Speaker 1: Welcome to Inside Active, a podcast about active managers that
Speaker 1: goes beyond sound bites and headlines and looks deeper into
Speaker 1: their processes, challenges, and philosophies and security selection. I'm David Cohne,
Speaker 1: i lead mutual fund and active research at Bloomberg Intelligence.
Speaker 1: Today my co host is James Seifert, ETF, analyst with
Speaker 1: Bloomberg Intelligence. James, thank you for joining me today.
Speaker 2: Yeah, thanks for having me. David, happy to be back.
Speaker 2: It's always fun to do these.
Speaker 1: Things, definitely. So we're today we're going to be talking
Speaker 1: about a hedge equity strategy, which you know, kind of
Speaker 1: reminds me of, you know, the popularity that's happening right
Speaker 1: now with buffer ETFs, options over lay ETFs. What have
Speaker 1: the flows been like to those products so far this year?
Speaker 2: I mean, if you are looking at those buffer defined
Speaker 2: outcome ETFs as we call them, the options overlay ets
Speaker 2: where you're getting income or protection of some sort, they
Speaker 2: are arguably one of the hottest categories in ETFs in
Speaker 2: the US as far as a percentage growth basis. I mean,
Speaker 2: they're not taking in as much money as a standard
Speaker 2: standalone s A P five hundred type product, but if
Speaker 2: you're looking at it on a percentage growth basis, I mean,
Speaker 2: it is some serious it's a serious category. And when
Speaker 2: you combine the two of them, I mean, right now,
Speaker 2: in the US alone, you're looking at for those defined
Speaker 2: outcome ETFs, eighty seventy billion dollars in ETF, so only
Speaker 2: on equity. There's some in other areas. And then if
Speaker 2: you again, if you're looking at options overlay, again only
Speaker 2: in equity, that's almost one hundred and ten billion dollar category,
Speaker 2: which granted it's not a trillion dollar category, but it's big.
Speaker 2: And the main thing I want to point out is
Speaker 2: it's growing quickly. So they're taking in combined three billion
Speaker 2: dollars a month like clockwork, pretty much for the year
Speaker 2: of twenty twenty five. So if you're an issue or
Speaker 2: advisor kind of targeting the same sort of strategy, it
Speaker 2: should be looking pretty good for you that you can
Speaker 2: maybe pull away some of the money that's going there.
Speaker 2: You know, the fish are jumping in the boat. People
Speaker 2: obviously like the ideas behind these categories, so it'll see
Speaker 2: how it turns out.
Speaker 1: Well, there's definitely a lot of interest, which makes a
Speaker 1: great segue to our guests today. I'd like to welcome
Speaker 1: our name Holzer to the podcast. Our name is the
Speaker 1: global macro strategist and client portfolio manager at Easterly EAB
Speaker 1: and a portfolio manager on their Easterly Hedge equity strategy.
Speaker 1: Our name thank you for joining us today.
Speaker 3: Thanks for having me, David, and great to meet you, James.
Speaker 1: So let's dive right in. What is the investment philosophy
Speaker 1: behind the strategy.
Speaker 3: The philosophy is very simple. What we're trying to do
Speaker 3: is create an asymmetric return pattern where we get more
Speaker 3: of the upside of the S and P than we
Speaker 3: get of the downside of the S and P, and
Speaker 3: particularly minimize drawdowns so that what you do is improve
Speaker 3: sharp ratios and sortino ratios, give investors a smoother ride,
Speaker 3: but actually give them a much more efficient hedge dequity
Speaker 3: approach than what's available and other products.
Speaker 1: Well, let's stick deeper. What is the investment management process like?
Speaker 1: So how does it work in terms of how do
Speaker 1: you approach this?
Speaker 3: Well, at our core, our firm is a is a
Speaker 3: derivatives research firm, and the work that we did showed
Speaker 3: that you know many many of the down drafts that
Speaker 3: occur in the market historically are in the one to
Speaker 3: two standard deviation area, in other words, between two and
Speaker 3: ten percent down drafts, and so we're really not trying
Speaker 3: to defend the deepest, you know, fifteen twenty percent down
Speaker 3: drafts in any one moment. We're trying to basically make
Speaker 3: relevant protection in that one to two standard deviation area
Speaker 3: and really hedge that. And then if the market continues
Speaker 3: to go down, we'll roll down further and we keep
Speaker 3: our trades kind of short. In other words, the structure
Speaker 3: of this is usually three to five week trades, and
Speaker 3: the market really goes down twenty five or thirty percent,
Speaker 3: you know, in a five to ten day period. By
Speaker 3: monetizing more more irregular down drafts, more occurring down drafts,
Speaker 3: you're actually able to protect more relevantly rather than waiting
Speaker 3: for that big down draft that often occurs only once
Speaker 3: every three four five years and you pay a lot
Speaker 3: for that. So our idea is to monetize to make
Speaker 3: offset from lower down drafts and then reinvest at those
Speaker 3: rates and get a quicker clawback. And what you find
Speaker 3: is a more relevant and actually a more efficient defense mechanism,
Speaker 3: a more efficient participation mechanism that gives you better sharp
Speaker 3: and sortino ratios than even the underlying S and P.
Speaker 2: So I'm going to jump in here real quick. Can you, like,
Speaker 2: how are clients using this strategy? Are you seeing it? Like?
Speaker 2: Are people using this as a core allocation? Are they
Speaker 2: using it as defensive or tactical? Like? Exactly is it?
Speaker 3: Like?
Speaker 2: Where is it going in the portfolio?
Speaker 3: I guess this is a great question, James, And you're
Speaker 3: going right to the meat of the issue. And if
Speaker 3: you don't mind, let me you know, kind of construct
Speaker 3: what the difference and how this and how this is
Speaker 3: used versus other funds, other buffer funds and kind of
Speaker 3: defined risk funds are basically defending one for one down
Speaker 3: drafts and participating and giving up some upside participation to
Speaker 3: do that. And they're really dumbing down. They're really muting
Speaker 3: volatility kind of equally on the upside and the downside.
Speaker 3: And that's really the problem, I would say into the
Speaker 3: Great Financial Crisis, which was we've got to figure out
Speaker 3: how to give our investors a less volatile ride, because
Speaker 3: the moments that they dealt with in terms of the
Speaker 3: tech wreck and in terms of the Great Financial Crisis
Speaker 3: were primarily not correlation expansion or beta problems. They were
Speaker 3: primarily volatility issues, and that volatility scared investors. Now what
Speaker 3: happened post to GFC is really interesting. The problem that
Speaker 3: we see occurred post the GFC is that correlations became
Speaker 3: much more unstable and David and James the real issue
Speaker 3: with modern portfolio theory is that it optimizes to volatility.
Speaker 3: But what we found, the kind of conundrum that investors
Speaker 3: and advisors have, and we talk to advisors every day,
Speaker 3: is that when you need correlations to be stable, which
Speaker 3: is the assumption in modern portfolio theory, they're uniquely unstable.
Speaker 3: And so your real problem from the Great Financial Crisis
Speaker 3: going forward and has been seen in the last five
Speaker 3: years post COVID, is that correlations across multi assets are
Speaker 3: just not stable. And so, for example, fixed income has
Speaker 3: been more often correlated to equities in the last four
Speaker 3: or five years than uncorrelated. And so the problem that
Speaker 3: you have from a portfolio management point of view is
Speaker 3: not so much giving a lower volatility to the overall portfolio,
Speaker 3: which is why people use the buffer funds. The traditional
Speaker 3: buffer funds that defend one for one, we defend twice
Speaker 3: the notional to the downside, and the reason is we're
Speaker 3: trying to the correlation problem and the beta expansion problem.
Speaker 3: And so by defending that downside with twice the notional
Speaker 3: downside and put spreads, what we do is we squeeze
Speaker 3: the beta risk to zero as the market goes down
Speaker 3: into our put spreads. That's a very different problem. And
Speaker 3: what we're doing is we're saying, look, your big issue
Speaker 3: from a portfolio management point of view, is it across
Speaker 3: even your equities alone, James, your correlations blow out much
Speaker 3: more meaningfully than they used to. And part of that
Speaker 3: is because inflation, because multi assets really perform differently than
Speaker 3: they used to. So what I would say is, in
Speaker 3: the past, you just use it as kind of an
Speaker 3: additional volatility MUTER. Now with our fund, what we're seeing
Speaker 3: is people are using it as a the diversification part
Speaker 3: of fixed income. They're substituting that piece. So not anybody
Speaker 3: in a sixty to forty model needs forty percent of
Speaker 3: their portfolio for income purposes. Of that forty percent in
Speaker 3: their allocation, often fifteen or twenty percent of that was
Speaker 3: actually for diversification per pose. So we're a very good
Speaker 3: substitute from a diversification point of view to plug in
Speaker 3: in that part of the portfolio. But now more and more,
Speaker 3: what we're actually seeing, after particularly eighteen, but more twenty two,
Speaker 3: where you saw S and P core positions, this core
Speaker 3: satellite idea and equity portfolios. What you're seeing is some
Speaker 3: folks say, wait a second, if the S and P
Speaker 3: went down nineteen percent in twenty twenty two, how good
Speaker 3: a core position was that? Really? From a risk management
Speaker 3: point of view, the fact that our fund was down
Speaker 3: less than three percent, if you had had that at
Speaker 3: the core. And yes, it's an active fund, and yes
Speaker 3: there's a fee management fee, but on a net basis,
Speaker 3: being down under three from a risk management and an
Speaker 3: efficiency point of view, it becomes a very interesting core
Speaker 3: equity allocation. And we're beginning to see more advisors say,
Speaker 3: wait a second, can't I look at this hedge dequity
Speaker 3: almost like a factor fund. Yes it's not growth or
Speaker 3: value or capsize or dividend, but it's a factor of volatility.
Speaker 3: And this you know, these funds manage actively the way
Speaker 3: they play the volatility range, and that factor adds value
Speaker 3: as an equity fund. So we're beginning to see people say, wait,
Speaker 3: a second, this can be actually a core equity allocation,
Speaker 3: and over the last three years it's you know, it's
Speaker 3: it's outperformed, for example, equal weighted SMP with half of
Speaker 3: the risk. So it's a very interesting core equity piece
Speaker 3: given how well it's performed.
Speaker 1: A way to partially replace traditional bonds that that section
Speaker 1: of the portfolio. But now it's taking up more of
Speaker 1: the equity side.
Speaker 3: Would you say, yeah, I think I think the the
Speaker 3: the issue for equity investors, particularly in this environment. And James,
Speaker 3: you know you probably see this quite a bit with
Speaker 3: the growth in some of these specialty funds, but you
Speaker 3: know AI extended tech, you know, very focused renewables, energy funds.
Speaker 3: You know, in the old days, there was you know,
Speaker 3: years ago, there was the marijuana based funds. You're seeing investors,
Speaker 3: you know, obviously you know the frontier emerging markets. You're
Speaker 3: seeing investors say, look, I think where there's not perfect information,
Speaker 3: I can get very high alpha in some parts of
Speaker 3: my equity portfolio. But David, the problem with those allocations
Speaker 3: is that you expand the potential for beta risk, for
Speaker 3: beta expansion risk, and so if you want to search
Speaker 3: for return and more of these younger clients. These forty
Speaker 3: and fifty year old clients are looking for relevancy in
Speaker 3: their equity portfolios. The problem with that as an advisor,
Speaker 3: and I talk to advisors every day, is they're saying, yes,
Speaker 3: I understand they want crypto, I understand they want AI.
Speaker 3: But the beta risk of these funds it might look
Speaker 3: like a one point four beta to the S and
Speaker 3: P in quiet times, But if you get a liquidity moment,
Speaker 3: or you get a big decline in the SMP, that
Speaker 3: one point four or one point three beta could become
Speaker 3: a two point five beta, and then what do I
Speaker 3: do with my equities? They could really hurt my clients.
Speaker 3: And so using a fund like ours that squeezes beta demonstrably,
Speaker 3: you know, it goes from a normal forty to forty
Speaker 3: two beta to towards a zero beta. In twenty eighteen,
Speaker 3: we actually made money when the market was down. In
Speaker 3: twenty two we squeezed that down to less than a
Speaker 3: point one beta. In those kind of extreme environments. Allows
Speaker 3: your equity portfolio to stretch for return with higher alpha funds.
Speaker 3: But at the same time, David, in the decline moment
Speaker 3: that creates a beta risk, you have that you have
Speaker 3: that defensive fund in the middle that provides that balance. Yeah.
Speaker 2: I know it's cliche, but like everyone's saying, it's the
Speaker 2: death of the sixty forty. But the more and more
Speaker 2: I talk to people that are allocators, like advisors and institutions,
Speaker 2: it really is kind of gone. For the most part.
Speaker 2: It's becoming more like or at least what is in
Speaker 2: those sixty and forty categories has expanded. It's like sixty
Speaker 2: thirty ten or seventy twenty ten where they're doing more
Speaker 2: strategies like yours, like those alpha strategies are going thematic
Speaker 2: investing or crypto or something along those lines. In those
Speaker 2: satellite positions. Things really have changed as far as the
Speaker 2: allocation side of things goes, and from my point of view,
Speaker 2: it really exacerbated things in twenty twenty two, and you know,
Speaker 2: your equities and your bond's went down together. I think
Speaker 2: that's part of the growth we're seeing in strategies like
Speaker 2: yours and buffers and overlays. So I guess my next
Speaker 2: question would be, is there a tactical component to your
Speaker 2: equity exposure, like are you going after low vall stocks
Speaker 2: or is it just beta to the S and P
Speaker 2: five hundred on the equity leg. Can you just talk
Speaker 2: a little bit about that.
Speaker 3: So we'll get into the structure. So the biggest risk
Speaker 3: as a forty year financial professional, the biggest risks you
Speaker 3: have in markets is really mismatches, right, It's leverage and
Speaker 3: it's mismatches. So the mismatch issue is you don't want
Speaker 3: to own single stocks if you're trying to reduce beta risk.
Speaker 3: If you're trying to reduce risk, that correlations blow out.
Speaker 3: So we own the S and P. The structure owns
Speaker 3: the S and P through spy, and we leverage the
Speaker 3: structure thirty percent extra exposure through a swap with Golden Sacks.
Speaker 3: So we're in essence a one thirty thirty five, So
Speaker 3: it's thirty percent swap with Goldman Sachs. So we get
Speaker 3: one hundred and thirty percent exposure, which right away gives
Speaker 3: you additional exposure to an asset that starts at the
Speaker 3: bottom left and goes to the top right. So that's
Speaker 3: a good thing. We then sell up to one hundred percent.
Speaker 3: We never sell the thirty percent, any thirty percent of
Speaker 3: that swap, any of that exposure in calls in the
Speaker 3: two to four percent range. On a let's say a
Speaker 3: one month trade, and we use that to finance two
Speaker 3: hundred notional two hundred percent of our notional in putspreads
Speaker 3: in a one to two standard deviation, which would be
Speaker 3: two percent down to seven percent down a ninety eight
Speaker 3: ninety three put spread. That's a one to two standard deviation. Now,
Speaker 3: the reason we do that is basically, we want to
Speaker 3: get exposure to where declines normally happen, and when those
Speaker 3: declines happen, we're going to monetize excess return, right because
Speaker 3: we're hedging two hundred percent of our notional, not two
Speaker 3: hundred percent of the hundred not not you know, one
Speaker 3: hundred percent. Most buffer funds are constructed on three month
Speaker 3: trades and they only defend their notional so they don't
Speaker 3: have leverage, so they don't get access return from the
Speaker 3: S and P and they don't get excess return from
Speaker 3: their hedge because they're only they're only hedging their notional amount.
Speaker 3: They're one hundred dollars basically, so we get access return
Speaker 3: if the market does go into our range, and as
Speaker 3: the market recovers, we have room to rise into our
Speaker 3: sold calls, into our short calls. That's financial structure is
Speaker 3: in a positive income, positive data, so we don't bleed,
Speaker 3: and that's a very important thing because many option structures
Speaker 3: provide defense, but they bleed, so you're losing return of
Speaker 3: the market. And because we never sell, we never short
Speaker 3: calls on that thirty percent of the swamp, we always have.
Speaker 3: In the worst market for us, which would be something
Speaker 3: like twenty seventeen, where there's no volatility in the market
Speaker 3: goes straight up, we're going to get thirty to thirty
Speaker 3: five percent of the market with about thirty five percent
Speaker 3: of the volatile. It's a you know, forty percent of volatility.
Speaker 3: It's a very it's a very safe structure even in
Speaker 3: a very low vol straight up market, but most investors
Speaker 3: don't buy us for that environment because they have other
Speaker 3: equity products that really work in that environment. What happens
Speaker 3: is normally, after very low vall environments, you get a
Speaker 3: high vowel event and we we do exceedingly well in
Speaker 3: those events. But that structure is not is not discretionary.
Speaker 3: It's a it's a structure, a systematic structure that we've
Speaker 3: researched works now that the strikes of that whether it's
Speaker 3: a three week trade or a five week trade, whether
Speaker 3: it's a ninety eight ninety three put spread or a
Speaker 3: ninety six you know, you know eighty five, the range
Speaker 3: might vary a little bit based on the math of
Speaker 3: where the options are, the volatility is, and that kind
Speaker 3: of constructs the actual put you know puts, and the
Speaker 3: dimensions of the trade. But the structure of the trade
Speaker 3: is always in place and stays relevant to the market.
Speaker 3: So if market goes up, we're following up the market,
Speaker 3: and then if the market falls from that elevated level,
Speaker 3: we start to defend in that range where some of
Speaker 3: the longer traits, the three month trades can become very irrelevant.
Speaker 3: If the market goes up, their puts may be irrelevant
Speaker 3: to normal declines. And again if the market goes down
Speaker 3: through their puts, they may no longer participate to the downside.
Speaker 3: And what we do instead is we stay relevant to
Speaker 3: the up and to the down of the market because
Speaker 3: our trades are shorter. So that's the structural difference. It's
Speaker 3: not so much discretionary as it is systematic based on
Speaker 3: the math of the market.
Speaker 2: So I guess basically like I get you're saying, the
Speaker 2: structure is determined based on what's going on in the
Speaker 2: market and how options are being priced, whether it's the
Speaker 2: state of the time value to kay vega, what all
Speaker 2: those Greek letters that go into valuing it. That's what
Speaker 2: you're determining where things are. So do you distinguish it
Speaker 2: all between secular and secular changes or are you just
Speaker 2: kind of maintaining your same sort of structure no matter
Speaker 2: what's going on in your your situation is basically determined
Speaker 2: by what's going on in the market and how where
Speaker 2: your hedges correct.
Speaker 3: The structure is systematic, but the levels where it trades
Speaker 3: depend on the math of the market. And the benefit
Speaker 3: of that has really shown through because if you're really
Speaker 3: fixed in your structure and your very long term you
Speaker 3: can't adjust to the math of volatility, and you can't
Speaker 3: adjust to the skew of the options market. And the
Speaker 3: benefit of our structure is if skew is to the call,
Speaker 3: you know we're able to take advantage because we don't
Speaker 3: have to trade our trade at a particular level versus
Speaker 3: where we are. If skew is to the call, we
Speaker 3: can set our call, our short calls at a much
Speaker 3: higher level, which gives us more room to participate up
Speaker 3: so our percentage of participation will actually be better in
Speaker 3: that environment. And if skew is to the put, you know,
Speaker 3: then we're able to sell our put spreads a little
Speaker 3: bit more optimally in a different fashion as well. Whereas
Speaker 3: the structures, you know, some of the buffer funds and
Speaker 3: some of our competitors are very stuck in a dogmatic
Speaker 3: trade that is numerically basically structured. They can't adjust to that.
Speaker 3: And so that's very important, particularly when you recognize that
Speaker 3: the changes in the options market the last several years
Speaker 3: and the really the retailization of options has given us
Speaker 3: tremendous advantages because it's allowed us to do, I think,
Speaker 3: to even adjust our structure more optimally then we might
Speaker 3: have envisioned five ten years ago when the structure started.
Speaker 3: We just passed our ten year anniversary this last month,
Speaker 3: by the way. But when the structure was initially envisioned,
Speaker 3: I don't think we recognized the potential for some of
Speaker 3: these ranges. With skew and retail interest zero one two
Speaker 3: day to expery that has you know, really increased the
Speaker 3: liquidity and some of the ranges for the technical part
Speaker 3: of options that that I don't think anybody expected and
Speaker 3: it's actually helped our product.
Speaker 1: So if we if we think about this for our
Speaker 1: listeners that don't understand options, you know, if they're thinking
Speaker 1: about it, how does this strategy typically behave you know,
Speaker 1: relative to S and P five hundred during rallies versus corrections.
Speaker 1: So if we just kind of simplify it.
Speaker 3: So there, there's there's It's really like a light that
Speaker 3: has the characteristics of a particle and has the characteristics
Speaker 3: of a wave. So so the particle is the equity market, right,
Speaker 3: so we follow the equity market. If the equity market
Speaker 3: goes up, we have a high correlation to equities. We
Speaker 3: have you know, for those who know you know correlation,
Speaker 3: we have a we have a well over ninety R
Speaker 3: squared to the equity market. So we participate well as
Speaker 3: the market goes up. When the market goes down, if
Speaker 3: it goes down very little, yes we go down a
Speaker 3: little bit as well. But if the market goes down
Speaker 3: through the one to two standard deviation area, which is
Speaker 3: kind of in that two to seven percent area, if
Speaker 3: it goes into that area and volatility rises, that's the
Speaker 3: wave issue. We start to correlate to volatility and we
Speaker 3: get a benefit from that and our puts start to
Speaker 3: generate return. And so the idea here is we really
Speaker 3: the factor that we're making money off of is the
Speaker 3: cyclicality of volatility. So investors have historically been hurt by
Speaker 3: volatile times. Some people call it volatility drag, it hurts portfolio.
Speaker 3: Some people like to call it beta expansion. But what
Speaker 3: we do is we participate with equities on the in
Speaker 3: normal markets and in upward rising markets. But if there
Speaker 3: is any kind of cyclicality to volatility or a volatility rises,
Speaker 3: that gives us a second form of compensation, and we're
Speaker 3: able to take advantage of that because of the nature
Speaker 3: of our trade, which has a tendency to buy volatility,
Speaker 3: you know, kind of on the cheap side, and sell
Speaker 3: volatility more on the rich side. We have a tendency
Speaker 3: to sell equities on the you know, in the normal markets,
Speaker 3: because we sell calls, you know, in that two to
Speaker 3: four percent above where we are. So we sell calls
Speaker 3: equity up on the upside, and we tend to buy
Speaker 3: equity on the downside because as the market goes down,
Speaker 3: our extra defense is compensating us, is monetizing us, and
Speaker 3: we'll roll to a new structure and the excess goes
Speaker 3: into units of the S and P. And so what
Speaker 3: you see with a structure like this that is overdefended
Speaker 3: is we get overcompensated for the downside, which means we
Speaker 3: have money to buy low and when the when the
Speaker 3: market mean reverts, and historically the market has always mean reverted, thankfully,
Speaker 3: that means that we have a tendency to buy more
Speaker 3: units in those lower amounts, which means we claw back fast,
Speaker 3: which helps you overall portfolio because you have an asset
Speaker 3: that's starting to come back sooner than the market, you know,
Speaker 3: than other products in the market.
Speaker 2: So you just basically said that volatility actually is pretty
Speaker 2: good for the returns of this type of strategy. So
Speaker 2: I guess my question would be what is the worst, Like,
Speaker 2: what are you going to underperform the standard beta of
Speaker 2: the market the most?
Speaker 3: Is it?
Speaker 2: Based on what you said, I'm going to guess it's
Speaker 2: a low volatility regime where the market is ripping. Essentially,
Speaker 2: that is when you're going to have the highest in performance.
Speaker 3: Is that right? Right? So, if we think about tail
Speaker 3: risk being kind of a one in five to seven year,
Speaker 3: like real tail risk being a one into five to
Speaker 3: seven year kind of event. I would say the opposite side,
Speaker 3: you know, the right tail risk, not the left tail risk,
Speaker 3: the right tail risk, which is the very low VALL
Speaker 3: and you know, fifteen to twenty five percent up year
Speaker 3: with VALL with the vis being let's say six to
Speaker 3: eight and realizing you know, three to four. The twenty
Speaker 3: seventeen year is a perfect example of that kind of
Speaker 3: a tail year that it doesn't necessarily the strategy doesn't
Speaker 3: lose money, but it's it's more that thirty to forty
Speaker 3: percent participation in the S and P and lowish VALL,
Speaker 3: but you don't get that very high sixty to eighty
Speaker 3: percent of the SMP that we'd like to ex effect
Speaker 3: with you know, forty percent of the volatility. That's that
Speaker 3: kind of a market is unusual. But even an up
Speaker 3: market if you get cyclicality in volatility, and we've seen
Speaker 3: some of those the last few years where you get
Speaker 3: a fifteen to twenty percent return but the VIX is
Speaker 3: still at fourteen to eighteen, that kind of a year
Speaker 3: where you have and you have a couple of little
Speaker 3: scares is a perfectly fine year for us. It's really
Speaker 3: the year where you get that perfect storm of no
Speaker 3: volatility and straight upward to the to the right that
Speaker 3: that makes us look pedestrian. In other words, will be
Speaker 3: you know, we'll have a slight advantage over high yield
Speaker 3: at about the same risk or maybe a little less risk,
Speaker 3: but it won't be that fifty to seventy sixty to
Speaker 3: eighty percent of the s and P with forty percent
Speaker 3: of the risk kind of year, which is a home run,
Speaker 3: you know. Thankfully, I would say sixty to seventy percent
Speaker 3: of the time we're in our sweet spot. Maybe ten
Speaker 3: percent of the time. It's more of that twenty seventeen
Speaker 3: kind of year. But the good news is in those
Speaker 3: kinds of years, James and David, everything else in your
Speaker 3: portfolio is just on octane, high octane, and so no
Speaker 3: one's really worried about this part of their portfolio.
Speaker 1: So if you think of another situation, how has it
Speaker 1: behaved in rising rate or inflationary environments where traditional fixed
Speaker 1: income is kind of struggled.
Speaker 3: It's a it's a it's a really good question. If
Speaker 3: you if you look at two thousand, you know, twenty two,
Speaker 3: for example, I was referring to it before the strategy
Speaker 3: was down was down two point seventy five percent and
Speaker 3: the market was down you know, close to nineteen percent
Speaker 3: depending on how you looked at it. You know, eighteen
Speaker 3: plus percent. That's a very significant defensive performance. And you
Speaker 3: know that's an environment where if certain data points had
Speaker 3: worked out a little bit better, you know, we could
Speaker 3: have been basically flat on the year. We have a
Speaker 3: we have clients that came through that period that came
Speaker 3: to us and basically said, we're going to up our
Speaker 3: allocation to you because we realize that having too much
Speaker 3: in the core S and P category. Now, granted, you
Speaker 3: know people were paying you know, James, I know you're
Speaker 3: going to love this comment, but people were paying seven
Speaker 3: basis points right for the S and P and feeling
Speaker 3: great that you know, passive is great, and owning the
Speaker 3: S and P is great because it's passive and that
Speaker 3: does better than active managers. And you paid seven basis
Speaker 3: points for the SMP, but you're down eighteen plus percent
Speaker 3: for that seven basis points. And granted, folks pay more
Speaker 3: to own our fund, but you know they were down
Speaker 3: two point seventy five percent, So not many of our
Speaker 3: clients were unhappy with owning our fund at a normal
Speaker 3: management fee. Versus the S and P. Because the S
Speaker 3: and P doesn't truly give you defense. Indexes are not riskless.
Speaker 3: And I think what you're beginning to see here, because
Speaker 3: of this beta expansion risk, and because of the tendency
Speaker 3: for the SMP, because it's a market cap weighted index,
Speaker 3: it has much more beta expansion risk than people understood.
Speaker 3: If you look at the equal weighted SMP versus you know,
Speaker 3: even versus the market cap weighted SMP, you know, the
Speaker 3: equal way to SMP was down eleven point five basically
Speaker 3: in twenty twenty two versus the eighteen plus in twenty
Speaker 3: two versus R two seventy five. So there is a
Speaker 3: fair amount of kind of hidden risk within these indices,
Speaker 3: passive indices. And I think what you're seeing advisors, and
Speaker 3: I talk to advisors just about every day. What you're
Speaker 3: seeing advisors basically say, is passive is interesting visa VI
Speaker 3: the active conversation, right, but it's not necessarily as interesting
Speaker 3: versus the risk management versus the risk efficiency conversation. And
Speaker 3: I think that dimension of the conversation is a really
Speaker 3: important one. Now, the traditional buffer funds, the traditional defined
Speaker 3: outcome funds, they don't do beta. They don't control beta expansion,
Speaker 3: so they don't give you the same benefit in this
Speaker 3: particular discussion. But alternatives that are able to really claw
Speaker 3: down you really drop down your beta expansion are actually
Speaker 3: a very interesting conversation visa VIP passive. And I think
Speaker 3: this is a topic that I've made a lot of
Speaker 3: headway with with with modelers. You know, I go to
Speaker 3: see you know, institutions, I go to see you know,
Speaker 3: distribution channels when I talk to that their modeling groups,
Speaker 3: And this is the place where you're starting to see
Speaker 3: some very interesting headway because you can never make headway
Speaker 3: on the passive active discussion. There's just it's a really
Speaker 3: hard conversation to have anybody, you know, kind of open
Speaker 3: up their mind to. But when you talk about the
Speaker 3: passive active conversation around risk management, that actually is one
Speaker 3: where the door is cracking and you're beginning to see
Speaker 3: people really, really solid people say, wait a second, this
Speaker 3: does make a difference if you're able to bring that capability,
Speaker 3: that characteristic into portfolios.
Speaker 2: So let's get into something we've danced like the entire
Speaker 2: time we've been talking here. Let's go into like a
Speaker 2: little bit of a direct comparison to buffer or options
Speaker 2: overlay ETFs. I mean for I don't know if the
Speaker 2: listeners will know this, but there's like the last few
Speaker 2: months there's been this blow up of AQR from the
Speaker 2: likes of Clifford Assenas mainly writing papers basically attacking these
Speaker 2: buffer products, saying they're overpriced and nothing but a marketing gimmick.
Speaker 2: I kind of view it like there's pros and cons
Speaker 2: to each, right, Like, I don't think it's just a
Speaker 2: marketing gimmick. I think there's benefit for some people. They'll
Speaker 2: be like, I know I'm going in here, and I
Speaker 2: know exactly what my downside risk is. I know exactly
Speaker 2: where things can go. And I think that's just like
Speaker 2: easy for some people who don't understand finance and the
Speaker 2: benefits of a portfolio construction to go in and know
Speaker 2: what this is. And like, this has been a huge
Speaker 2: area in the annuity market, right that this is structured
Speaker 2: product is a huge thing at banks and high networth individuals.
Speaker 2: So I guess, like, are you when you're talking to people,
Speaker 2: are you directly competing with these types of products? How
Speaker 2: do you compare yourself when you're trying to sell your product?
Speaker 3: You've already said it.
Speaker 2: You kind of move up and down with the market,
Speaker 2: Like do you also get compared against these options over
Speaker 2: where they're only selling calls to the upside, so you're
Speaker 2: still subject to a lot of the downside, but you
Speaker 2: get some income. Like how what is your main pitch
Speaker 2: and like why you say in a succinct way, like
Speaker 2: what is your argument? And like who do you agree with?
Speaker 1: More?
Speaker 2: Do you agree with the Clifford asking this QR side
Speaker 2: of things? You do agree with the buffer? You more
Speaker 2: like me sit in the middle of pros and cons
Speaker 2: to each.
Speaker 3: Well, you asked me to be succinct, and you gave
Speaker 3: me a question that literally could be like it don't
Speaker 3: be succinct. Yeah, thank you for the podcast format, David. Okay,
Speaker 3: let me first say, it really matters what problem you're
Speaker 3: trying to address.
Speaker 1: Right.
Speaker 3: If you're trying to address the volatility problem, which I
Speaker 3: really view as the you know, the tech wreck and
Speaker 3: Great financial crisis problem, which was volatility scared people, some
Speaker 3: of those structures are very interesting. And remember modern portfolio theory,
Speaker 3: it doesn't just have an assumption that correlations are stable.
Speaker 3: It also makes an assumption that individual utility functions are
Speaker 3: very similar along risk and reward. And you know, I
Speaker 3: I'm you know, I'm an orthodox you know economists from
Speaker 3: from from Princeton, and I love that work, and I
Speaker 3: studied under malcol and you know, Markowitz, I think is
Speaker 3: you know, has done wonderful work. But some of those assumptions,
Speaker 3: you know, probably need to be tested more behaviorally, and
Speaker 3: I think there's been some good work around that. And
Speaker 3: you know, so the Cliff, you know, and by the way,
Speaker 3: tremendous respect for Cliff, and I think a lot of
Speaker 3: the things he said are legitimate because I don't think
Speaker 3: some of the existing products are really worth what what
Speaker 3: they They don't necessarily offer as good a performance and
Speaker 3: they don't necessarily solve the problem as well as they should.
Speaker 3: But but I also would say this to Cliff, and
Speaker 3: that is that the utility function of investors is much
Speaker 3: more variable than you know, these conservative, moderate and aggressive
Speaker 3: models or you know, depending on you use three or
Speaker 3: use five. You know, it's very hard. Advisors have the
Speaker 3: toughest job in finance, and they have to try to
Speaker 3: fit individual client asset liability and and and behavioral tendencies
Speaker 3: into these these models. And so what some of these
Speaker 3: buffers and defined models have done. Is really solved for
Speaker 3: is try to at the edge, you know, at the
Speaker 3: incremental level, try to trim some of that to meet
Speaker 3: individual investors' behavioral you know, kind of utility functions. And
Speaker 3: in that regard, even though they may not be perfect,
Speaker 3: they probably help some advisors solve for Okay, this client's
Speaker 3: got more volatility fear than they it would be willing
Speaker 3: to acknowledge in stress. I'm going to solve for that
Speaker 3: problem by lowering some of the volve. Now, these products
Speaker 3: I don't think solve the problem as elegantly as they should.
Speaker 3: I think they're you know, they're too long a trade.
Speaker 3: I think they're not asymmetric. They certainly don't solve the
Speaker 3: twenty fifteen to the future problem, which is really beta expansion.
Speaker 3: But I think that's what those funds have done, and
Speaker 3: so to that extent, I think the cliff is a
Speaker 3: little harsh, But to the extent that those funds, because
Speaker 3: they're not asymmetric, because they can become irrelevant because they
Speaker 3: don't solve the problem that is really the future problem,
Speaker 3: which is really how do you manage and constrict beta
Speaker 3: expansion in a world where fixed income no longer has
Speaker 3: a bull market behind it and is negatively correlated. I
Speaker 3: think they're anachronistic and they're really not effective. And when
Speaker 3: we show our numbers against our competitors, it's it's very
Speaker 3: clear that it's a better solution to be a symmetric
Speaker 3: and squeeze downside risk. It's it's very clear. And if
Speaker 3: you look at our upside downside capture ratios, it's very
Speaker 3: obvious that the asymmetry makes a difference. So we can
Speaker 3: still solve for the volatility problem, but we really solve
Speaker 3: for this this beta expansion problem. Now, the other question
Speaker 3: that you ask is, you know, why have these products
Speaker 3: been so popular? Part of it is because from a
Speaker 3: marketing point of view, they're very easy to market, compliance approves,
Speaker 3: the very straightforward documentation. You know, they seem optically to
Speaker 3: do what they say they're going to do, and so
Speaker 3: they solve the problem. They scratch an itch, but they
Speaker 3: don't necessarily give you the deep tissue massage that you
Speaker 3: need to be resilient in that crisis situation. And that's,
Speaker 3: you know, that's a very big difference. And I think,
Speaker 3: and to that extent, I think if Cliff had looked
Speaker 3: at a broader set of funds. We were not included
Speaker 3: in his data set. But if he had included a
Speaker 3: broader set of funds, I think he might not have
Speaker 3: come quite so harshly down on the entire you know,
Speaker 3: tard the whole industry. But but the main point is correct,
Speaker 3: which is, if you're paying anything for a fund that
Speaker 3: doesn't really solve the real problem, you're paying too much.
Speaker 3: And and so that's you know, one of the things.
Speaker 3: And what we try to do is really get the arias,
Speaker 3: you know, to get advisors, you know, even small institutions
Speaker 3: and even some institutions that we're talking to, to really
Speaker 3: understand the portfolio risk allocation implications of having something at
Speaker 3: the center rather than using an MPT a modern portfolio
Speaker 3: approach looking more towards a total portfolio approach, where you
Speaker 3: start analyzing your risk in holistic terms and not trying
Speaker 3: to put everything into style boxes, but saying, how does
Speaker 3: this firm add to the risk efficiency of my fund?
Speaker 3: And when you look at that and you say, wait
Speaker 3: a second, if this fund has better sharp and sortino
Speaker 3: than the market, than the equity than SMP, that means
Speaker 3: I can take that budget that lowered risk that and
Speaker 3: I can use that efficiently somewhere else, And that concept
Speaker 3: is very valuable of risk budgeting. We have not seen retail,
Speaker 3: we have not seen small institutions really do that. But
Speaker 3: I've spent some time recently with consultants and some small
Speaker 3: institutions who really are starting to understand volatility has been
Speaker 3: used by very big institutions for a long time to
Speaker 3: just sell vol They just sell, I'll sell, I'll sell
Speaker 3: all until it doesn't work, it blows up, and then
Speaker 3: when it blows up, it's interesting to sell all again.
Speaker 3: But because it seems like a one way trade, that's
Speaker 3: the way everyone's used it. But very few people have
Speaker 3: used this idea of a hedge VOWL kind of management
Speaker 3: approach which takes advantage of vowel ranges and cyclicality evolve
Speaker 3: almost like an equity factor. And I think that piece
Speaker 3: because what happens with a lot of these factor funds
Speaker 3: is they get so overused that they disintermediate the value added,
Speaker 3: whether it's cap whether it's value, whether it's growth, whether
Speaker 3: it's small or low vowel funds or dividends. Those factors
Speaker 3: start out with a certain ir but when more and
Speaker 3: more people pile in, they lose their value. What's interesting
Speaker 3: about volatility This has been this issue has existed for years,
Speaker 3: but very few people have really piled in. In fact,
Speaker 3: I think most people have not used volatility correctly. I
Speaker 3: think we use it correctly. And I think that opportunity
Speaker 3: as an equity care characteristic to harvest is what differentiates us.
Speaker 3: And and that's notably different from you know, the kind
Speaker 3: of traditional buffer funds that you see out there.
Speaker 1: So we're starting to run out at a time. But
Speaker 1: since you are a global macro strategist, I would be
Speaker 1: remiss if I didn't ask you about the markets. You know,
Speaker 1: we've read your you know, your market overview for April
Speaker 1: has what has changed in your view since then?
Speaker 3: Well, you know, prior, prior to the pandemic, we would
Speaker 3: have thought there was some room for the FED to
Speaker 3: create some kind of easing, you know, maybe maybe even
Speaker 3: just twenty five basic points. But obviously since you know,
Speaker 3: Liberation Day, some of that has changed. And I think
Speaker 3: it would be unrealistic to assume that the FED, you know,
Speaker 3: that the FED has has an easy path here. We
Speaker 3: we believe secularly that the inflation equilibrium has changed post pandemic.
Speaker 3: We think that it probably means that that our star,
Speaker 3: although no one wants to talk about it. I'm still
Speaker 3: wondering what's gonna happen at Jackson Hole. But it seems
Speaker 3: like we think rates are a little bit higher, will
Speaker 3: remain a little bit higher, and that inflation will will
Speaker 3: remain a little bit higher. And the call that you
Speaker 3: know that Scott Besson has had to drop rates one
Speaker 3: hundred and fifty basis points, we think that probably a
Speaker 3: lower number is going to be realistic. I think it's
Speaker 3: going to be a real challenge for the Fed. You know,
Speaker 3: we have a highly unorthodox president, we have some unconventional times.
Speaker 3: We think that the mortgage market is probably the bigger
Speaker 3: problem that the FED needs to solve for I think
Speaker 3: if you look at the economy, obviously there's some labor
Speaker 3: issues that are picking up. There's still some incipient concern
Speaker 3: about inflation with the trade tariffs. But I just don't
Speaker 3: see the FED having the freedom to drop rates as
Speaker 3: much as the market is expecting. I think potentially, you know,
Speaker 3: this fourth quarter, we could see one decrease. I don't
Speaker 3: think we're going to see as many as the market
Speaker 3: would anticipate. But I also think that the Fed really
Speaker 3: should be looking in terms of the balance sheet, the
Speaker 3: mortgage side. I think the Treasury Secretary should really be
Speaker 3: looking at, you know, the privatization of Fanny and Freddy.
Speaker 3: I think the problem we have to solve war here
Speaker 3: that also affects you know, inflation, is what's going on
Speaker 3: in the housing market. And so while we're in very
Speaker 3: unconventional times, very unorthodox times, there is a way to
Speaker 3: thread this needle. Productivities come in relatively well. You know,
Speaker 3: there is a potential that the tariffs could be could
Speaker 3: end up at just a low enough rate that the
Speaker 3: combination of companies with margins and some of the sellers
Speaker 3: taking some of the peace and consumers still getting a piece,
Speaker 3: that it not be so disruptive if productivity remains relatively high,
Speaker 3: and that would probably mean rates come down, but not
Speaker 3: as much as people are expecting. I think that means,
Speaker 3: you know, medium terms to long term bonds are not
Speaker 3: a great place, which witness my comments about correlations on
Speaker 3: bonds not being a great diverse fire and why you
Speaker 3: need these kind of alternatives that give you some beta
Speaker 3: expansion protection. I think that that's still true, but we
Speaker 3: need to thread this needle and volatility and implied correlation
Speaker 3: in the market is kind of complacent, you know, just
Speaker 3: to give you a sense, when we look at skew
Speaker 3: in options, given where the market is near market highs,
Speaker 3: we would expect the option skew to be pretty significantly
Speaker 3: to the put. But in actuality it's only modestly let's
Speaker 3: say point three point four standard deviations to the put,
Speaker 3: I would expect it to be, you know, over one
Speaker 3: standard deviation to the put. The reason for that is
Speaker 3: people just frankly, are not selling their calls. It's not
Speaker 3: that they're necessarily over you know that they're underbuying puts.
Speaker 3: They're still buying buying puts, but they're really not selling
Speaker 3: their calls. There's a lot of retail. When I was
Speaker 3: talking before about their retail impact on the market, you
Speaker 3: should see some people selling their calls, right, monetizing and
Speaker 3: and kind of defending. So the hedging piece isn't necessarily changing,
Speaker 3: but the speculative piece is kind of staying in place.
Speaker 3: And so that connotes a little bit of a little
Speaker 3: bit of you know, uh, just a little bit of apathy,
Speaker 3: a little bit of complacency, and the implied correlation because
Speaker 3: of these because of because of the dispersion trade, which
Speaker 3: sells options on the S and P and buys vow
Speaker 3: on the single stocks, is really pushing the vics down,
Speaker 3: I think, to areas that are probably a little low
Speaker 3: for where the macro risks and the FED risks still are.
Speaker 3: So it's a position that I think kind of warrants. Okay,
Speaker 3: the market can be wrong for longer than I can
Speaker 3: be right, so you need to participate. But I think
Speaker 3: investors should be aware that you know, there's still you know,
Speaker 3: there's still a relatively tight thread, a tight needle that
Speaker 3: we have to thread here, and and you know we
Speaker 3: still have some concerns.
Speaker 2: Alright, So last question and then we'll wrap up. You
Speaker 2: just spoke about a whole host of things with Ward's,
Speaker 2: the FED and the economy. So I guess, like what
Speaker 2: is the primary risk? You see, this is going to
Speaker 2: kind of be a two parter, like from any economic standpoint,
Speaker 2: from the FED cutting rates, like are you most concerned
Speaker 2: with inflation? Are you most concerned with the unemployment? Job market?
Speaker 2: Are you work concerned with productivity? Which I guess goes
Speaker 2: to the job market. The other thing you mentioned is
Speaker 2: the housing market is frozen, and Trump and everyone is
Speaker 2: talking about lowering rates. But if you look back to
Speaker 2: the last time the FED lowered rates, the tenure actually
Speaker 2: went up and the mortgage rates market actually went up.
Speaker 2: So is that actually going to solve things? And then
Speaker 2: like after that part, like of all those things, what
Speaker 2: is the primary risk the stock market? There's a huge
Speaker 2: talk about like the stock market is not the economy anymore.
Speaker 2: It's kind of become disassociated in some ways. Do you
Speaker 2: agree with that, Like, can you just talk about the
Speaker 2: primary risk you're seeing from both an economic point of
Speaker 2: view and a stock point of view.
Speaker 3: I look, I think those are great questions. You know,
Speaker 3: the American excellency is is is still in place. It's
Speaker 3: taken a bit of a hit because of some policy uncertainty.
Speaker 3: I think it's also taking a bit of a hit
Speaker 3: because the fiscal the fiscal house is not in as
Speaker 3: good as shape. The debt, you know, the the the
Speaker 3: debt to GDB ratios do cause some concern. And part
Speaker 3: of the reason why the US dock market has really
Speaker 3: always been supreme basically, and it's hard for people to
Speaker 3: understand this is that the Fed's backstop and the US
Speaker 3: Treasury's backstop as the global financial system. You know, asset
Speaker 3: of choice have been rock solid, and so you know,
Speaker 3: the FED couldn't have dropped rates as much as they
Speaker 3: have several times in our last several crises unless there
Speaker 3: was tremendous uptake and desire to hold US treasuries. You know,
Speaker 3: you can't drop rates like that as a central bank
Speaker 3: if no one wants your paper, because we don't finance
Speaker 3: ourselves completely domestically, right, So the question here really is
Speaker 3: is you know, the US the put here, the FED
Speaker 3: put really depends on a sound fiscal situation. Now, the
Speaker 3: last auctions there were a couple in early August, you
Speaker 3: know that weren't perfect, but for the most part, the bid,
Speaker 3: the cover ratio and the amount that's been hit you know,
Speaker 3: having to be taken by dealers has been manageable. But
Speaker 3: you know, you don't want to get to the place
Speaker 3: where people are concerned about your credit rating, where people
Speaker 3: are concerned to the place where it affects the uptaking
Speaker 3: your auctions, because if that occurs, more meaningful and we're
Speaker 3: not at that level now. But that's the concern here
Speaker 3: that you don't impugne policy and the importance of the
Speaker 3: US the preeminence of the US Treasury in the auction process,
Speaker 3: because that would in fact handcuff the FED. And so
Speaker 3: when you see the long end, you know, kind of
Speaker 3: steepen on some of these pieces of news, it gives
Speaker 3: you a sense, okay, with the inflation issue. The inflation
Speaker 3: issue is still here, and the treasury risk premium is
Speaker 3: coming back. What we want is the treasury risk premium
Speaker 3: to be as low as possible and not handcuffed the FED.
Speaker 3: But there's also a natural equilibrium that productivity seems to
Speaker 3: be high, and the natural demographic and supply chain dis
Speaker 3: globalization issues seem to be raising the natural rate of inflation.
Speaker 3: So all those things give you a much narrower band
Speaker 3: of where rates can be, and pees you assume some
Speaker 3: drop in rates here, and pees assume some improvement to earnings.
Speaker 3: That do have a productivity dependency, and with lower educational
Speaker 3: inputs to our productivity, more of these productivity inputs are
Speaker 3: dependent on AI and all these software innovations. Usually this
Speaker 3: kind of productivity takes three, four or five years to
Speaker 3: fully be felt. We're still in the investment phase of
Speaker 3: Productivit is that going to be seen in a quicker timeframe.
Speaker 3: Because of the nature of the disruptive nature of AI.
Speaker 3: I have a sense that that part of it's correct,
Speaker 3: but I think more of it depends on interest rates
Speaker 3: than the market may want to acknowledge, and so squaring
Speaker 3: that circle is actually the risk. James, are we going
Speaker 3: to be in a place where the FED is more
Speaker 3: handcuffed than we'd like to admit. That's why I think
Speaker 3: when you look at the vic's futures contracts, the front
Speaker 3: end has dropped noticeably into the fifteen range. But if
Speaker 3: you look from a month ago and you look at October, November, December,
Speaker 3: you still see very high levels for the VIX futures curve.
Speaker 3: And that tells me smart money understands that that threading
Speaker 3: of that needle is not as easy as implied correlations
Speaker 3: as the current you know, cash level of the VIX
Speaker 3: would would would signal.
Speaker 1: Well, this is great. Unfortunately we have to end here.
Speaker 1: Thank you again our name for joining us. It's been
Speaker 1: my pleasure and great meeting you, James.
Speaker 2: Good seeing you again, David, wonderful to me was well,
Speaker 2: our name, This was fun. That last part was my
Speaker 2: favorite part. I think the macro topics.
Speaker 1: And James, thank you for being my co host today.
Speaker 2: Thanks for having me.
Speaker 3: David and I.
Speaker 1: Want to thank our listeners. If you liked the episode,
Speaker 1: please subscribe and leave a review. Also, if you'd like
Speaker 1: to see more of our research, go to bifund go
Speaker 1: and bi Stocks Go on the terminal until our next episode.
Speaker 1: This is David Cohne with Inside Active