ETF Edge - Hedging Against Interest Rate & Volatility Risk

Episode Date: August 30, 2021

CNBC host Bob Pisani spoke with Paul Kim, Co-founder and CEO of Simplify ETFs – along with Dave Nadig, Director of Research at ETF Trends. They discussed the road to record highs - more investors are seeking out ways to hedge against equity risk, interest rate risk, volatility and everything in between. In the ‘Markets 102’ portion of the podcast Bob continues the conversation with Dave Nadig from ETF Trends. Hosted by Simplecast, an AdsWizz company. See https://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, exchange traded funds, you are in the right place every week. We're bringing you interviews, market analysis, breaking down what it all means for investors. I'm your host of Fassani. Today on the show, we'll be diving deep into the world of hedging through ETFs. on the road to record highs, more investors seeking out ways to hedge against equity risk,

interest rate risk, volatility risk, and everything in between. We look at some seemingly complex strategies involving new ETFs with an options overlay, and we'll break it all down for you. Here's my conversation with Paul Kim CEO and founder of Simplify ETFs, along with Dave Naughtig, Director of Research at ETF Trends. Paul Simplify is trying an old strategy overlaying hedge fund like. functions to protect against downside risk for stocks, interest rates, volatility. What's the overall strategy here? Can you replicate a hedge fund-like strategy using

ETFs? So I think let's dial it back a little bit. I think that is exactly what we're trying to do. We're trying to democratize the access to sophisticated capabilities and portfolio tools that traditionally have been only available to the largest institutional investors like hedge funds, i.e. things like access to OTC derivatives, access to thoughtful well-constructed portfolio leverage and thoughtful systematic strategies and access, frankly, to talent. And so what we're trying to do at simplify is disrupt the sort of classic 212, i.e. the hedge fund world, as well as structured products, as well as reinvent sort of what

you could do inside of an ETF. Well, let me start with one of your strategies. Let's start with the equity strategy, for example. So you have this equity plus convexity ETF. Got to get a simpler title there. S-P-Y-C. S-P-Y-C. Okay. You're buying the S&P with an options overlay. Now, explain how that works. So options overlays have been around a lot. They're often accomplished through large institutional providers through SMAs. So our strategy basically takes the same concept.

We're buying a portion of the portfolio that was invested in an option overlay calls and puts. Why is that important? Well, it gives nonlinear exposure. When markets rally strongly, those calls kick in and they could help, juice those returns, and when the market sell off significantly, for example, what we saw in March, puts actually do a really great job in protecting a portfolio. And again, in today's environment where bonds are struggling to deliver that portfolio diversification, direct hedges using options are powerful. So here in SPYC, you have S&P 500. Basically, you've only S&P 500, and then you have a small percent of options.

These are put and call options as well? Yes, exactly. So it's 97 percent or 98% IVV, which is an underlying passive ETF, and then we overlay on it a couple percent a year annualized spend on calls and puts. Now, you also have a similar product, the equity plus downside in Vexity ETF. Here essentially it seems like you're owning the SEP with just a put option overlay, essentially. Same thing, except you're not owning. Yeah, same thing. I would say both of these strategies, as well as our third strategy, SPUC, are taking advantage of

low delta options. What does that mean? You pay a little bit for a small probability of a very large return. Again, think of it more as almost like a catastrophic insurance instead of trying to overpay for perfect hedging, which will then drive all the returns out of a hedge strategy. Yeah. So Dave, weigh in on this. I mean, you make sense for people who want to get some protection without getting too fancy. This seems like an interesting way to do it. For example, in this market, they're going to perform with the S&P 500. Providing you don't get too much crazy volatility, the SPYC. Right. Yeah.

Even today, you're going to underperform a little bit with the put-option strategy because 3% is in put-option. So you have to assume you're going to underperform if the markets are sort of boring and flat or slowly rising, which, you know, a lot of the time that has been the market, this sort of endless bid market where we're up half a percent another day and another day. What strategies like this do is give you an opportunity to profit or protect when you get to those edges. And a lot of advisors we talk to really talk about this tipping point market we're in, where it feels every day like things are a little overvalued, but they could melt up or melt down on almost any catalyst.

That's what you're hedging here is those melt up and meltdown scenarios all in one package. This whole category of sort of protection ETFs has pulled in a lot of money in the last year. Because my impression is it's not that big. I mean, if you get... Well, $5 billion over the last year. That's a reasonable amount of money. not all in Paul's products, but in that whole class of using options to sort of mold your returns, it's been about $5 billion a year to date.

There was a flurry of interest earlier in the year on protection against inflation. So we had the INFL, and we had the I-VOL, which bought, I think they buy tips. They buy tips. They try to protect against the curve steepening. They're trying to protect against interest rates rising. So it's sort of a multi-head strategy in I-VOL. A real darling. That was a flurry of interest in protecting against higher all of a sudden inflation. Right.

Inflation rates. Yeah. Yeah. Now, you recently unveiled two new hedge fund-like products, one to protect against interest rates, the other to protect against volatility. Explain the interest rate one. Sure. So the interest rate strategy, ticker P-fix, is a brainchild of one of our managing partners,

Harley Bassman, who actually is the father of the Move Index. So he's been around the fixed income market. It essentially allows access to ETF investors into the OTC derivatives market, specifically the Swaptions market. That is the most liquid and the most sort of cost efficient way of getting interest rate protection. And the key to this strategy is that it's essentially a concentrated call on yields. So if yields go up, if long-term yields go up, over seven years, so it's not picking the timing, it's saying over the next seven years, If something makes interest rates go up, this strategy is positioned to do well and protect an overall portfolio. And so you're designed to protect the overall portfolio, right?

So you're essentially, you're owning long-dated put options, right, on 20-year treasuries. That's simple to understand, at least. And what about the volatility one? You've got the simplified volatility premium. That's the other one. Explain how that works. So Ticker S-FAL, we're essentially collecting. a premium. If you look around the marketplace, how do you deliver yield or return or income

in a very low yield environment? Certainly fixed income is struggling. Equities have low dividend yields now and are priced to perfection. One of the most attractive premium in our views that has yet to be tapped broadly is the volatility premium. And why is there a premium? There's a significant demand for insurance. So as everyone starts thinking about protecting their portfolio, they're buying things like puts, or also when they're buying calls to protect the upside or enhance their upside, it's creating a very steep VIX curve.

And what this strategy does is collect the difference between two parts of that curve. Sounds complicated, but it essentially drives a lot of carry potential. And this strategy, the way it's constructed, has the potential to deliver in the tens of percent of carry. This is a complicated one.

The other one, it's very easy to explain. you're only put options on treasury bond, 20-year treasury. This is a little more, keep this full screen up. You're seeking a daily return of minus 0.2 to minus 0.3 on the SPB. So it's an inverse, right? You're flipping around. So if volatility, the VIX is up 1%, you're going to be down 0.2.0.3% on the day. And at the same time, you're also buying futures contracts, put in call options to hedge against the moves.

in the VIX at the same time. So the flip side to that risk you're taking a VIX going up, that curve is very steep. So if you're buying a month ahead, as your contract gets closer to the near month, you're actually clipping essentially a carry in that curve of 100%. 100% return where you 100% exposed to that.

So we're 0.25. We're 25% exposure to 100% carry curve. We are able to deliver somewhere in the neighborhood of 20% to 25%. So how would you, under what circumstances would this strategy really outperform? Well, oddly, despite the fact that it sounds complex, what this really is is an income vehicle, right? And with the bond market the way it is right now, nobody really wants to get one and a half on the tenure. It's just not attractive.

Advisors are looking for any sorts of additional income they can, particularly for their older clients who are in retirement. Now, I'm not suggesting that this is for everybody who's headed into retirement to widows and orphans type product, but we've seen a raft of these types of products that extract income. from unlikely places because frankly, there's nowhere else to get income. So that's really what's going on. I think that's a great way to characterize this. It seems like some complicated strategy to protect you against something or to play into the volatility or the lack of volatility. But it's really just a way of trying to clip some additional income. But how risky is this versus the assuredness of having 1.3% on your 10-year?

Well, look, nothing's ever... Under what circumstances is this really going to under? Nothing's ever going to be as low risk. It's buying an individual treasurer. and forgetting about it until it comes due, until it matures. That is the lowest risk thing you can do. We know what you get for that right now. You get one in a change percent on a 10-year lockup. So the question is, if you want more than that,

what kind of risk are you willing to take? A lot of investors aren't willing to just take equity risk anymore, so they're looking for these strategies to pull that out. How risky is it? Well, it depends a little bit on what the equity markets do. The good news here is if the equity markets are frothy and volatile, it will do what it's supposed to do and generate a lot of income for you. Right.

So if all of a sudden, though, if the volatility goes up dramatically, you know, if the VIX goes from, pick a number of 16 or something to 40. To 40 or something. What happens here? You're going to underperform that Sval is going to... So our short VIX position would underperform, but we also have an overlay, again, of an option strategy, where we're actually buying VIX calls,

spending a little bit of money a couple percent a year, But that's enough of an overlay to significantly mitigate a lot of that sell-off. And if the VIX spike is steep enough, it could actually turn into a net gain in the overall strategy. So, again, it's sort of trying to clip a carry coupon off a very attractive curve, but while playing some defense through the use of limits through options. Now, there was a change in the regulatory environment last year to 40 Act funds that I don't want to get too far in the weeds in this, but essentially allowed ETFs to do a lot more in the derivative

space. And I take it, you're one of the firms that are, we're taking advantage of that idea, which I think is a good one. Is there any evidence that this is significantly becoming a big business using derivatives to, I'm intrigued by the ability

to extract, because I think you characterize this very well. This is a play on people trying to get a little more money for their interest. And not so much a play. necessarily on volatility. It's not what it necessarily looks like. So I think it's less about what flows have consequently come from that change,

but I think it's more what is in the realm of possibility. Now that you've opened up sort of the last sort of hurdles that differentiated an ETF vehicle from other vehicles, right? Sort of the hedge fund vehicle itself took advantage of greater flexibility to use leverage and use derivatives and be more flexible and nimble. Now the ETF continues to democratize, first from vanilla equities to fixed income to commodities, and now we suggest that hedge fund world is going to be democratized by the ETF. And this is your SPYC is 25 basis points?

It's 25 plus the 3 bits from IVV, so 28 total. Yeah, yeah. Your thoughts on this overall? Yeah, I think this is actually some of the most interesting things going on in the ETF industry right now. I think most of the interesting product innovation is using multiple asset classes to generate new patterns of return. We don't need more vanilla equity funds. We don't need more vanilla bond funds. We do need better solutions for people trying to solve real problems like generating income.

Yeah. I don't know how, I mean, I think this is a very interesting way to look at the whole issue, because the number one question I get is how do I get more income in a safer way? I have a friend who just sold his restaurant business, the physical building. He collected $1.2 million. Literally, he had a check. He showed it to me for $1.2 million. And he said, now I want you to tell me, can you give me some stocks to invest in that has good?

I hope he ran screaming. Yes, I went away. I don't do investment. Yes, advisor friend. Advice, yes, not advisor friend. But he really wanted to know. He said, I'm interested in, you know, dividend aristocrats. Give me something that's 2% that's growing.

I don't want to have Exxon at 6%, that it may be, dividend may be in trouble. Just give me something 2% in growing. I said, well, you know, you look it up. You know, go to the dividend aristocrats. S&P. You're only Johnson and Johnson and stuff like that. Right, but even there, people are worried about valuations

because this does feel like, I mean, honestly, you and I were there, this feels a lot like 1999-2000 to me, right? These valuations seem very high. We have a lot of noise in the system. People are worried about that, so just buying dividends may not come. Yeah, except this time it's not Pets.com. I don't see a lot of Pets.com out there.

That's the NFT market. There is stuff that still is not making money. It's still on the horizon, but it doesn't feel exactly. Yeah, and this time you can't run to the bond market because their interest rates starting right place is very different. Yeah, you're not going to go. There's no alternative. Where were we in 1999?

Where was the... Four and a half four. Yeah, that sounds right. Yeah. So it's a very different environment. That's a very different calculus there. Thank you guys. Now it's time to round out the conversation with some analysis and perspective to help you better understand ETF.

This is the market's 102 portion of the podcast. Today we'll be continuing the conversation with Dave Nautnick from ETF trends. And Dave, we had a fascinating discussion with Paul Kim about hedge fund-like strategies. But I just want to move on to some other topics that I think are kind of important in the ETF space. ESG is continuing to rake in some numbers. You can update us on some new numbers that have just come in. but tell us what you think is going on. I find it interesting that Gary Gensler continues to put out comments saying,

I want to know more about what an ESG is, and you people have to do a little better job. He keeps moving earlier he was talking about, I've asked my staff to please ask people more, and now he's getting a little more insistent, you know, that's ramping it up. Where do you think, first off, tell us what flows we're seeing, and where do you think this ESG discussion that Gensler is trying to frame is going to go? Well, I mean, I think this is yet another place where the SEC is well behind investors.

So investors put in $20 billion in the ESG ETFs without asking Gensler's permission this year. This year, right, bringing us up to about 80 billion. So it's about 25% of the assets in ESG ETFs have showed up in the last six months. So clearly, investors care. Now, I think it's reasonable to be skeptical about ESG primarily because I don't think you can get any two people to agree on what those letters even mean. I mean, they're environmental, social, and governance, but one person's social is another person's not. So I think it's a tricky space because you can't define it very well. So this is one of those places where I think having a financial advisor in the mix is actually really important.

Because a good financial advisor can work with a client to help figure out whether an ESG product is actually relevant for the things they value, the things they care about. Sometimes it might be, right? If your real modus operandi is to focus on climate change, there are a lot of great climate change focused ETFs out there, either those that will profit from a decarbonizing economy or those that are going to punish and avoid companies that are big polluters, lots of different ways of approaching that. But as soon as you get into something as broad as covering environmental issues and social justice issues and what is good corporate governance, you're starting to mix so many things together

that I think it's reasonable to say this might be a little too complex to put one label on. Is it reasonable to say that not everybody would necessarily support all three of those even? So I might be somebody who supports climate change and diversity in the boardroom, but some of the other social justice issues I may not be that interested, or I may actually be opposed to it. I was about to say, you could be antithetical to them, right? And remember, we have values-based funds that are both the Catholic Values Fund and the LGBT Fund. Those are funds that exist. They obviously do not hold the same companies and have almost antithetical investment profiles.

So they're both considered socially conscious. It's just your definition of socially conscious can be completely different. So where can you go with this? What's the whole point of Gensler saying? Tell me a little bit more about what you are. What could the SEC even do to mandate rules on what ESG is? Can they do that even? I think it would be very difficult.

There are certain specific things that are quite easy to do. Things like reporting your carbon impact. That's happening throughout Europe. It's happening through most of the United States as well. That's a specific number that investors, particularly institutional investors, are really interested in. So mandating that's quite simple. Talking about things like diversity in the boardroom, again, fairly easy to figure out how

you would measure that and report that. When you start getting into more complex issues, though, I think it's very difficult. How well a company manages its international ex-US political environment as a governance issue. It's very qualitative, not quantitative. Very difficult to put a number on, right? And so I think there are always going to be these push-pull issues when it comes to ESG. There's no question there's demand.

I think it's the most natural place in the market for advice. You need somebody to help you walk through these choices. Yeah, I'm not easy to do that. I tend to think that you're right. I mean, he's already made it very clear on environmental issues. There's two issues he's made it very clear he's going to be aggressive out. They're going to seek information on climate change of disclosure as a nudge and on diversity in the boardroom, particularly as a nudge. He said that already.

But ESG encompasses a lot more than that. So there's a sort of I'm going to be a nudge on climate change. I'm going to be a nudge on boardroom diversity. But I'm also going to ask, because the third thing, like, I want these funds to define more generally what ESG is. So there's a sort of ESG, you know, push by Gensler sort of separate from the disclosure on boardroom diversity and disclosure on climate change. So that's where I'm sort of not sure what, if anything, he can really truly mandate. There's got to be some other precedents that exist here where definitions of things have been fuzzy, and they have forced them to clear them up through rulemaking or some kind of regulatory structure.

But if you actually look at things that we call funds all the time, growth versus value, large cap versus mid-cap, those are not defined by the SEC either, right? We call the S&P 500 a large-cap fund. By almost everybody else's metrics, it would be a large mid-cap fund. But the SEC doesn't get in there and say, well, you can't call that large-cap anymore because it's got some mid-caps at the bottom of the tail. And some small caps. Right, and some small-cap.

Right. There's some $5 billion market cap companies there. Right. So I think it's a little tough for the SEC to put really, hard guidelines on this stuff, I think it's reasonable for them to be asking where they can, and that seems to me what they're doing. Let me move on to crypto. Do we have anything new to add to this endless debate? So the whole community now believes that Gensler is going to be looking favorably upon a Bitcoin futures ETF because it's in a regulated space and not favorably on a Bitcoin ETF that owns physical Bitcoin. Would you concur with that, number one? And number two, where do we go from here with that information?

Yeah, so, I mean, they've already approved the first Bitcoin Mutual Fund. ProShares filed for that. It's live in trading. It hasn't generated an enormous amount of money, but it is an existing fund now. I think it's just a matter of time before we get approval on one of the, I don't know, 300 filings that there have been for Bitcoin futures, ETFs. One of those will get approved. I actually don't think there's going to be an enormous flood of money into these because, frankly, owning Bitcoin futures is not owning Bitcoin. It's not really solving the bridging problem for a crypto-native who wants a convenient way to move in and out of the normal securitized markets.

It's not really solving a problem for a traditional investor who wants a little bit of crypto exposure. So I think it lives in a difficult sort of in-between space until we get some movement around regulating cryptocurrencies themselves and therefore put them in a structure that we can invest in as a U.S. citizen in a pooled vehicle. I don't think we're going to get much further on this. Meanwhile, that that industry is going to reinvent finance without us. Yeah. Is the rollover risk really, I mean, to me, that's a real problem. We've seen it happen in the oil market, owning oil futures. It seems like an inferior product to me.

I'm just trying to figure out, the normal person would seem to me, when truly apprised of the risk, would probably shy away from this, I would think. Yeah, you're taking on this whole secondary risk of rolling over those futures contracts. Frankly, you have the same problem if you invest in oil right now. If you invest in oil, you use USO, which is the front month futures ETF, you're getting exposure to oil, but you're also buying into that contango of oil rolling over month after month.

With Bitcoin, it's even worse in the sense that we don't really know what the natural state of contango and backwardation are. It's all flows based in that market. And so there's no natural base state to say, oh, the contango should be 20% a year annualized or 100% a year annualized. There is no correct answer. So what that means is that market, if we do get ETFs launched, is going to be perturbed by the very presence of those ETFs and the hedging around it.

I think they'll be interesting products. I don't think they're going to be something the average investor is going to flock to. I think they're going to remain institutional tools for the foreseeable future. Before I let you go, talk to me about flows this year. We're approaching $7 trillion in assets under management. I don't know. What are we dealing with $500, $600, $600 billion in inflows? Can you characterize how it's been so far?

I've been impressed by the inflows into just plain vanilla equity ETFs, you know, you're just S&P 500 funds in general. Is there anything other than that that sticks out to you? Like, wow, this is interesting. Well, you know, it has been the year of the rise of thematics. I think thematics are the new sector funds. We see, you know, if you put thematics up as a sector, they pulled in more money than all of the other sector funds combined so far this year.

Now, a lot of that's the Kathy Wood story. That's, you know, Arc Invest. But all that's really done is put thematics on the map. And we've seen big flows into products from Global X, from crane shares, like up and down the issuer list, thematic products have really caught fire. I think that's here to stay. I think people are recognizing the idea of thinking about what consumer cyclicals mean in the emerging markets is sort of silly.

But thinking about, hey, what does the consumer look like? like in emerging markets in all of that glory, that makes a lot of sense. So we see products like, I don't know, EMQQ tracking those themes and doing very, very well. I guess the problem I have, I agree with everything you said, it's much more intuitive. The average consumer is going to say, I want to own cybersecurity stocks. I don't want to own consumer cyclicals. It makes more, it's more understandable. The problem I have is a Jack Bogle disciple because I can see Jack looking down on us saying,

why don't you tell him the truth, Bob? Which is, it's not going to outperform, Bob. In the long run, there's a reversion to mean on most of this, and you get it if you own a broad, diversified, you know, S&P small cap, S&P midcap, S&P large cap, Bob. So the Jack Bogle in me wants to sort of warn people about chasing fattish trends. But the good news is, you open this up, talking about the six or seven hundred billion pick a day that's going to move, that have flowed in. As you pointed out, an enormous amount of that flow has been into cheap

beta. And that's probably a good thing because of the Jack Bogle argument, right? Most investors should be in cheap beta and never pay attention to it except for like every five years going for a rebalance. That's what most investors are doing. Yeah. It's never a full show unless I bring up Jack Bogle, a man who's had the most influence of my whole life on me. And probably the most shoutouts on this show. Yes, probably so. Thank you for pointing that out. Dave Naug, my old friend from ETF Trends, joining us today on the ETF Edge Podcast. Dave, thanks very much. Thanks for having me.

That's it for today. I'm Bob Bizani. Thank you for listening. And make sure you tune in next week. And in the meantime, you can tweet us your questions or topic ideas at ETF Edge, CNBC. InvescoQQQQQ believes new innovations create new opportunities. Here's to greater possibilities together. Learn more at Invesco.com slash QQQQ.

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