ETF Edge - 100% downside protection? 4/29/24

Episode Date: April 29, 2024

A new type of fund promises upside exposure – to a limit – but with 100% protection to the downside. How does it work? Plus, why it might face stiff competition from good old money market funds. ��      Hosted by Simplecast, an AdsWizz company. See pcm.adswizz.com for information about our collection and use of personal data for advertising.

The ETF Edge podcast is sponsored by InvescoQQQ, supporting the innovators changing the world. Investco Distributors, Inc. Welcome to ETF Edge, the podcast. If you're looking to learn the latest insights on all things, exchanged, traded funds, you are in the right place. Every week we're bringing you interviews, market analysis, and breaking down what it all means for investors. I'm your host, Bob Pisani. Most of the good, with none of the bad. Today, we'll look at structured products that promise a good chunk of upside exposure,

but perhaps more importantly, a 100% protection from the downside. How do they pull that off? Here's my conversation with Matt Kaufman. He's the head of ETFs at Calamos and Todd Zone from Stratigas. So you launched this Calamos S&P 500, Structured Alt Protection ETF. That's a lot, folks. CPSM this Wednesday. What are you doing here?

It's essentially options combinations. How are you getting the 100% downside protection? That's right. launching this Wednesday the Calamos Structured Protection ETF we keep it short so CPSM we're entering into three options positions so it's a zero strike call and at the money put and a short call there's three positions they all work together it's a fully funded options package that delivers the upside of the S&P 500 to a cap with 100% capital protection over a 365 day

outcome period and then at the end of that year the options reset stay in the ETF and keep on going so I just want to you said a zero strike I'm make sure that's a deep in the money call sure we're talking about yeah so I want to do a little example here yeah go ahead let's let's pretend like you have a hundred dollars so you're gonna get that deep in the money call and how much is that gonna cost you about ninety eight dollars it's gonna take up most of your budget okay and now you're gonna buy and at the money put did you say is I know what this money put that's the second part that's right that's the second like okay and they

So that's going to cost about $5. That's a protection against the downside right there. Full downside protection. That'll cost you $5. Yep. So now you've broken your budget. Wait, you already got $103. It's been $103.

So how do you get back to 100? I have to sell off enough upside to collect $3. So you're going to sell out of the money call? You got it. Okay, for $3. And let's get you to $100. And the strike price is your cap. So 9.65%.

Is that how you get to 9.6%? It's exactly right. Yes. We can do the math on this, but I'm going to take your word. Oh, you're good. So there's three components here. Correct. All options. That's right. There's no tricks. There's no magic. Well, but I'll tell you what's hard for people to understand is you have the challenge here is that whoever's buying this has to understand there's a very specific day that makes the most sense to buy and sell on. Otherwise, the whole proposition doesn't make as much

economic sense. Explain that. Yeah, so this is a type of target outcome ETF, but it's delivered over a one-year time frame. So this is the first suite of ETFs to do 100,000. 100% protection over a one-year time frame. So if you buy in on day one, you get that 100% protection. You know, even day two, day three, there's probably opportunities to buy in all along the way. So these, Todd, these structured protection products, they're part of a larger group. You and I have talked about this, target outcome products. I don't know what we should call them, but it's a whole group of them. They basically provide some downside protection while still saying in the market. So we've covered the JP Morgan premium income product. That's JEP

JEPI. That in there you're selling options to generate income. Right. We've also talked about buffered products. Bruce Bond runs buffered products that deliver partial protection against the downside. Here we have full protection. What's the appeal of these products? They all kind of offer protection. Why are they being sold? When you think about ETFs in general, they're an innovation vehicle. We started with plain old passive vanilla 30 years ago, moved into bonds, moved into active-fix-acom, active equity, and now we have this option derivative explosion. This is the next step of the evolution of the ETF. And I think when you think about broader American demographics, there's a lot of

adults approaching retirement who will have money on their balance sheet, who will still want to say investing, but they don't want to have a recurring 2000-200-200-type scenario. So these products make perfect sense for those who want to still generate equity return, but have that protection. I think that's really important here. lot of sense. We constantly warn people about the dangers of market timing. You can't, if you're really nervous, but you know, you still want to stay in the market, you can't pull out and then put money back. It's very dangerous to do that. We know that market timing generally doesn't work. So how do you still stay in, but you're nervous? It seems like this

answer is at least some psychological need at the very minimum. Definitely psychological and the asset class, right? I know Matt and his team there have large cap, small cap, I'm going to assume international, I think he's probably involved in there too. So you have S&P 500, NASDAQ, come in June and then we're on file for Russell in July. I think if you look at the, you know, buffer ETF space in a low rate environment, you can do really good upside capture with a buffer, but as rates have moved, you know, off of zero or four or five percent now, we can afford to deliver capital protection over an outcome period. And when you can do that, there's a lot of opportunities to use these products, not just for de-risking equity markets, but there's cash

on the sidelines. You know, people are now buying CDs. They're buying money. money markets again, they're buying fixed index annuities. And so now you can get capital protection over an outcome period. It's a space the ETF really has not captured yet. Yeah. Go ahead. You think about this in terms of asset class too. If long duration bonds don't work, this is also a substitute.

Because if you can generate that low single digit return with the protection, that's another way to get your income, assuming equities are still okay. That's right. Do you have any data on, I mean, you must believe, obviously there's a target audience. here. Older people makes a lot of sense as a target audience. Anybody else out there? Yeah, I think, you know, retirees looking to provide for themselves when they no longer work. This gives them the opportunity to outpace inflation. You can get greater than the risk-free rate, you know, upside of the market. Your money is linked to the market. Right. And this is tax-deferred, too?

I mean, how is this? This is all tax-deferred growth. So let's think about your trade-off. You know, you could go into a 5% guaranteed product. At the end of that term, it expires, and you're going to have to pay ordinary income rates on that money. So your 5% will turn into call it 3.2% or here's your trade-off. You can turn that in, get the upside of the S&P 500 to a cap of 9.65% and you can earn much greater than what the risk-free rate is delivering. So what happens after one year after this? You suppose May 1st, somebody buys this product. What happens May 1st next year? Yeah, April 30th of next year, the options will expire and they will enter into a new set of options. You'll get a fresh 100% protection level and a new upside. So you can just stay in and it rolls over.

Stay in. That money will grow tax deferred and can compound tax deferred. And then if you've held the product for longer than one year, you're not paying ordinary income tax. And even if I'm in it, I'm not in a tax advantage account, even if I'm not in a retirement cop, even if I'm just in a regular brokerage account. Yeah, this money grows tax deferred. You hold the ETF longer than a year, you pay long-term capital gains when you sell. Okay. Well, that's an additional benefit right there, just attached to Fergat. The tax alpha is huge.

More magic in an ETF wrapper. Yeah, it's really quite remarkable. And I think that's one reason, you know, people have always said, like, could I do this myself? It's like, you could get close, but you can't get quite as efficient as if you were to do it inside the ETF wrapper. And this is, I mean, I keep looking for innovation here. You and I keep talking about the maturation of the ETF business.

And most of the money that's coming in, $500 billion or so that comes in every year, still goes into index funds, plain vanilla index funds. And the industry is looking for ways to get new products in. I mean, most of this need for innovation is because of the saturation in the index business. So the business needs to grow. Yeah, this is one way, through options, and more complex, sophisticated type strategies that the common investor may not be familiar with, but there's clearly a very good value proposition. And unless you get a significant bare market, that money is going to stay in those index funds, right? There's no reason to sell out of them unless you have to for some taxable reason. So, issuers will continue to innovate.

There's going to be different types of these strategies. I'm sure Calamos will come up with another way to spin it, whether it's different protection, different asset class. We'll have these in crypto for all I know in a couple of years. But it's just more from the ETF industry. I think you cannot fade this industry right now, relatively. the other vehicles that are out there. And yet people still seem to be in love with their money market funds. And who could blame them at 4.5% or whatever we're getting right now?

Why move at all? It seems like a lot of fairly risk-free, at least short-term. Yeah, we're seeing upwards of $9 trillion across CDs and money markets. I mean, that's larger than almost the ETF space itself. And so these types of investors can now enter into an S&P 500 upside with no greater downside risk over that outcome period. So I think there's a lot of money on the sidelines that could move into this. And you're launching additional suite of products around the NASDAQ 100 and the Russell 2000 as well? Our plans to launch 12. We're going to launch one every month for the next year.

We want people to have a chance to get in at that beginning. But it's three different groups, like S&P 500, NASDAQ 100, and the Russell 2000. And then we're going to repeat that series. So S&P in May, NASDAQ in June, Russell in July, S&P in August, NASDAQ in September. keep repeating over the next 12 months. There'll always be a monthly entry point. So you'll have four of them, essentially, four S&P 500. That's correct. And four NASDAQ 100, just different strike expiration,

or different option expirations. That's right. And where else do you see this going? I mean, what are the kind of products do you see? I'm just asking you to put on your ETF thinking cap. It's a fantastic question. The ETF vehicle is 30 years old. You know, the mutual fund turned 100 this year.

So there is a remarkable amount of innovation that I think is going to take place over the ETF, over the next several years in the ETF wrapper. We really like to look at where flows are going. People are now, like you said, buying money markets again. They're buying CDs again. We can deliver capital protection inside of an ETF wrapper. That's extremely innovative. It really couldn't have existed over the last 10, 15 years in a lower rate environment.

Now the rate regime is shifted, and we've got this whole new wave of innovation that's going to come through the ETF wrapper. Yeah. I'd be curious. Whenever rate cuts decide to come along and you get them down at 2, 3%, the proposition of money market funds really declined. So I wonder if a lot of that money will find its way into these types of strategies. But you're making an assumption there about going down to 2 or 3%. Where is that? Where do you think that's coming from? Not this year. No, I don't. Not this year. Yeah, it seems, you know, higher for longer definitely seems to be the mantra. Yeah, no, that is here. I'd be very, wouldn't you be surprised if money market funds went down to 3%? percent this year this is not having this year I don't yeah I don't see it's going down four percent what are you getting now four and a half uh somewhere on there

you can get five and a quarter on a bandguard on the Vanguard money market fund it's a five and a quarter right now that's something roughly that's an amazing proposition and still money inflows though into bonds this year still yeah I mean active fixed income I think is a really big opportunity for issuers outside of the whole option product explosion that's going on. They are about 12% of industry AUM that's including mutual funds and really growing fast. I think a lot of investors have realized they need a professional hand at the wheel when you change interest rate regimes like we did recently from 0% always the bottom. But this is the argument the active guys always make. Oh, in a volatile environment, we're going to outperform the passive guys.

This is the one turn in history in 40 years in the bond market. Maybe if they did it, they would have added some value. Other than that, in the last 40 years, it hasn't mattered. No, no, no. Well, that's the, that's the marketing for it at least right now. We don't know if we'll mean revert back to the lower path of interest rates, but I think issuers are looking at it as a higher for longer, as you're saying before, and so you want that active touch. I think the growth in options, ETFs, too, is largely driven by that low rate environment. You know, we saw it being difficult to get risk management and income from bonds when rates were so low. Now that we're moving out of this, you can actually use bonds.

once again for risk management and income and so you know we that's how we're seeing at Calmos as well all I know is I the viewers messes me all the time how deliriously happy they are at four and a half or five percent and that money is very sticky in those money market funds and that is very real competition I agree market right now when you get a risk-free at you know five percent and it's a real rate of return now you're getting a positive real rate of return that's really competition and I think it's terrific. I don't think it's terrible. I'm perfectly happy to see the

competition for the stock market because this makes sense. One percent 10 year yields did not make sense, which we had. Who's going to give the government 1% for 10 years? It makes no historic sense at all. It's a nice extra stimulus, especially you're dealing with inflation here, with having the 5% whether it's real or nominal helps you pay some sort of a bill. And I keep complaining, I mean, viewers are best to me. I, you know, I don't want a 6% mortgage or a 7% mortgage. I said, look, I got news for you. 3% mortgages are not normal.

That was never normal. And I don't know why people thought that that was somehow the new normal, and it never was. That was an anomaly that happened there. And I'm glad people took advantage of it. But if you think that it's going to go back to 3%, I would not bet on that. 6% or 7% is much more normal interest rate for a 30-year mortgage. When I got mine in 1985, it was 11. and a quarter. And that was typical throughout the 80s and into the early 90s.

I will say the part of this the benefit here is now you're seeing more targeted duration fixed income ETFs, right? We have whole suites now. You want one month, you want three month, one year, you can get it. You don't have to buy a market money for money market plan. You can do it in the ETF too. Well, gentlemen, thank you for coming by. I appreciate it. Again, the key point here is these kinds of products are filling a niche for people who are concerned about the markets, maybe a little older, but still want to stay in the market. That's what we had Matt on today. So now it's time to round out the conversation with some analysis and perspective to help you better understand ETFs. This is

the Market's 102 portion of the podcast. Todd Sone from Stupagus continues with us. And Todd, we were talking briefly about fixed income, which is continuing to see inflows, rather remarkable to me. Fixed income ETFs are about a quarter of assets under management now. That's twice what it was six years ago. And it's really quite remarkable. And yet when I look at some of these products, you know, like you were, we had discussed this before, Treasury ETFs like TLT. TLT is the 20-year plus Treasury ETF. You would think this is a safe, non-volatile investment, but it's down 50% in the last three years. This has got to be one of the greatest bond debacles in history. Absolutely. And yet it had inflows up until recently. They didn't

Just because the label says treasury bonds does not mean it's a safe vehicle. And I think a lot of investors have really learned that over the last two to three years, right? We are an entirely different interest rate regime than we've been used to over the last 10 to 30 years, 40 years even. And long duration, when you buy something like TLT or long duration, you're adding as much volatility as you would buying an S&P 500 index fund to your portfolio. But that's remarkable. Like people don't think of it that way. And everything you said makes total sense. So why, if you're getting the same thing for a money market fund with almost no volatility, it's a dollar, but this money market fund, why would you do this?

So one part, I think it's a two-part question and answer right there. One is investors have to rebalance into the long-duration part to keep their allocation there just in case. And then secondly, I also think there might have been some buy-the-dip mentality that going on there. The type of money I was going into TLT reminded me of what happened with, ARC in 2020 or hedge equity ETS back in 2013 and 2014, this surge and kind of mania. But I also believe that it does go back to the balancing of allocations within your portfolio.

Then one other item to keep in mind though, there was a lot of fear of recession. You buy long duration when a recession comes into play because bonds should get bid and the prices will increase on those long duration bonds as rates plummet. But that just hasn't unfolded. So it made way more sense to stay on the short end of the curve where interest rate risk is less of an issue. And actively managed fixed income is now 12% of the assets in demand.

What do we have $8 trillion? Something like that. So yeah. Oh, go ahead. Something like that. So they're probably right. Like for once, you know, the active guys, oh, when things get volatile, that's when we earn our money. And when you had a disaster, you know, like bonds going down for three years like that.

This is where you want. Active can do a little bit better, right? Ideally, yes, if you have the right active manager, the right issuer, they can step in and find where the opportunities are. It doesn't have to be just treasuries, corporates, munis, any sort of the exotic stuff out there. And so issuers are trying to expand their product lineups, innovate their product lineups, and active fixed income really seems like the area where they can do that because of such a low base and such a high potential growth rate going forward. Yeah. You know, what is interesting, you and I were talking about these structured products on the show, how much? much complicated this is all getting. Like it seems like most of the money now still goes into

plain old boring passive S&P 500 index funds and NASDAQ 100 index funds. And to attract people now, these products are getting more and more complicated. These structured products have all of these options in them that's pretty complicated to explain to people. I guess this is a natural outgrowth of the fact that the industry needs to expand. This is a relentless drive for innovation. And to expand, the products get more complicated. More complex, sophisticated strategies that really haven't been available to common investors this entire time.

It's been mostly high net worth or hedge fund-like strategies that are now coming into the wrapper. For 90% of people, maybe they just, they don't fit anywhere in portfolio. They'll be good with their typical 60-40 or 60-30-10. and then, you know, alt-sleeve or something like that. But for me, I'm always a keep-it-simple-stupid, keep-it-simed kind of guy. But I believe issuers feel like they need to expand beyond passive equity, passive-income-type ETFs because there's so many of them.

The problem for me is, having covered this for all these years, is there's a point at which some of these products, new products make some sense, and some of them don't. Sometimes I see these products, say, who's going to buy these products? These kinds of products make some sense because people are concerned about the markets downside but still want to stay invested. So it fills some intellectually a product that I think makes some sense. Some of the other ones, you know, does the world need triple leverage inverse oil ETFs or something like that? Do we really need all of that?

I wonder, but that's what the market. One thing I've learned about Wall Street, 34 years covering this is the need to innovate. and grow is built into the system. Status quo is not really acceptable. So the industry can't sit around and say, well, we're just happy just to collect money on S&P 500 index funds, because there's no growth in that anymore. Someone else will come along and take that share from you.

Yeah. I wouldn't, I wouldn't downplay human psychology that there's always an itch for some folks out there who want to be involved, right? At the casino or whatever you want to call it. Exactly. All right. Thank you, Todd. Always a pleasure. Todd Stone's from Straticus, everybody, and that does it for the ETF podcast. Thanks for listening and join us again next week when we'll be talking about another big move in the ETF space. InvescoQQQ believes new innovations create new opportunities.

Become an agent of innovation. InvescoQQQQ, Invesco Distributors, Inc.