The Concept of Return Stacking with Corey Hoffstein

Episode Summary

Executive Summary: Corey Hofstein discusses his path from aspiring game programmer to quant investor and founder of Newfound Research, then explains how backtesting, market structure, liquidity cascades, portable alpha, and return stacking shaped his philosophy. He argues that markets are mostly efficient but can become fragile under leverage, passive flows, and forced selling, and that diversification is best implemented through capital-efficient structures.

Main Topics: Hofstein’s career origin and entrepreneurial path (Priority: 5/5): He expected to build video games, learned programming early, then shifted into quant finance at Cornell and Carnegie Mellon. A college research model unexpectedly became a business after a Boston asset manager paid him in basis points and the strategy grew large. Backtesting, model misuse, and regulatory skepticism (Priority: 5/5): Hofstein explains how a client allegedly misrepresented his research as a live strategy, triggering SEC scrutiny. That episode made him wary of backtests as marketing tools, even while acknowledging they can be useful for due diligence when honestly presented. Factor investing, trend following, and capital preservation (Priority: 4/5): His investment philosophy developed through screening stocks and studying value, momentum, and trend. He emphasizes downside protection, notes the limits of sample sizes in market history, and favors trend following as a more robust capital-preservation tool than simplistic factor narratives. Portable alpha and return stacking as capital-efficient diversification (Priority: 5/5): He defines portable alpha as layering diversifying returns on top of core exposures using futures and swaps. Return stacking is his more accessible framing, designed to help investors keep core exposures while adding diversifiers like managed futures, gold, or carry strategies. Liquidity cascades, market fragility, and crisis dynamics (Priority: 5/5): Hofstein’s liquidity cascades work argues crises are usually multi-causal: Fed policy, passive investing, and derivatives interact to amplify selloffs. He highlights 2020 examples like market-maker balance sheet strain and mispricings between bond ETFs and mutual funds. Product design, ETFs, and investor behavior (Priority: 4/5): He moved from research to fund management to control implementation and messaging. He prefers ETFs because of tax and operational efficiency, but stresses that product structure should match the strategy and that advisors need building-block tools that reduce behavioral friction. Crypto, NFTs, and opportunistic trading during lockdowns (Priority: 3/5): During the pandemic he explored crypto and NFT markets, describing them as a temporary but highly mispriced environment dominated by retail trading, leverage, and limited arbitrage before the 2022 unwind closed the opportunity set.

Key Arguments: He believes his early business success came from an accidental but real market need: a quantitative model licensed to a firm that scaled dramatically, proving the research had value even before he built a fund company. The SEC episode reinforced that backtests can be abused as marketing, but he argues honest historical analysis still has value for stress testing and understanding how a strategy might behave in crises. He sees trend following as attractive because it can help cut downside risk and because no one can reliably forecast macro cycles across a small number of historical recessions. He argues that value investing, while useful in some periods, is not consistently defensive across regimes; its apparent safety in the dot-com crash was not universal and failed in other crises like 2008. He defines diversification as a funding problem: adding an asset usually requires selling something else, which creates both a return hurdle and behavioral challenges for investors. Portable alpha/return stacking solves that problem by using leverage-efficient exposure to core assets so investors can add diversifiers on top without giving up their benchmark portfolio. He argues leverage is not inherently bad; it is a tool that can either magnify risk or unlock diversification benefits, depending on what is being stacked and how liquidity is managed. He thinks 2008 damaged the reputation of portable alpha because margin calls, redemption freezes, and counterparty risk made the strategy operationally fragile, not because the concept itself was flawed. He believes modern market fragility comes from interacting forces rather than a single villain: ultra-low rates, passive flows, market-maker concentration, and derivatives all reinforce one another. He favors ETF-based return stacking for RIAs and other allocators because it simplifies access to institutional-style tools and helps clients stick with diversifiers during long underperformance periods. He thinks many investors unnecessarily play the game on hard mode by trying to time markets or pick stocks in the toughest universe, when easier paths to their objectives often exist.

Data Points: Years running Newfound Research: 16 years - Hofstein says the business was never intended to still exist this long, but it grew out of his college research. Initial client size that used his model: from zero to several billion dollars - The Boston asset manager’s strategy based on his models scaled rapidly after licensing. Client assets at time of SEC scrutiny: $13 billion - The asset manager’s business was large enough to trigger a routine SEC exam. Client assets later: $25 billion - Hofstein says the business kept growing during the SEC investigation before later collapsing. SEC inquiry outcome: No further inquiries - He says the SEC eventually stopped pursuing him and issued a letter saying it was not pursuing further inquiries. Portable alpha adoption pre-2008: 25% of major U.S. pensions and institutions - He cites this as evidence the concept was widely used before the financial crisis. Return gap in alternatives: Hundreds of basis points - He says investor returns in alternative categories can lag investment returns by this amount because investors chase performance. March 2020 bond ETF discount: 6–7% discount - He describes a period when a Vanguard bond ETF traded materially below the mutual fund NAV. Market decline in 2007-2009: 50% to 56%+ - He references the S&P 500’s drawdown during the financial crisis in discussing margin pressure. Current assets in Return Stacked ETF suite: over $800 million - He says the suite crossed this level roughly 18-20 months after launch. Number of Return Stacked ETFs: 5 - He describes five ETFs with different core exposures and overlays. Dungeons & Dragons group size: 7 people - He plays weekly with six others in the industry. Weekly D&D session length: 3 hours - He uses the game as both social and creative outlet. Tampa area storm surge: 8 or 9 feet - He describes severe flooding damage to his neighborhood after hurricanes.

Pivotal Quotes: "Risk cannot be destroyed, only transformed." — Corey Hofstein: He uses this principle to explain that finance transfers and reshapes risk rather than eliminating it. "Why are we playing the game on hard mode? Play the game on easy mode." — Corey Hofstein: His advice to younger investors is to avoid unnecessary complexity and low-probability market timing. "Diversification is a problem of addition through subtraction." — Corey Hofstein: He explains the funding tradeoff involved in adding diversifiers to a portfolio.

Implications: The conversation suggests investors should focus less on heroic forecasting and more on robust portfolio design, liquidity awareness, and implementation. It also implies that ETFs and capital-efficient overlays may be a major future path for democratizing institutional diversification tools.