Animal Spirits Podcast - Talk Your Book: Yield at What Cost?

Episode Date: October 14, 2024

On today's show, we are joined by Jonathan Molchan, Managing Partner at STF Management to discuss how the trend following rules work, issues with traditional call option writing strategies, trend following performance through different cycles, and much more. Find complete show notes on our blogs... Ben Carlson’s A Wealth of Common Sense Michael Batnick’s The Irrelevant Investor Feel free to shoot us an email at [e-mail] with any feedback, questions, recommendations, or ideas for future topics of conversation.   Check out the latest in financial blogger fashion at The Compound shop: https://www.idontshop.com Past performance is not indicative of future results. The material discussed has been provided for informational purposes only and is not intended as legal or investment advice or a recommendation of any particular security or strategy. The investment strategy and themes discussed herein may be unsuitable for investors depending on their specific investment objectives and financial situation. Information obtained from third-party sources is believed to be reliable though its accuracy is not guaranteed.   Investing involves the risk of loss. This podcast is for informational purposes only and should not be or regarded as personalized investment advice or relied upon for investment decisions. Michael Batnick and Ben Carlson are employees of Ritholtz Wealth Management and may maintain positions in the securities discussed in this video. All opinions expressed by them are solely their own opinion and do not reflect the opinion of Ritholtz Wealth Management. The Compound Media, Incorporated, an affiliate of Ritholtz Wealth Management, receives payment from various entities for advertisements in affiliated podcasts, blogs and emails. Inclusion of such advertisements does not constitute or imply endorsement, sponsorship or recommendation thereof, or any affiliation therewith, by the Content Creator or by Ritholtz Wealth Management or any of its employees. For additional advertisement disclaimers see here https://ritholtzwealth.com/advertising-disclaimers. Investments in securities involve the risk of loss. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. The information provided on this website (including any information that may be accessed through this website) is not directed at any investor or category of investors and is provided solely as general information. Obviously nothing on this channel should be considered as personalized financial advice or a solicitation to buy or sell any securities. See our disclosures here: https://ritholtzwealth.com/podcast-youtube-disclosures/ Learn more about your ad choices. Visit megaphone.fm/adchoices

Today's Animal Spirits Talk Your Book is brought to you by STF management. Go to STFM.com to learn more about their two tactical growth strategies. The Tug, TUG, STF technical growth strategy, and the TUG and STF technical growth and income strategy, both ETFs, and we'll check out STFM.com to learn more. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnik and Ben Carlson as they talk about what they're reading, writing, writing, and watching. All opinions expressed by Michael and Ben are solely their own opinion and do not reflect the opinion of Ridholt's wealth management. This podcast is for informational purposes

only and should not be relied upon for any investment decisions. Clients of Ridholt's wealth management may maintain positions in the securities discussed in this podcast. On today's show, we're joined by Jonathan Mulchand. He is a managing partner at STF management, and we got into trend following and option. Overlay Strategies of the NASDAQ 100, which has been a very popular corner of the market. I think what's interesting about what Jonathan is doing is he's taking a different approach to generating income on top of the trend following model. That we haven't seen.

No. It's also interesting to see people from the hedge fund world get into the ETF space. Yeah. Because this is the kind of strategy you would never have seen an ETF in the past. No, no. We didn't get into this on the show, but he spent time at SAC Capital and Millennium at Ben's Point. And a theme that we've been talking about on other shows is the ETF milestone of $10 trillion in assets.

It's not just index funds. In fact, a lot of the growth in the market is coming from active strategies like this. And the ability to do it in a wrapper like this, that's liquid and tax efficient. And you're able to put all sorts of different interesting strategies is something that's unique and new and interesting. Yeah. So these strategies are starting with the index as the baseline. But then it's also adding a tactical overlay and trend following. It's also on the other strategy, tug-in, it's adding an income options overlay as well.

One thing that we got into on the show at the end of it was what might happen to the income being generated on a lot of the popular strategies in a falling rate environment, which is something that I think is not being appreciated by investors in the market and an interesting consideration for those that do. So with no further ado, here is our conversation with Jonathan Mulchand. Jonathan, welcome to the show. Thanks for having me. For the audience, just if you don't mind, give us a quick 30 second background. How do you get here? Who is STF? What are you trying to accomplish in the market?

Sure. So STF management is a ETF issuer based out of Texas. We are focused on active ETFs that complement traditional asset classes, but with an innovative twist that help investors remain invested to different market cycles, as well as solving for the challenges associated with generating consistent current income. We do that through two ETFs, TUG Tug and TugN TugN. These are what I call the third generation of options income ETFs that have moved from a passive underlying passive income to a passive underlying and.

active income to now fully active and touching all asset classes while solving for that income need. What does STF stand for? Simple, transparent, and focused. Okay, not bad. Okay, so the, so the, like you said, the first two option-based income strategies are, I guess, are pretty well known. So how does yours differ from those? What are you trying to expand on? Sure. So about 10 years ago, I became involved in the UTF industry after starting my career on the hedge fund side. There was a collective curiosity to see if options-based strategies could gain traction within the retail investment community. And what Tug and Tug in do differently? So Tug is basically the underlying benchmark. So if we were to think about passive, say, Byrider covered coal products, you know,

they're tracking the S&P, the NASDAQ, or the Russell 2000 to name kind of the three big ones. So what Tug does is it can toggle between an allocation to the NASDAQ 100 and a full replication, but in times of downtrends or heightened market volatility, it can toggle into U.S. Treasuries to provide a risk-off component without incurring the cost of a hedge like many hedged equity products. So the key difference is that unlike a passive index product, it has the ability to de-risk. in times when maybe you don't want to be 100% long stock. In regards to tug-in, the underlying is the same. The difference there is that it has an active option overlay, and unlike a typical covered call product, it's selling a monthly call spread.

The benefit of that is it can still support the high current monthly income and the distribution, and right now it has a 12-month-trailing yield of 12%. But it can help and reduce capping that upside participation, unlike a passive product can. So, you know, one, you're solving for income, two, you have the ability to remove the option prior to expiration if the market's moving higher so you can increase that participation. And it also allows you in changing market environments to be able to lock in those gains and close that option out.

All right. So let's stick with Tog and then we'll get to Tug on you because you just said a lot that I want to dive into. So a lot of the hedged products were really built for bear markets. And the reality is bear markets are fortunately few and far between. They exist for sure, obviously. But the challenge is for some of these products that have come to the market, certainly after 08 and even through, you know, pick a year, they weren't able to survivable market.

And if you can't survive the upside, then you're no good to anyone during the downside. So how is your product accomplishing both surviving the upside and being able to potentially survive the downside as well? Right. So in regards to Tug, it's looking at moving averages, rates of change, market volatility. And as a trend turns south, it has the ability to, in general, regardless of market environment, there are three scenarios that you'll see the portfolio composition. So you'll be 100% stock, and let's say the market starts to slow down and then roll.

We can go 50 stock, 50 bond. If the market continues to roll, we can maintain a position of 10% stock, 90% treasure. So if we want to look back in time, and this is just looking at the market, this has nothing to do with the ETF. in 01 with the dot com, it would have taken you almost 15 years to recoup that same level of principal balance. That's a long time. So our ability to de-risk is the key difference. What I will say is that, you know, the biggest risk, let's just say with the passive covered call strategy,

It's not necessarily that your downside is essentially unlimited, less the premium received. It's that it could potentially take you forever to recoup the principal loss and the sell-off. So we'll use an example here. So let's say the VIX is at 20 and you sell an at-the-money call. Typically, VIX divided by 10 is the premium you'll receive for a one-month-out expert. So you brought in 2%, the market's down 20. So you're down 18, the market's down 20. Alpha.

So now the VIX is at 40, four weeks later. So you bring in 4% and the market has a V-shaped recovery and now the market's flat. So you're down 14 and the market's flat. That's the biggest risk to these strategies is how do you recover the losses? Fast forward to 2022, which was probably the most unique year that I've ever seen. In that year, you saw the S&P down 18. You saw the NASDAQ down about 32. On that back end of that, long bonds were down about 32 as well.

So risk off was still risk on. If you then look at, say, the passive CBO indices, so BXM, BXN indexes. BXM was still down 11, and the BXN, which is the passive app, the money on the NASDAQ was down about 19. So you participated in 50 to 2 thirds of that downside. But if you look at what happened 23 to now, they've only participated in 50% of their recovery. And, you know, what I find interesting about this is that even if you were to use Tug as

an asset allocation benchmark, the way in which, you know, Tug end with that options program operates, it's participated in 90% of that total return over that same time frame. So that's what I like to highlight is yield at what cost. How much total return are you potentially sacrificing while chasing that double digit yield? I'm curious, a couple things on the strategy. First, I guess, how often do you look at your trend signals to determine whether to have risk on or take risk off? So that's monitored daily and throughout the day. That being said, there are guardrails in place to not overtrade and for turnover to not be, you know, 4,000 percent. You're looking at probably four to five reboundses annually.

In a quiet, sleepy market, you could see maybe one or maybe none. So the option overlay is something that you're obviously very intimately familiar with. What do you think are some of the differences between the spreads that you put on versus some of the traditional? stretches that have gotten really popular in the marketplace? Sure. So the idea behind the spread is married to the underlying structure of the Tug model. So being that it has the ability to de-risk and has the ability to also source income from treasuries, if in that scenario, the spread can still support a 1% distribution.

The benefit of the spread versus, say, just a straight at the money call is at the money call, it's going to be short 50 deltas. So basically, what that means is for every 1% move higher or lower in the market, you're participating in 50% of that. We're short 20 to 30 deltas. So we're increasing the upside capture when the market moves higher. And when the market moves lower, we don't necessarily depend on that short. call to buffer the downside to the same extent because we can then go out of 100% stock into 50 stock, 50 bond. So I'm curious how much of this is rules-based and how much of this is just you understanding the options market? So I would say the majority is rules-based.

There is a bit of an arc within options and understanding when certain moves and changes in market structure don't add up. I mean, there's been no shortage of events in the last two, three years since the funds launched. They hit their two-year track record in May of this year. So the idea here is to support the distribution, reduce the upside cap, and, you know, seek to track your underlying benchmark more closely than a passive strategy cap. Set it and forget it. You know, The people talk about buy and hold, we kind of talked about the advantages of Tug versus buy and hold and its ability to de-risk, not participate all the way down and then hopefully recover on the way back up. The idea of the option is to be complementary and to reduce

that negative contribution to the total return. For the underlying holdings, are you using ETFs or individual stocks? So on the stock component, we fully replicate the NASDAQ 100. Okay. So the trend following, was that at the index level or the stock level? And how does that work? So it's at the index level. So Tug was created as a way to combine two uncorrelated assets. And that over time you could smooth the return profile of a risk on asset and a risk off asset basket. So in these two funds, the risk assets in NASDAQ 100. The risk off asset is the least correlating. U.S. Treasury, regardless of duration, the twist. Oh, so sorry, so that sort of interrupt, but so that the bond piece can change then

depending on the environment. You don't use the same bond piece for every, every sell-off or every downturn. That's correct. It's the least correlated to the equity complex. And the reason for that, you know, was visible in 2022, where, you know, a long-duration treasury ETF participated in the same downside as NASDAQ-100. caused the downside. Yes.

And, you know, especially with inflation being front and center over the past couple years, you know, historical research shows that, you know, anything 10 years and farther out, that correlation actually comes in materially to the point where it's a detriment to the portfolio. I think, you know, this is the advantage of, you know, tug and it's purest floor. being a innovative solution to the traditional 6040 portfolio because not only is it helping investors remain invested and not capitulate with market volatility, but it's also solving for the risk off piece. So maybe right now you want to be a 90-day paper.

If that changes, maybe you're in, you know, seven-year duration. Maybe at some point in two years you're in 20 to 30-year duration. But so it's solving. for those two pieces, and then tug-end takes it a step farther and gives you income without, while seeking to not sacrifice that tool return. I'm curious on the tug-end piece. Do the tactical rules supersede the income strategy? So, like, if you're totally risk off and you're 10% in stocks and 90% in bonds, obviously

that income piece is a lot smaller, I would imagine? No, so with tug-in, it actually is able to collateralize all of the underlying securities, both equity and fixed income. So if we are in a sideways to down market, we are risk off, we can still support that distribution to the selling of the monthly coal spread. So then in theory, the investors benefiting because they're still supporting the income need on a monthly basis, and they're getting paid to wait for the market to rebound. And that's the big advantage of tug, is that it's removing the emotional.

bias from investing the market. It's saying the model is taking care of when do I sell, when do I get back in? Because those are two very difficult decisions for any investor to try and make. So just getting back to the trend following, I'm not exactly clear how it works. So the trend is measuring is being measured at the index level, but then you've got the replication of the individual security. So is there an in-out or is it like, is it gradual with only certain holdings? How does how does that happen? So from the holdings perspective, the idea was to give investors the same core exposure that most of them already possess. So exposure to NASDAQ 100 and exposure to U.S. Treasuries. At a single stock level, there is no consideration. Now,

the shift between how the portfolio is allocated is gradual in many cases. So you could be 100% stock. You see a move and the market moves lower. You'd probably get a 50 stock, 50 bond. If it continues lower, that's when you would go to 10 stock 90 bond. And it would take a catastrophic event to see something where you would shift from 100 to 1090 or inverse. So the movie average, the movie averages, you said, measuring them as as zoomed in as even daily? So they're monitored daily, but they can,

they go from, you know, anywhere from three days to 200 days. What about an environment like 2020 where there's just a lot of sloppy sideways, where the longer term trend is sideways, but the intermediator trend, there's just a lot of bare market rallies and you're in, you're out, you're up, you're down. What about an environment like that? So that, you know, when stocks and bonds become more positively correlated, that's obviously a serious challenge for a trend following model that's toggling between risk on, risk all. And operating within the constraints of an ETF, unlike a personal account, you can't go 90% cash. So there still is that risk aspect within the fixed income complex. What I would highlight, though, is that since

inception, Tug has outperformed despite 2022, the traditional 6040 of S&P and Bloomberg ag. So I was going to ask that. Is that your benchmark that you think investors should look at is this is more like a 6040 portfolio in terms of, I guess, return expectations and risk expectations? That's correct. So this is looking to give you a smoother return profile so that, you know, we can avoid the most volatile days and, you know, in that desire to continue to remain fully invested throughout different changing markets. If you were to look at the lifetime of the back test or even since inception, do you think that 6040 is the right benchmark?

Are you close to, on average, 60% fully invested? Like, where did that benchmark come from? So based on if we were to go back over time, you know, A 60-40 is probably the most widely understood or followed benchmark. We also use that because of the recent rule change for a more broader benchmark as a comp for all ETS. You know, since inception, you're looking at probably a 70 to 75% on average allocation to stocks. I'm curious why you chose the NASDAQ here. Is there a certain, does it trend more?

Is it better for trend following rules? Why the NASDAG 100 is opposed to like the S&P 500 or Russell 3,000 or something like that? Sure. So the two ETSs were actually born out of a SMA conversion. Oh, interesting. Tell us about that. So Tug and it's, you know, at the Tug level has been widely followed and used for a little more out a decade at this point. In other, you know, SMA type models, signal research, etc.

And, you know, it grew to a point where the idea was to open it up to the broader retail community through two ETFs. TugN is brand new. It took Tug and then added the income component. What's great about the Tug approach is that it's basically a widget maker. That risk-on component can be switched out in other strategies or products. So the legacy SMA was the NASA. stack 100 and then long duration bonds. Obviously, as we came into launch and correlations and bonds and stocks went to near one, that's when the legacy bond allocation was kind of brought into a more

adaptive allocation and being able to toggle across the curb. You know, I'm not surprised to hear you say that it was an SMA conversion because I was surprised to see that you've got almost $200 million in the strategy and it has been two years. Yeah, you said the two-year anniversary. That's pretty impressive for a tactical ETF. So are part of the flows due from legacy holdings converting? That is true. But we have also seen for a new product that is active, which many ways, you know,

extends the period of time that investors want to see the ETFs perform. net creations and both fonts has been impressive, even in this market environment of, you know, tremendous uncertainty. What do you think is a fair period for people to judge the performance of the product? Because trends don't change on a dime, especially the type of upward trend that we have. There's very much a buy-the-dip mentality. And so you can go through a sideways to corrective action and still be in a longer-term uptrend. So what do you think is a fair, like do you need a year?

What do you think is a reasonable time period for you to judge? I guess that would be market dependence. So maybe it's not a fair question. But when people ask you, how do I judge your performance? What do you say to them? So, you know, back to 22 being incredibly unique, if we were to just look over the last year and a half, I think that's a pretty decent time frame to look at and why I say that, you know, COVID is a tough time frame to show.

But the last year and a half is interesting because we see rates go from effectively zero to five, trends sideways, and now we're in this, you know, rate-cutting environment where there's no shortage of, you know, declining interest rates. If we were to look at any time frame before COVID, I mean, it was four decades of lower rates. That's not a fair way of looking at how a trend-falling model would look. You've got lower rates, a rising market, and you're just long the market. So you got increasing rates, flat rates, lowering rates the last year and a half. You had a ball event that hadn't been seen since COVID.

So there's a healthy mix, and that's all alongside inflation. Now, inflation's come down, but it's still relatively high. And, you know, if you look at the performance there relative to, you know, the S&P, you know, over this time frame, the S&P's up about 53%. Tug's up about 55%. It's outperformed, you know, the 6040, which is up around 36%. And what I think is even more interesting is that Tug N is up about 50% over the last year now. That's a lot. Jonathan, credit to you for not saying full market cycle, because That's a phrase that I think people use, and I still don't know what it means. I'm curious how you would, if an advisor or an individual investor came to you and said, hey, listen, we're interested in these strategies.

We like the tactical approach. We like the rules-based nature. We like to have an equity-based approach. It's a little more cognizant of volatility. How do you help people decide between the two strategies in terms of the pros and the cons, and which one is better for which type of investors? So there are still some investors that options are not the right solution for them. And eventually we're going to come to a point where with the plethora of products that have come to market in the last few years, that that spotlight is most likely going to come out and how options-based products are actually achieving what they are selling.

for someone that is a, you know, let's go back to 60, 40, this is a product that can sit kind of on that 50 yard line. So it's taking care of that incremental revalence for you. The income with Tug and can, you know, for every 10% allocation in a portfolio that's allocated to it, you're increasing your portfolios yield by, you know, greater than 100 basis points. So there are different ways of looking at it. Sorry, so you're talking a double-digit yield on that then based on the option income. Right. You said that there was to be a spotlight to come on some of the strategies.

What do you mean exactly? So as rates come in, the pricing of call options is going to change materially. And, you know, let's use any of it could be products that provide upside with protection. It could be, let's just start there. So as rates come in. and the pricing of call options begins to normalize to traditional levels. The call at the current level is going to bring in less premium than it has been during this higher rate environment.

So does that mean less upside protection or less downside protection or both? To maintain similar downside protection, that means that the call that is sold needs to come closer to at the money or closer to where the market currently sits when it's put on. So, you know, 22, 23 were very interesting because in many instances, you could sell somewhere between 4 to 6% out of the money and fully finance and at the money put. And it didn't matter if you were looking at home builders, utilities, real estate, or an index. The historical norm is that in order to satisfy 2% downside fully protected would be an at the money call. So as this interest rate dynamics starts to change and rates come in, it's going to be more difficult

to provide that same upside over the last few years with that same downside protection being so tight. Because options are based on interest rates and volatility, so in a lower rate environment and maybe a lower volatility environment, those options are either going to to be more expensive or there's not going to be as much range. Like you said, it's going to be harder to cap the downside while also giving you more room to run on the upside. That's correct. So two things to point out. From 03 to 06 and a Fed hiking in world, right? By rights, even passive byright indices outperformed the historical annual return of the S&P every year. They were double-digit returns. So they could satisfy that yield. Now, in declining rates, like, well, we just

saw coming out of COVID, they could not. So is, you know, a rising rate environment actually benefits the overright, declining rate environment is more difficult, one, because markets, equity markets tend to appreciate considerably when rates are lower declining. And the price of a call option declines, relatively speaking. So that means for that same protection in a hedged product, your upside is reduced. So in other words, if you were able to get 100% downside with 80% of the upside in the previous regime, now you're saying you get, if you're still trying to get that downside, maybe you can get, we're making up numbers, 65, 70% of the upside, whatever it is, not as much as you can get when interest rates were higher. That's true.

Okay. All right. The actual levels remain to be seen, but as the price of calls comes down and skew normalizes, the price of a call relative to a put at the same level is going to be vastly different than if interest rates are at two, two and a half versus five. So how does that impact the income on your tug-end strategy then? What does that do to your options? So the benefit of the spread is that it can change based on rates. exchange in market volatility.

So as, let's just say, the market moves higher and yield or volatility comes in, that spread will widen. So that outer wing that you're buying to kind of cap your liability in a running market higher will be cheaper and will still allow you to, you know, seek that full 1% or greater. premium received of the NAV of the fund. And if, you know, we see the inverse happen and volatility goes up, then it's naturally being supported because of the spike and volatility that directly impacts the price to the options.

Okay. Very good. Jonathan, really appreciate you coming on today. If people want to learn more about your strategy, how do they find you? They can find us at stfm.com. They can also Google T-U-G or T-U-G-N. We are always around and love talking to investors and really focused on the education component of the benefits of tactical and this active approach, as well as what we think is the next generation of sourcing income from options.

Awesome. Thanks, Jonathan. Thank you. Okay, thanks again to Jonathan. Remember, check out STFM.com. Learn more about both of these strategies. email us Animal Spirits at the CompoundNews.com, and we'll see you next time.