First and foremost, we need to choose what we want to stack on our portfolio.  In theory, we can stack just about anything.  In practice, however, we want to consider at least two important points.

First, how similar is what we’re stacking to what we already own?  Ideally, stacking allows us to introduce new, diversifying sources of return.  Here we want to consider not just how the exposures behave on average, but in the tails as well.

Second, we want to think about liquidity.  Stacking highly illiquid assets (or even just funds with a higher probability of gating redemptions in a stressed market environment) can prevent you from rebalancing during periods of market stress, potentially causing significant misalignments with intended risk profiles.

When stacking, it’s important to remember that we’re implicitly borrowing money, which means there is a financing rate.  Fortunately, the embedded financing rate in derivatives like equity and bond futures is usually quite low; historically, they have been in the range of 1-3 month T-Bills and/or the SOFR rate.  Other derivatives that can enable stacking, like swaps, may have different embedded costs.  We also need to consider the fees of any fund wrapper as well as the potential tax implications of how we’re implementing return stacking (see checklist item #8).

Taken together – financing rate, fees, and taxes – we create an embedded hurdle rate that our stacked exposure has to overcome before it can add any excess returns to our portfolio.  Understanding this hurdle rate is critical for setting expectations as to the potential value a given exposure can contribute.

The size of the stack is a critical component in defining the potential portfolio impact, including both the contribution to return and risk.  As a simple rule, the size of the stack times the exposure’s volatility will tell you, in the worst case scenario, how much more volatility and tracking error you’re adding to your portfolio.

For example, if you want to stack a 10% exposure to a managed futures program with a volatility of 15%, you’d multiply 10% by 15% and find that you’d be adding 1.5% to portfolio volatility and tracking error.  On the other hand, if you’re looking to stack short-term, high-quality corporate bonds that have a volatility of 3%, a 10% position would just add up to 0.3% to the risk and tracking error profile.

As we can see, what you’re stacking can heavily influence the appropriate size of the stack.  Stacking equity on top of an equity heavy portfolio will just add risk.  Stacking an uncorrelated asset or strategy might actually reduce risk.  For example, stacking managed futures on a 60% stock/ 40% bond portfolio has historically reduced drawdowns.

You can explore how different assets and stack sizes have historically impacted returns and risk with our return stacking visualizer tool.

Once you have figured out what you want to stack and the size of the stack, you need to figure out how you’re going to implement the stack.  In some cases, the exposure may already exist pre-stacked in a fund.

For example, if you want to stack an alternative strategy, funds may already exist that simultaneously provide that alternative strategy and either stock or bond exposure.  This can make implementation much easier, as you simply need to replace the appropriate amount of stocks (or bonds) with the pre-stacked fund.  In the figure below, we show an example of how a 100% Bond / 100% Alternatives fund could be used to stack either 20% or 40% alternatives exposure on top of a 60% stock / 40% bond portfolio.

However, not all exposures exist in stacked formats.  Or, perhaps, a strategy does exist in a stacked format, but you have a preferred manager for that strategy and they do not offer a stacked version.  In this case, you need to figure out how to free up room in your portfolio other ways.