted average of the expected return of cash (E[Rc]) and the expected return of the investment portfolio (E[Rp]), where the weight is the allocation to cash (c). The equation reads: E[Rw] = c x E[Rc] + (1 – c) x E[Rp].

Return stacking introduces a game-changing notion: what if investors could remain fully invested while accessing a line of credit at an extremely low interest rate, with interest payments automatically deducted from investment returns when the credit is used? This approach essentially enables investors to borrow cash to augment their investment portfolio without liquidating existing holdings.

In this new framework, investors can add back the same percentage they allocate to cash into their investment portfolio. As a result, the cash drag on their wealth is eliminated. The equation with return stacking reads: E[Rw] = c x E[Rc] + (1 – c) x E[Rp] + c x (E[Rp] – E[Rc]). Simplified, this equation yields the same return as the investment portfolio alone: E[Rw] = E[Rp].

In practical terms, if an investor allocates 10% of their wealth to cash, they can employ return stacking to increase their investment portfolio by 10%, effectively offsetting the cash drag.

Two essential considerations are highlighted. Firstly, return stacking assumes that the return on cash (E[Rc]) is similar to the implicit borrowing cost for leverage within the return stacking process. Secondly, investors can choose when and how to repay the borrowing, giving them flexibility in managing their leverage.

How to Implement Return Stacking

Implementing return stacking involves reallocating a portion of the cash allocation to enhance the investment portfolio. For example, in a fund where each dollar invested provides exposure to both equities and bonds, an investor can sell a fraction of their stock and bond positions, using the proceeds to buy a corresponding portion in the fund. This approach releases cash that remains safely in the bank while keeping the investment portfolio fully invested.

The critical advantage of return stacking is that it provides investors with an efficient way to right-size their investment portfolio without liquidating assets. It is akin to borrowing cash for additional investments while having the option to repay the borrowing according to their needs.

How Would This Have Helped?

A backtest of return stacking was conducted in a scenario where investors retained 10% of their wealth in cash, regularly adjusting to maintain this allocation. The investment portfolio was diversified across stocks, bonds, and managed futures, with periodic rebalancing. This approach allowed for a comparison between portfolios with and without cash drag.

The results reveal that, as expected, the total wealth of the investor without return stacking lagged behind that of the investment portfolio due to the 10% cash allocation. With return stacking, the total wealth grew in line with the investment portfolio. This outcome demonstrates that return stacking successfully eliminates the cash drag on wealth.

Conclusion

The concept of return stacking presents a compelling solution to the issue of cash drag on investment portfolios. Investors can now hold substantial cash reserves for short-term liquidity needs and maintain a fully invested wealth allocation. This approach ensures that both short-term financial security and long-term wealth accumulation are achievable. The backtest demonstrates that return stacking effectively mitigates the negative impact of cash drag.

Return stacking introduces flexibility, enabling investors to adapt their leverage to their unique needs and financial conditions. This approach encourages investors to harness the full potential of their wealth without being constrained by the presence of cash reserves.

In summary, return stacking transforms the conversation about managing cash and investments. It offers a way to reconcile short-term liquidity needs with long-term wealth goals, providing investors with a powerful tool to maximize returns and achieve their financial objectives.

This article is a summary of https://returnstacked.com/cash-drag-liquidity-needs-and-return-stacking/ additionally, pictures and graphs are from that site.

Silicon Valley Bank and Interest Rate Risk

You have likely heard by now that Silicon Valley Bank and its parent company SVB Financial Group (Nasdaq:SIVB) failed as a bank on Friday last week.  There were a number of influences that together spelled the downfall of the bank.

In 2020 through 2021 Silicon Valley Bank took in incredibly high deposits through PPP loans and through their clients that were taking their companies public through a SPAC (Special Purpose Acquisition Vehicle).  The bank took those deposits and decided to invest in long-term bonds such as mortgages and treasuries while interest rates were low.

2022 was a very different year and not only did Silicon Valley Bank’s unique customer base of private companies start to need cash and so pulled their deposits but also interest rates increased which impacted the mark-to-market value of their longer-term bonds.  The bank, in an effort to appropriately deal with the impact of mark-to-market losses, used a valid accounting change to consider those bonds “held to maturity”.  Any bonds that are held to maturity do not need to be updated with the market value but can be held on the books at cost.

Unfortunately, Silicon Valley Bank was unable to hedge their interest rate risk for any bonds that are in the “held to maturity” category as the accounting rules say that any bond that is hedged is not considered "held to maturity" and thus be marked at current value.

The combination of reducing deposits and too few assets that were marked at the market forced the bank to sell their held to maturity bonds to meet withdrawals by their customers.  When the bank sold the mark-to-market securities they were forced to realize the losses and those losses effectively overwhelmed the bank equity causing the bank to fail.

This all happened over the course of a week and really over 2 days.  The stock was worth $267.90 close of business Wednesday and worthless by the close of business Friday.

Did Silicon Valley Bank do anything wrong? The bank did not break any rules as they are written but they also did not effectively hedge their interest rate risk.  Their poor risk management ultimately spelled their doom.  It would have been easy enough to reduce purchases of so many long-term bonds back in 2021 but the appeal for the bank to make a little bit more money on their deposits was likely too strong.  Also how many market participants expected the Federal Reserve to raise interest rates so much so quickly?  They were caught offside.

Some have said it was a “bank run.” Is that right? Yes, when depositors realized that the banks tangible equity was falling, those who have more than the FDIC insured limit of $250,000 decided to take their additional savings out to be safe.  Some depositors also wanted higher interest rates they could achieve with a money market fund (4.5% vs. 1% at many banks), and finally many of their depositors needed money because their startup businesses were not as successful due to the market environment.

Is this a risk for the big banks (over $250B in assets)? No.  Big banks are stress tested regularly and are required to hedge their interest rate risk.  As a result those banks are not at risk of the same problems from Silicon Valley Bank.

What about smaller banks? Yes, some smaller banks with more aggressive treasury operations (what they choose to do with the deposits and how they hedge or not) are at risk.  Signature Bank of New York has also been seized by regulators and there are other midsize (less than $250B in assets) banks that seem to have low tangible equity.  Banks can be notoriously hard to analyze so I expect many who invest for dividends to find greener pastures.

Impact to the market? We’re not sure yet how this will impact that market other than introducing more volatility.  Some think the Fed must stop raising interest rates immediately to stem the losses of these poorly performing long-term bonds on bank balance sheets, while others think the Fed needs to continue to raise rates to combat inflation.  One thing is certain – bond market volatility as measured by the MOVE index is likely to be heading higher.  Last year when the MOVE index went higher, financial conditions tightened and the stock market declined and the economy slowed.  It is likely that will be the case again in 2023.

We invest for long-term returns and recognize events like this do happen.  Depositors will end up being OK. Equity holders of the banks will not.  If you have any questions about this or your portfolio, please give me a call.