Animal Spirits Podcast - Talk Your Book: How To Create Income in Your Portfolio

Episode Date: February 10, 2020

On today's show, we talk with John Schonberg, portfolio manager of the Covered Bridge Fund. John explains how they derive income in this strategy by selling covered calls, and how this could fit into an overall portfolio. Find complete shownotes on our blogs... Ben Carlson’s A Wealth of Common Sense Michael Batnick’s The Irrelevant Investor Like us on Facebook And feel free to shoot us an email at [e-mail] with any feedback, questions, recommendations, or ideas for future topics of conversation. Learn more about your ad choices. Visit megaphone.fm/adchoices

Today's Animal Spirits Talk Your Book is brought to you by Stonebridge Capital Advisors. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Battenick and Ben Carlson as they talk about what they're reading, writing, and watching. Michael Battenick and Ben Carlson work for Ritt Holt's Wealth Management. All opinions expressed by Michael and Ben or any podcast guests are solely their own opinions and do not reflect the opinion of Ritt Holt's wealth management. This podcast is for informational purposes only and should not be realized. upon for investment decisions. Clients of Ritthold's wealth management may maintain positions in the

securities discussed in this podcast. For today's talkier book, we spoke with John Schoenberg, who is the CIO and portfolio manager at Stonebridge Capital Advisors, and they run the covered bridge fund, which John mentioned to us before, the naming worked out perfectly because they have a bridge where they're located and this is a covered call strategy. So sometimes these things just work out perfectly. Yeah, I thought that the background on this, on how this happened was really interesting. So John was in the business for a long time and I think he was in retirement and he was like, okay, now what do I do? How do I make this money less? And he came up with a strategy, then got back into the business and now runs this for clients all across the country. Right. He told us he came up with

the strategy to invest his own money from his prior money that he made. It's interesting because this is one, and we talk about it a little bit in the interview, this is one of those strategies that tries to straddle the line between bonds and stocks. And I think anytime you do that, the majority of the way is going to be leaning towards stocks and bonds. Or the risk, certainly. Yeah, the risk. And this one is that way. But that's been a hard place to find for people, because especially for if we're in a one and a half to two percent interest rate environment, that's in if stocks are in their historical risk premium, let's say they do six. In between that two and six, that people want to find some middle ground there because they want to bring up that bond portion, which is

going to be a drag on portfolios. And he was trying to do that. Right. So a lot of times when you're thinking about, okay, I'm not in love with bonds at current yields. I think stocks have lower future returns. What do we do? And a lot of people have thought this for years now. And so one of the places that they've turned to was liquid alternative strategies, which have had a, which have been pretty rough recently. So this is a nice middle ground. I think a lot of people are familiar with the idea of covered calls, meaning you only underlying security, you sell away a portion of the upside. You really think a lot of people are aware of that? I don't think so. Okay. Some investors might be. I think for older investors, this is a strategy that is fairly

We cover what the basics behind it in our talk with John, but did you ever trade options in your trading days? Did I? Well, here's the difference. Here's the difference between what they do, what I do. I was gambling. Yeah, they were doing a, they're doing a systematic and you were just guessing. One time, excuse me, guessing. Let me get. You, you traded options on like earnings release days. Absolutely, I did. So one time, one time on a Wednesday, I bought, it was either group hunter Zinga. I wanted to buy calls. By accident, I bought, I just, I bought puts. I clicked the wrong button. I was like, oh, I guess I'm bearish now. Let's do it. So I guess the way that you described it is gambling. That's fair. Okay. So what they are doing,

obviously is not gambling. They are putting together a portfolio of blue chip stocks looks very much like the Dow companies that you've heard of. And they're selling away some of the upside. So what that does is it generates income. I think they said they were targeting six to eight percent, but here's the rub. This is not a perfectly hedge strategy at all. In other words, when the market falls, and particularly when it falls sharp, if you look at this and you expect this to be down 10% when the market is down 15 or 20, that's not really the case. This is going to, you know, there will be some, a bit of a buffer, but certainly not the whole. whole thing. So in a perfect world, you would set up the strategy, you would take the income and

you would not look at the underlying. You would not mark yourself to market every day. Yeah, he talks about how they're going to be, they either are or they're going to be paying out this income quarterly. He builds it as an income strategy, which is, it's always a tough place to be in my mind in terms of, well, we're just doing it for the income. It's like you still have to pay attention to total return, I think. Right. But if this was the kind of strategy where you saw the, the market value once a year and you just got your income on a quarterly basis. And he talked about six to eight percent. And I think that's kind of before the fees. Then you probably potentially taxes. So we got into that also. Yeah. But I, but this is the one where if this was like a private equity strategy where

you just never saw very often how much it's actually worth and you didn't see the fluctuations as moving of the stock market, you'd probably be better be better off if you're just using it for income. So I think anytime you're you're explicitly saying, we're, giving away some upside to earn this income and have a little bit of a buffer, I think that's an interesting place to be because most investors would never say, well, I want to give up the upside. But that's explicitly what they're doing. So I think the fact that they, he was very open and honest about how they run the strategy and how it works and the fact that you're still going to see losses. So I think this is just the kind of thing you have to really understand

before you get into. I was saying, we were saying before the conversation for advisors, like, This seems like a home run of a pitch, right? If you explain this story to clients, especially older ones that are in distribution mode, I think people can intuitively understand what they're doing. Oh, okay. So you mean if the stock market continues to run up higher and higher and higher, I won't capture all of it, I'll capture most on the downside. But put that to the side, the real point is that I will be able to generate income, which is tough to do in today's environment. Yes. And so that's probably why something like this actually is more made for an environment like today where you have these really low yields, where

if bonds were still yielding five or six percent, people probably wouldn't even look at this strategy as much. Now that rates are lower, I think this is the kind of one that people would kick the tires on for sure because the income is way higher. All right. So here is our conversation with John Schoenberg from Stonebridge Capital Advisors. Hope you enjoy it. We're sitting here with John Schoenberg, Chief Investment Officer at Stonebridge Capital Advisors. John, thanks for being here. My pleasure. Let's just start by giving us a quick, overview of the Covered Bridge Fund? Covered Bridge Fund is a mutual fund that seeks to provide a higher level of income than what's available in the fixed income market today. It's a product that buys large-cap dividend-paying stocks, and then we write a covered call on half of each of those individual

stocks to produce premium income that supplements the dividend income of those stocks. It's an equity-based portfolio. It has less volatility than a traditional full equity-based portfolio. For example, the beta of the funds since inception is about 0.7. And for the listeners, what's beta? Beta is a measure of volatility. The beta of the market is one. So the S&P 500 would be a beta of 1. This portfolio has a beta of 0.7, so 30% less volatile than the market.

So for people who are not familiar with options, explain to us what a covered call is. So it might be worth starting with puts and calls as just a general terminology. I always say, think of what their name is, right? A call gives somebody the right to call a stock away from somebody at a predetermined price. A put gives somebody the right to put a stock to somebody at a predetermined price. So the interesting thing is you can buy a put if you're negative on a stock because you can sell it at a higher price and if it goes down, you win. You can buy a call if you think a stock is going up. The interesting thing is you can buy a put or call and you can sell a put or a call. So most of the Most people can put a little bit of money. They buy a call because they think the stock's going up. If it does go up, they win. We don't do that in this fund. We are the seller of those calls.

So we own the underlying security. We are willing to sell away that stock at a predetermined price. And for that, we get a little bit of money to do that. Wasn't there a study showing X percent of options expire worthless? I know it's a big, big number. So maybe it's better to be the seller than the buyer? Well, it's interesting. 80%. So there is a study. 80% of calls expire worthless because you not only have to be right,

but you have to be right within a certain period of time. But when you are right, right, why do people buy the call? Because when you are right, you make a lot of tickets. Yeah, you spend a little money and you make a lot. And you know what? It's fun. It is fun. Let's be honest. Options are fun. Exactly. Options are fun. So we provide that other side of the liquidity, right? We own the underlying securities. I sell away the stock month after month. And we make a little bit of money on those options that we sell. So what is the tradeoff then? You are giving up some upside? Yes. You are giving up the upside, right? And I'm willing to give away that upside, but not on the entire position. And I think that's important. And we can talk about that. But I've never really understood why somebody would buy a stock and then sell away all the upside because in general, stocks go up over time. History has shown that. But I am willing to say, okay, guess what? I need more income. So I'm willing to sell away. part of my upside to generate that income into the portfolio. So why blue chip stocks instead of just saying owning an index? Great question. So the main goal of the fund is income. Capital appreciation

is like a secondary objective. So to generate that income, you want to sell away some of that upside. So why US blue chip stocks and selling the calls as opposed to just owning the, you know, an index fund? Blue chip stocks, the underlying holdings of this fund, they are. I mean, one thing I always tell advisors and clients is, hey, when you look at the underlying portfolio of this, you're going to recognize almost every name we own in the portfolio. So what are we talking? Coke, IBM, Procter & Gamble, Cisco. I mean, they're you. Giant companies. Giant companies. But all those companies pay a dividend. And that's the other important piece of this fund is you're getting part of that income stream from the calls, but you're also getting part of that income stream from the underlying

dividends from the securities. And that's important. It's about the average. It's about the average yield of the portfolio of the stocks inside are over 3%, 3 to 4%. And what happens when you layer in the income from the calls? The call premiums that come in month after month, the premiums range from about half a percent to 1 percent, giving what volatility is doing in the market. So when you add that up through time, it comes up to about 6 to 8 plus the option premium. It's about 3. And then after expenses, it's 6 to 8 percent on an annual basis, which is a pretty good income

stream stream? Especially with a 10-year yielding 1-8? Correct. That sounds great to a lot of people, I'm sure. What's the downside? What are the risks in a strategy like this? The main risks of the strategy, number one, which you wouldn't think about, is this fund will underperform in a rising market. By definition, I'm selling away half of the upside on each of the names in the portfolio. So in a sharply rising market, this fund, even though it's equity-based, will not and cannot keep up with the market because of the upside that's being sold away. My fear when I launched this fund seven years ago is that we were going to be in a straight up equity market and people were going to be disappointed. They should have would have rather been in stocks for the last seven years. It should have been buying calls on top

and leverage. And by the way, that's exactly what's happened since we've launched the fund, right? Is it's lagged overall equity mutual funds. The other side is in a sharply declining market that happens quick. Like last September, October, November, December, right? When the market went down, 2018, yeah, not last year, 18. When you're selling that option, you're cushioning the downside. That option is only a cushion to the decline in that time period. So in a quickly declining market, it works. It feels like it cushioned it. But if you're down 12% instead of 15%, it doesn't feel like it worked. even though you were up, you know, up by 3%. You're not buying puts.

Correct. You're not buying puts. So you talked about it lagging equities in a rising market. Don't you think that's an unfair comparison? I mean, how should investors think about benchmarking this? If they're just purely looking at it, how do I determine whether or not this is successful? It seems like if you're selling away some upside, then maybe the S&P 500 is not an appropriate benchmark. Correct.

It is not. But when it's an equity-based portfolio, people like to say, okay, we're comparing you to an equity index. When I created the product, I said it's a product with a goal. The last thing the world needs was another mutual fund when I created this. But I thought, okay, if you can earn 6 to 8% by income and have much less risk than the equity market, that's attractive to investors that need income. Think of the retired person out there that needs to live off their life savings in their IRA. They need to meet their RMDs.

How can they meet it when interest rates are this low? So this product literally is a product with a goal. And the goal is, first, six to eight percent income a year, no matter what the market does. And second, if the market's up, hopefully the fund is up more than that. So you view this as something in the middle ground between stocks and bonds, if we had to place it in an asset allocation or asset class perspective. Correct. I would say that it's a great replacement for fixed income, but it has much higher volatility than fixed income. So I would say, okay, if you have a portfolio and you're 50, 50, 50,

stocks and bonds. Maybe you take five out of equities, five out of fixed. So you have a 10% allocation to a product like this, which is going to give you a higher yield and lower the volatility. What is your official benchmark? The official benchmark, well, that's interesting. When we launched this product, I had two choices, like in Morning Star, right, where they want to put you. My choices were the Morning Star large cap value, because it's a large cap value. I mean, in that style box, the underlying holdings are top left corner, or like the alternative long short category. And I was like, that is the Wild West. I don't want to be in that category, right?

Because somebody's always going to be more bullish or more bearish and they're going to have a better product. So it's large value? It is large cap value, the underlying holdings. No. Three years ago, Morningstar created an option-based category inside of Morningstar. As soon as I saw that, we switched the product to option-based funds. And that's where it fits. It fits great in that category.

So in that category, the common benchmark is the BXM, which is the CBOE option overwrite index. That's a common index. That seems fair. Yeah. I think in my mind, I would put you as like, I don't know, does it sound like a 7030 moderate allocation? Yeah, absolutely.

So that's like a more appropriate. When a client is judging, well, how did this really do? Like the SEP 500 seems a little bit unfair. Bonds may be unfair as well. That gives you a hurdle that's too low. but maybe a 70-30 is a fair comparison. What a lot of people will do is they'll blend it into their fixed income piece to generate a little more income, understanding that it's going to be a little more volatile

than the fixed income would have been. Is the idea behind only writing calls on half the portfolio that you don't want to limit so much of your upside? Is that the idea? So this is, I think, one of the most important characteristics of the fund is that we only overwrite half of each security. Like I mentioned before, why would you? you overwrite all the upside. That never made sense to me. But it's also really important when you

get into volatile markets. And this is where option override funds fail, really, as a category and as a product. It's when you think about you're going along and you're earning a little bit of money each month by writing that call, right? You're making a little. The market's slowly declining. You're making a little. You're cushioning the downside. And think back to 2008, where this fund would have been fine. You would have made a little, made a little, made a little. I mean, the market went down for 12 months in a row. But at the bottom, it reversed and it reversed substantially a couple times, right, where the market all of a sudden rallied 15%. If you sold away all the upside in an option strategy at the low, you missed out on that one month return where it went up 10% and you

capped yourself at up 2%. You never got that return back. So you made a little, made a little, made a little missed a lot, and that's the death nail of an option fund because it loses its ability to recover when the market recovers. And that's why in this product, I only override half. So if we get into a market like that, the fund itself has the ability to recover from a market low. So in terms of security selection and the option overlay, how does that work? Is it discretionary? Is there some rules-based involved? What goes on in that process? So the underlying security selection is important. You can write calls on a stock all day long, but if it's declining in value, you're still not going to make a lot of money. So there is a lot of focus on security selection. We pick

large-cap dividend stocks, I would say the same way every other large-cap value dividend manager does. We want the same characteristics as everybody else. But that last step is what's important. It's the volatility of the underlying security, which fits into our strategy, right? If it's not even worth writing an option because the stock isn't volatile and you're not getting paid anything to write the option. Why would you even have it in the portfolio? So like a utility company that doesn't move very much, for instance? Correct. And it's funny, there are time periods where utility companies move a lot where implied vol is higher than historic volatility. Well, PG&E. Right. Well, exactly. That's not for that stock selection right there. But it's interesting that there'll be periods where

certain stocks do not have much call premium and you really, they don't fit in the portfolio because you're not getting paid anything to write that call given what the stock's going to do the following month. But so as far as the option strategy itself? So the option strategy itself, it is rules-based, and we can talk a little bit more about that. I actually received a patent in that years ago at another firm. But our goal, when we look at the option, is to say, okay, what is our standstill return over the next 30 days? And what is our return if called? And those are too important. And then we look at that on an annualized basis. And our goal is to get about a 1 to 1.5% standstill return for 30 day period in that option. And a return if called

to be about 2 to 4%. And that's the sweet spot of option writing. When you say standstill for people that don't understand myself included, what does that mean? So standstill return is, stock is trading $100 a share. You sell an option at 105 and you get a buck for it. So the stock's at 100. If the stock stays in 100 and never goes above 105, you keep that dollar. No matter what happens, right? So that is a 1% standstill return if the option it's not above its strike price and gets called away from you. So what does happen when a stock gets called away? So when a stock gets call away. In general, we let it get called away. That's the best environment when we write a call and the stock gets called away. That's actually when you're making the most money. We still own the

other half down here and it's still going above that strike. But the best environment is for the stocks to continually get called away because we're making that premium. We also write the strike price when we write that option. We generally have it just above where the stock is trading. So we get the income and a little appreciation. But when it gets taken away, it gets taken away. And we have to decide, okay, do we buy that stock back, write another option, or do we take that capital and put it in a new name that's a better opportunity and write an option over there? So really two choices, reinvest in the same security or pick a different name. So there's potentially a lot of rebalancing going on within the portfolio when this happens. There is. Options expire monthly, third Friday of

every month. I told my wife when he started this, I'm going to be really busy every third Friday. And we've done this for seven years now. And she's convinced that options expire like every two weeks because she's like, what? Options are expiring again? You're going to the office again? But yeah, it's a busy, busy thing. And I've been asked from advisors, why wouldn't I just do this myself? That's a good question that they always ask. And I'm like, you can, but you'll stop doing it after about three or six months because there's so many decisions to make every single month with stocks getting called away. What do I buy back? Do I write that option at the money for next month? Do I write at one strike up? There's just a lot of decisions you have to make on a monthly

basis. So it sounds like it makes sense for this to be in a qualified account because there's a lot of activity going on. Talk about maybe some of the turnover. And how is this income treated for tax purposes if it is in a taxable account. So it is not a real efficient when it comes to taxes. The option premium income is treated as a short-term capital gain. So it's taxed at a person's ordinary rate. And then the dividend income is a little more tax efficient, right? It's taxed at the dividend rate. But the income that you earned is six to eight percent over time. So I always say you can buy a corporate bond and earn two and a half percent and pay your taxes. Or you, you can just own this fund and pay your taxes on 6 to 8%. It's your choice. But you're right. It is

better to own it in a qualified account because it's not a real tax efficient strategy. So put yourselves in our shoes as an advisor. If you're an advisor and you want to put this into your client portfolios, what is the best explanation to explain this to normal people who maybe aren't involved in the markets? I try to keep it really simple. I try to say the underlying portfolio is large cap dividend paying stocks, you would recognize 95% of the names in the portfolio. It sounds like down names. Yeah, literally, down names. I mean, it's those names. It's large cap dividend payers, no exceptions. When we buy a stock, we always want a dividend higher than that of the S&P 500. That's kind of one of the things we look for inside the fund. The second thing I say is

without getting deep into covered call writing, is I keep it simple. And I say, when you sell a call, you're selling away the upside of that name and you're getting paid a little bit of money and that's what we're trying to capture. So it's large cap dividend paying stocks, sell away half the upside on the name. You get paid for that. That's your extra income. And I really try to keep it just that simple. And some people get it. Some people struggle. I mean, as soon as you start talking puts and calls with people, they like, oh my God. I got to imagine for retirees, though, just the income piece has to be the biggest selling point, correct? It is. And for the first time, when we launched this fund, we paid that dividend of the premium income out on an annual basis,

which created some issues because you earned it all year and then you had a huge capital gains distribution right at the end of the year. Last year, we started passing on that premium income on a quarterly basis. So it's a much more even income stream. It's not monthly like a bond would be, but at least it's quarterly. So you get the dividend pass through and the premium income passed through now on a quarterly basis. So it's not going to be up as much as the market when it's rising. It's not going to be down as much when it's falling. Is that fair to say? That is fair to say. Well, what are, I mean, it sounds almost free lunchy. So what are people missing? Like, what are the biggest risks here? Somebody might look and say, oh, wow, this is great. Why wouldn't

I put all my money in here? Like, what's the yeah, but? The yeah, but is it, it's a six to eight percent earner. So in a market that's up 30 percent last year, you're still going to be up. The fund was actually up 18% last year. It was a better return and produced 6.6% income, but you're going to lag in it up market. That's the big one. And then the other one that will be concerning to people is a sharply declining market that's quick, where the fund will be cushioned to the downside by the amount of the premium you take in, but it will still go down. So it will feel like you've lost money, but you'll still, no matter what happens, you're still getting that income. So you've got to think about it, if I want 6 to 8% of income a year with kind of medium volatility, this is a product

that's good. So just don't look at the price. Right. Don't look at the price. The price is going to go up and down. Man, if we all had that luxury that. Yeah, yeah, exactly. But your point is well taken. Like if the S&P 500 is down 18%, this is not a hedge against that. You'll be down. I'm making up a number 15%. You will be down. Correct. You will be down, but you will be down less than the market by the amount of the premium that you took in. Now, I do also have the ability in the fund, which I do not talk about all the time, but I did build in the prospectus, the ability to buy a protective put if things got really bad in the marketplace. So what does that mean? So I can protect the downside by buying an index put option within the fund if I think we're in a time period where the

market is going to be exceptionally bad. How would you know that and when would you do that? And call me before you do, please. Yeah, no. Well, interestingly. enough, we have an economist at Stonebridge that created a kind of secular, it's a secular market indicator based on the economy. It's basically told you when, since the 1960s, when you should be out of the market, because there's a recession coming. It didn't say sell for 87, the downturn. It didn't get you out last December of 18. Have there been any false positives in the last few years, or has it been smooth sailing? It's been smooth sailing up until right about now, which is interesting. John. Yeah, I know, I know that the economy is in the process of peaking. Again, this is an

economic indicator, not a market timing indicator. So we'll take it with a grain of sand, as we say on the show. Right. Take it with a grain of sand. But for the first time in 10 years, it's saying, hey, this economy might be as good as it gets. In my mind, this is a great opportunity for a product like this that is, number one, less volatile. And number two, when things start to get hairy, well, I try to protect more of the downside. I will. I mean, I am one of the largest shareholders of the fund itself, which is important. Which is very important. I love it when my friends call me. I'm like, oh, John, your fund had a bad day the other day. I'm like, really? I didn't notice. I mean, it's crazy. So it's my capital in the fund as well. I want to, if I think I need to protect the downside,

I'm going to try to protect some of the downside, not all of it. But I'm trying to cushion it even more. I'm going to try. If I'm wrong, guess what? I'm just not going to make as much. I'm not going to lose more. Right. You take, let me your upside again. Yeah. Anything that we didn't cover that you wanted to get to? Not that I can think about the top of my head. You said, where does this fit in a portfolio? It fits into somebody who needs income. And in this low income environment that we're in today, it's tough. You have to reach for things that you don't necessarily want to reach for. You have to either extend your maturity out in fixed income or go down in quality.

Not the time you want to do that, I think, in the market. So this is a good alternative income product for people that need income. John, thank you so much for coming in. We really appreciate you taking the time. I appreciate being here. Thank you. Thanks again, John, and everyone at the Covered Bridge Fund for coming on. This was an interesting strategy because not something that we've really talked about before. So we'll include links to their fund and all their research in the show notes. Send us an email, Animal Spearspot, at gmail.com.