Animal Spirits Podcast - Talk Your Book: Protecting the Tails

Episode Date: October 9, 2020

On this edition of Talk Your Book we sat down with Simplify Asset Management's Paul Kim to discuss how investors can protect their portfolios from both upside and downside volatility in the stock market.   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

Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnick 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 relied upon for investment decisions. Clients of Rithold's wealth management may maintain positions in the securities discussed in this podcast. On today's talk to your book, Ben and I sat down with Paul Kim, co-founder and CEO of Simplify Asset Management to talk about

one of their new products. Simplify U.S. Equity Plus Convexity ETF, SPYC is the ticker. It's interesting because we're seeing a pretty big influx of new ETF products that are using options and leverage and some more sophisticated, for lack of better term, strategies that you didn't have access to in the past. And we talked to Paul about this. He said that there was a reason for that because in the past this stuff wasn't allowed. But this one piqued my interest. So we'll get into the specifics of it on the show, but it basically invests the majority of the money in an S&P 500 ETF, 98% of the fund. And then the other 2%, 1% of it is in a option that hedges your tail risk on one end for losses. And the other one is an option

and the hedges of tailors for huge gains. So you're basically investing in the stock market, but with some options to take advantage of enormous volatility should it happen. And I think on the downside, so this is new, so there's no track record. But in a really bad market, would this give you something like a 6040 exposure? I'm sure he wishes that they would have launched this a year ago, but the company has literally been launched this year in the midst of the pandemic. So it's actually, I think, a perfect candidate for something like this year where we saw a 35,

percent pullback and then stocks take off whatever 60 or 70 percent. That's a perfect scenario for this kind of fund where you have volatility in both directions. I think that there's going to be a decent size of appetite for this sort of thing for a few reasons. One, after Q1, people are interested in tail risk again. And this is an idea that people want to get rid of the downside, but what they often end up doing is getting rid of their upside, right? Because most of the time, stocks don't go down, but if the hedge is too expensive or if the product can't survivable market, then it's effectively garbage. It's useless. And this can survive a bull market and give you some downside protection. There are very few. So the idea is there's a left tail and a right tail on a distribution.

The left tail is the bad losses that you want to get rid of. The right tail is huge gains. And most people say, why would I ever prepare for huge gains? It's like because those happen just as often or more often than the huge losses. So I do like that most products and strategies these days are more concerned with the downside. I like the fact that they take care of the upside too and plan for both scenarios where it's hard to predict where upside volatility is a thing, even though a lot of people don't really plan for that. So they're positioning this as a core replacement. This is not supposed to, I guess in their mind, obviously they want the whole piece, but this is not tactical.

What's nice about this is they rebalance for you. They're managing all the options inside of the ETF. So it's very hands-off, right? Which is nice for people that are trying to incorporate this into their portfolio. Yeah. And it rebalances for you and the costs are low. I think this is the kind of product that is kind of a win for the individual investor that they never would have seen before or trying to create this yourself would be

extremely difficult to do. If you can do it in an ETF wrapper at a low cost, I think that's a win for this small investor. I was trying to think about this. And I think we asked Paul, what's the catch? Because this seems sort of free lunchy and we know those don't exist. That doesn't exist. So what do you think? Where are some of the holes? That's like your favorite question to ask, by the way, for these things. I don't want to be naive, but this really sounds. Well, no, it's true because a lot of times the sales pitch doesn't, like the hole is, sometimes the stock market just there's not a lot of volatility. It can happen. That happened in the mid-2000s. That happened

a few years ago, the 2013 to 2017 period, there wasn't a ton of volatility. Sometimes stocks just go up in a slow plotting manner. So volatility isn't forever. So when there's no volatility, you're paying insurance premiums on this. Yeah, but I guess my point is like you know that. You know that going into it and it doesn't seem like a ridiculous cause that's going to bleed you dry. Right. But yeah, it's a small enough piece where the options are far enough out where you're not paying a ton. And that's the way to think about a hedge is you're paying an insurance premium and for when those volatile situations happen because you know that they do. And I've been saying for a while, I think markets are probably going to be more volatile going forward. I think that's a

real possibility. And this is an interesting way of dealing with that. All right. So this is our conversation with Paul Kim from Simplify Asset Management. We're joined today by Paul Kim, CEO and co-founder of Simplify Asset Management. Paul, thank you so much for coming on. Thank you for having me. Before we jump right into the product discussion, some of our audience might not be familiar with you, but you have a really interesting background. Can you give us like 30 seconds? Who are you? Sure. I started my ETF career with Pimpco back in 2009, helped build out Pimpco's ETF platform, which is a little over 20 billion, worked closely with Bill Gross and others, launch funds like Mint and Bonds. That was a very, very interesting education, really

straight out of business school. And then from there, after Bill left Pimpco, I was poached by principal, and I helped build out principal's ETF business to about $3.5 billion. And then most recently, I saw an opportunity and option embedded strategies, thought there'd be really cool way to bring out new solutions for advisors. And that was really the genesis of simplify asset management during the heart of COVID. Yeah, how has that been starting a new firm in the pandemic here? The hardest part was sort of sending in the resignation email because that was just scary.

You just knew once that went out, that was it. But once that sort of email went out, it just got easier and easier. Actually, it kind of works well in that as a smaller firm during COVID. You could reach people easier with Zoom and all sorts of the technologies out there. And so not having to spend a lot of time traveling, I made things a lot easier. And then from just kind of the logistics, in New York, I know the industry and sort of the key players. So it's been fairly, fairly easier than sort of what I had feared going into it. All right.

let's get into this. Please, explain in layman terms, if you can do such a thing. What the hell does convexity mean? First, positive convexity is a good thing. Investors are willing to pay to add convexity to portfolios. Positive convexity basically means an investor may profit more as prices go up and lose less as prices fall. It's a term familiar to bond investors, Pimco guy, bonds with positive convexity like treasuries, trade at a premium or lower yield, then bonds with negative convexity, like high yield or mortgage-backed securities. So it's a good thing. And all we're doing in our first set of ETFs is really combining SMP 500 exposure and bringing positive convexity to that equity strategy. I'm looking at your U.S. equity plus convexity ETF. It's

ticker SPYC. The explainer that you guys give in your video, it makes sense. So you're talking about, okay, we're taking 98% of basically S&P 500 risk, and then we're trying to hedge out the tails, both upside and downside, which I think it's interesting because I've made the point on the podcast that I think going forward with interest rates low and valuations high, we could see just way more volatility and way more booms and bust. So it's interesting in that realm. So how are you using options to hedge out these two tails? How does that work? So first step back, think of options as taking out insurance. So out-of-the-money options are essentially catastrophic insurance. We're protecting against extreme outcomes. And so focusing on the tails in that case means you are

minimizing the cost of insurance because if we try to hedge out every risk, right, all risk, it also means squeezing out all the returns. So hedging out tails can be done at a reasonable cost. And so that's one element. Spicy SPYC is designed as a direct substitute for SMP-500 index fund. And so as a replacement for S&P 500, the first goal is do a decent job tracking the benchmark. That's accomplished by having, like you pointed out, 98% of the portfolio in SMP 500. We literally own shares of IVV. And then the remaining 2% think of that as sort of your insurance premium and it's funding catastrophic insurance on tail risks. We've found that sort of out of the money index options, think about 25 to 50% out of the money in this.

So pretty far away from the current price provides a lot of protection and really does a good job of giving you bang for the buck in a broad range of scenarios. So if you talk a little bit about the mechanics, how does this option's budget work? So you've got 2% of the funds and then you're doing what exactly with it? So with the remaining 2% we're annualizing that and sort of buying each quarter, think of it as spending roughly half a percent of options. So buying some out of the money calls on one side and out of the money puts on others. we're buying it in the right place where it could do, again, the most bang for the buck.

Let me ask you this. Why go after the right tail, which is, I guess that's the positive convexity part. Wouldn't just the exposure to the S&P 500 be good enough? Or is the idea that if we go on some sort of parabolic increase in the market, that the return from the call is going to offset the cost of the put? Or what's the thinking behind that? So in this strategy, and we have other versions that are one-tailed, so either just the downside or just the upside. This particular strategy, we're trying to both protect against sort of your historic drawdowns or 15% or more, but we've also studied the melt-ups. And if you're honest, that's sort of what we face today and today's sort of investment environment. On one hand,

you have sort of the potential for deflation and a retest of the lows and the significant drawdown because we have all these stretch valuations. And just as poorly on the other side, you have massive money printing, $6 trillion with trillions of dollars. to come, potential inflation, potential devaluation of dollar. And so if you're thinking about investment driving positive real return, you should at least consider the right side. And so we built in the scenarios where we're protecting against both likely scenarios. So what are some expectations investors can set in something like this? Obviously, you can't give specific parameters because the cost is already changing of these options. But at what point can investors hope that

these options kick in on the downside and the upside? So it's hard to give a very specific forecast options. Like if you bought bonds inside your portfolio, you wouldn't say if stocks sold off this percent, you would exactly get this return. But I think it's safe to say the more volatility there is and the faster the drawdown, the more these options become in value. So volatility and sort of the distance away from the strikes are what drives these options prices. So even if you don't hit specific thresholds, those options become worth more as you get closer and more volatility hit in the market basically. Exactly. Exactly. So could you share, for example, I know obviously it's a back test because this thing just went live frequently, but what would the strategy have done in the first

quarter of 2020? How much downside protection would you have got? So again, we can't really reference the back test, but I think it's very helpful to consider some basic illustrative models. For example, we all lived through a peak detrae earlier this year, S&P fell about 35%. If you had a balanced portfolio about 6040, let's say spy and TLT, for example, you would have only seen about half the drawdown and help perform actually year to date. And interestingly enough, a basic out-of-the-money strategy that's 99% SMP 500 and 1% invested in 30% out-of-the-money puts would have performed comparably to the 6040. In other words, a 1% allocation to out-of-the-money puts would have provided the protection and outperformance of a 40% allocation to bonds.

That's interesting. But, okay, question about the mechanics of this. Are you taking advantage? So in other words, we see a 35% draw down very quickly and the S&P 500, ostensibly the value of these out of the money puts explode. Are you rolling that? Are you taking money off? How exactly does that work?

What do you do when? So if it moves far enough in your favor, for example, like a March scenario or or maybe a flash crash event. We have monetization rules, so we don't just sit there and watch options go 30, 40x, and then hope it holds for three months. We have monetization rules, but the primary driver of outperformance is just having exposure

that cuts off your downside, so you lose less, and then rebalancing and monetization when you make enough money to do that, and then that geometric return you get from cutting off your downside. And then I would also note that these options are structurally cheap if you go sort of a long out of the money straddle, i.e. long calls and long puts from my 2012 onwards, you basically had a free lunch. You received insurance, and you were paid to put on that insurance policy. And so I think there's a lot more supply of these options than has at least been historically demand.

So I was going to ask that there's some sort of rebalancing thresholds here where you guys are making changes, is not just kind of bindhole in these options. Yes, but it's done systematically. We're not trying to go in and hope our emotions hold up and sort of time when we rebalance. We built that in, and we've studied historically a wide range of drawdowns. We found that they cluster into sort of two main groups. You have sort of your March episode where you see, you know,

call it a 35, 40 percent drawdown in a very short period of time. And then you also see a lot of historical scenarios where you see over two years it's a slow bleed. And so if you only protect it against, and in slow bleed, I mean, in the Great Depression, you saw an 80% drawdown for two years, right? That's pretty painful. And if you only protect it against sort of the sharp drawdowns, one, your portfolio does not protect against a lot of other outcomes,

but you're facing up to that kind of 80% drawdown without protection. And so we're basically splitting our budgets to buy some really short maturity out of the money puts for cluster one. and then more longer term kind of one year puts, that captures a lot of that sort of protection for the other cluster. So it sounds like this is a rules-based strategy. I imagine that this follows some sort of an index. So it's not an index, but it's a rules-based strategy.

It's actively managed overlay with a passive S&P 500. Why is it actively managed? Well, we want to keep it systematic. So we want the advantages of taking the human emotions out of it. But at the same time, we want to keep it relevant. We learned things about the market or different scenarios about sort of central bank policies you want to be able to incorporate things into it. Think of it as sort of a fast improving index strategy. So options-based strategies are becoming a little more prevalent in the ETF space. It's still

relatively new. How do you explain this type of strategy to someone who is not really familiar or comfortable investing in options in the first place? I think of it as another menu item and one that's increasingly important because, again, in the past bonds, particularly treasuries, have done such a great job in providing downside mitigation and diversification, especially when historically, equity premium is not that big compared to what bonds have given, call it 11% annualized returns in equities, 8% in bonds. And so you're not giving up that much for that protection. But you come to today, the 10 years at 70 bibs, wherever it is right now, one, that premium versus equities has gotten a lot bigger.

And then secondly, how much more can it protect you? How much more can bonds protect you when rates can't go that much further, right? Down. And so you're kind of challenged looking around for ways to protect your portfolio. And options are a very, very interesting way to do it because SPX options, for example, are literally anti-correlated. Direct hedges to the S&P. So you don't have to worry about correlations.

We just talked about how structurally they are cheap. and increasingly liquid. And so they're a really, really viable alternative to bonds. And you're seeing that offered in the ETF vehicle because it simplifies the execution of those strategies. Would something like this have been possible to execute an ETF, say, 10 years ago? Definitely not. There was an outright ban on swaps options in the future.

So that's part of it. The ETF rules are a lot more flexible in what you're allowed to bring to markets. You're seeing sort of the regulatory environment change. you're seeing growing adoption of options, everything from single-name stocks that you see in the Robin Hood crowd to, again, things like these options. There's about $250 billion of options traded every day. That's over the past week, for example. And that's not even the notional coverage. That's just the value of the option. So you're talking tens of trillions of dollars of equity

valuations. So it's a very, very liquid market, very standardized market. And the regulatory and demand characteristics that are all sort of trying to make these become a lot more easy to use. So I assume, obviously, you're hedging out the tails upside and the downside, which is interesting because a lot of times you hear people just constantly talk about the downside, not the upside.

So I assume that means the middle ground is probably a worst-case scenario where the market kind of plods along and you just eat the cost of those options. That's not worst-case, but that's just where those options don't really come into play very much. Yeah, and you think of it as sort of a weed-structured it's an explicit and transparent cost of insurance, you factor that in. So let's go back to my

previous example. If you're not putting 40% of your portfolio into bonds that yield 70 bibs, and you're now able to put some of that into the equity allocation, what's really the net cost of running a hedge using SPX options. It's not exactly the 2% drag that we built in. It's actually less. And then what's the potential upside of these options relative to bond? or just taking risk off. And so I think all of those things need to factor, but we at the minimum want to give investors another really attractive way to think about risk mitigation. This sounds like a free lunch.

What are people potentially missing? Because I know free lunches don't come around too often. There's definitely no free lunches today. But like I said, in the past decades since 2012, you've essentially gotten a free lunch. VIX was in the low teens, and today it's sort of in the high 20s. So the price of that lunch has gone up, but we would argue it's still fairly cheap relative to all the other sort of ways you could, again, mitigate risk. Because your long volatility, the worst case is basically a period of low or sideways volatility

and you can see a drag of whatever you're putting into these insurance. But also remember that even historically, when you look sort of a calm period for years is not a historical norm. An average annual drawdown in the S&Ps about 13% a year. when you've seen about 20% or more drawdowns, i.e. a bare market, one out of every four years. And that's historically. I'd argue going forward, you should expect volatility to go up more. Market structures change a lot. There's a lot more passive investment. There's ample liquidity right at the sort of bit an offer, but not a lot of depth. And then you have a lot of systematic strategies

that tend to sort of be pro-cyclical and sort of exaggerate moves up and down. And obviously, all those things combined. And we've seen some of that in March. We've seen how quick bits can disappear and how quickly the market can move. Yeah, and I think the idea here, too, is that people try to bet on these volatility ETFs, which are really hard because it's hard to understand the structure of them. But this is a way to invest in or bet on volatility without guessing which way it's going to go, right? Because we've seen both upside and downside volatility this year. Yep. And that's a challenge because, be honest, people are horrible at timing market shifts

or portfolio shifts. And so this is a way to keep a strategic sort of protection built into your equity allocation, not time the market, but in essence, buy cheap insurance for, again, catastrophic insurance, no timing skill, no need to sort of rebalance during the most emotional market periods. It's doing that work by buying options before. And then during volatile periods, it's automatically sort of benefiting from market volatility. And then you could choose to either allocate away from equities or stay in there because, again, you don't need to time it if it's built inside of your equity allocation. So this is a new product. Talk about somebody that might look on Yahoo finance or whatever and say, oh, there's only a few million bucks in this strategy. I'm not comfortable.

There's not enough assets. It's not liquid enough. How does the ETF solve this problem? Why should they not worry about that as a risk? One, an ETF is as liquid as its underlying holding. And so if 98% of our portfolio is holding IVV, we could literally accommodate a billion dollar inflow and not even blink about it. So that's one, and similarly an outflow, that's one. And then secondly, the ETF itself, even though it's small, it's a heck of a lot bigger and easier to use than doing it yourself, an SPX option, which is what we're using. At the money SPX option has a notional of about $335,000 and the contract trades for $7,000. So good luck using that and allocating that across your customers if you're an advisor. Also, there's guideline and collateral challenges.

Custody options is painful. And then the paperwork to get permissions to use them and all those things. And so what we're doing like many successful ETFs is taking a very, very difficult to access strategy and bringing it inside a commingle fund, single ticker, replace your SPY or IVV position. So you just spoke about the cost of these options. Are you getting exposure through synthetic positions, or are you actually going out and purchasing the options directly? We're buying SPX options directly. They're tax advantage. There's no counterparty risk. They're all clear and guaranteed by the OCC. So you don't face the counterparty risk of seller of options. They're liquid. They're transparently priced. And you can see their prices on exchange every day.

So you don't have to give your full business plan outline for the future. But possible to do this for foreign stocks or small caps? Or is it just that the S&P 500 is so much more liquid? It's easier to do that in the space because of the options market. Yes, it's possible. It's easier where there's a lot of options liquidity, right? Because it's just cheaper in terms of transaction costs and more effective. I would say there are certainly more benchmarks that we could tackle where there's ample liquidity. It gets more challenging the nicheer you get. So EM might be just at that borderline, certain other U.S. benchmarks, for example, are liquid enough, and then commodities are a place where options can be very useful. Think about what happened to oil, and it went negative.

Ben took physical delivery. Yeah, exactly. So an option is non-recourse leverage, and there isn't a whole lot of premium relative to things like features and swaps built in. And so can you make much more sort of safe product development ideas that take advantage of that characteristic? And that's what we're trying to do. I'm also kind of curious how you decided on the 98% in the IVV. Obviously, there's tracking error consideration. So you could have said, we're going to put 90% in the S&P and put 5% in each of these hedges. So how did you come to that realization on picking that amount? Well, we started by saying, is this going to be a tactical bet? People are trying to time when ball is cheap and leg into it, or do you want this to be a strategic allocation? And the

answer for us was, we want this to be a strategic allocation, which means the size, of that insurance, the drag can't be too high. Imagine three or four years in a row if your insurance are sort of wasted. Where you see a sideways market, if it's 10% of the portfolio, you're talking big, big drawdown relative to the benchmark. You're not going to be able to hold that position. If it's 2% a year, one, that drag is a lot lower, but we found 2% to be plenty of ammo to help protect and enhance returns. So this is not that easy to understand. understand, but it's also not incredibly complicated. I assume that a financial advisor would be the natural buyer of this. Is that right? Yes. Okay. And then what would be the pitch for them

to an average Joe, for lack of a better word? What's the pitch for this? Another way it might be saying sort of who's the natural buyer for this. And yes, I think advisors are certainly top of the list because it's sophisticated enough where you don't want to have to tell the story to every single investor, but an advisor understands sort of different ways that they could build out a portfolio. And secondly, we are solving a problem that advisors have in that there's ways to get option strategies and overlays. It's clunky, expensive paperwork involved. So we're trying to simplify that. But beyond that, we're solving the biggest problems today. If you think about sort of your classic 6040 portfolio and that 40% of that bucket being really challenged, we'll have

helping at least give an alternative to that. And then even on the equity portion of that, we think both from a potential outperformance perspective, but also from just sort of a preference of clients to not think about drawdowns or worry less about drawdowns. I think there's a room. There's a lot of room for being able to hedge out equity exposure. It's the biggest, the most important part of your portfolio. We've done a great job in providing access as an industry, at very cheap prices, we're just starting to sort of build out ways to enhance that allocation. All right. You hear all the time about option-based strategies blowing up all the time.

What's different about what those people are doing and the stuff that you read about in institutional investor versus what you're trying to provide? Most option-based strategies are chasing yield. If you think about it, for the most part, they're writing options. They're writing insurance. They're not buying insurance. So our strategy is the reverse. We're not interested in chasing yield.

We're not interested in picking up the nickels and dimes in front of the bulldozer. We're a long option. So we know exactly what's the max. We could lose any given time. That's very different from selling options or as we just talked about using futures or swaps because a listed option that you're long, you know the worst case scenario is you'll lose your premium. Paul, is there anything else that we didn't ask you that you wanted us to be up for you? Not specifically.

This is my first podcast. We're super excited. We're a brand new company. We've been having a lot of fun just talking to advisors, the timeliness of what we're trying to bring. If you think about an RAA, there really entrepreneurs are at heart too. So we've sort of had kindred spirits that we were able to talk to. And it's been a lot of fun. Awesome. Well, we're excited for you. We think that there was a lot of potential in this space as the 6040 portfolio. Comes under assault might be too strong of a word. A little bit. It died six years ago. I personally just want to say I love the name of your company. Simplify. That's my whole thing I've been writing about for years is just simplifying things. So I think I love the name. And I think these are really interesting. And I do love the fact that you're talking about buying insurance for both sides because so many people talk about in stocks is not to be something to be ignored either. Yeah, we talk about this all the time. If something can't survive a bull market, it's not going to be there for you when you need it. So this sounds like it'll be there in good times and bad. So. Paul, thank you very much for coming on. We appreciate it. Thank you both for hosting, and I've enjoyed my first podcast ever. It's fun. All right, Paul, thank you very much for coming on. Animal Spiritspod at gmail.com. Thank you very much for listening, and we will see you next Wednesday.