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Today's Animal Spirits Talker book is brought to you by Invesco. Go to Invesco.com to learn more about Invesco's Income Advantage ETF Suite. That's Invesco.com to learn More.
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B
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 and watching. All opinions expressed by Michael and Ben are solely their own opinion and do not reflect the opinion of Ritholz Wealth Management. This podcast is for informational purposes only and should not be relied upon for any investment decision. Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.
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A
Welcome to Animal Spirits with Michael and Ben. Michael, we talk often about strategies that have a psychological component to them. That there's the math piece and this is the quants have the blinders on and they look at just the math, right? Does this make sense from a math piece? The Sharpe ratio, the risk adjusted returns, the whatever return per unit of risk. And then there's a psychological component where there are just psychological hurdles people have a hard time getting over. And it's interesting that in an exploit in a bull market where growth stocks are exploding and AI speculation is happening, that we're also seeing an explosion in option income strategies. That almost doesn't seem to make sense in this. Like, why would you want to own income strategies when the stock market is going bananas?
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C
Counterpoint, that does make sense. Or maybe, maybe this is what you were getting at psychologically. You might say, hey, the market's up 15% in the year for the last eight years. I want some exposure, but not all the exposure. And this is a way to do that. I don't want all the smoke, I don't want all the upside, I want all the downside.
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A
Right? It's a way to get yourself some regular income because these type of strategies pay out monthly, but also just take some stuff off the edges, right? We're not going to go down as much. We may not go up as much either, but it's equity exposure. And I think people like seeing those 8, 9, 10% yields. And there's obviously the yield products that have 50, 60, 100% on individual stocks. And we're going to talk about those today. So we talked to John Borrello, John is a senior portfolio manager at Invesco, about their whole suite of these option income strategies called Invesco's Income Advantage ETF Suite. So they have one on the Qs on equal weight on the ifa, interestingly enough, that the equal weight is the biggest one, which surprised me a lot. So here is our talk with John.
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C
John, welcome to the show.
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D
Thanks Michael. I'm a big fan of the podcast, so it's an honor to be here.
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C
Oh, well, than.
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D
Thank you for that.
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C
All right. Why, why do you think it is that on maybe the last year, year and a half, income has been one of the hottest investments, which is like sort of counterintuitive. It's pretty boring. Is it? I don't think it's a demographic thing. It's not like all of a sudden everybody turned, you know, 65. Is it, is it interest rates? Was there a rule change? Like what is it about the, what caused the explosion in these income oriented ETFs?
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D
Yeah, I mean, I think if you take a step back and think about option income in particular, it's a diversifying source of yield that's not interest rate sensitive at all, or at least when there are shorter dated options, there's no real rate sensitivity there. So the outcomes that option income strategies are built for, what they're trying to deliver are pretty broad demand themes that, you know, I think are going to be around for, you know, into perpetuity, basically. How do you stay invested in the equity markets, but do so with the addition of monthly income that's attractive and again not rate sensitive and reduce volatility to the broad markets and with, you know, the bull market we've been in and, and you know, a lot of concerns around valuation and other things with the markets having that risk reduction plus the yield that's again, no duration is, is been a, I think, a value proposition that more and more investors are turning to.
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A
So do you, do you think that there are investors who were maybe dividend investors in the past who've made the switch to options income? Because obviously there always has been a cohort of people who just. The dividend just makes them feel good and safe and comfortable, whatever it is. Do you think that's a shift that's happened in recent years?
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D
For sure. And actually that's how income advantage was born within my team. So we actually were managing a multi asset portfolio that was looking for equity income with dividend stocks. And we started to get concerned that the amount of risk that we were being forced to take to generate attractive yields was not as attractive anymore. And you think about concentration in certain sectors like utilities or mortgage REITs or traditionally more higher yielding parts of the market. We found ourselves with very high concentration in sectors, but also A value bet. And some of those names also got really volatile. And so we started looking at is there a way for us to go up in quality, maintain diversification that you would get with a broad index exposure and then add that monthly yield while reducing risk all at the same time. And that led us to the option income strategy that we deploy now within ETFs and under the Income Advantage name. But from firsthand experience, we did this to drive those outcomes within multi asset portfolios, much like how we see advisors plugging it into broader portfolio context. And then when we're out on the road and we're talking to clients about the strategies, we're hearing the same concerns around dividend names. Sometimes it's too crowded. The value bet again is people are getting tired sometimes by having that type of drag when they're looking for yield. And in this case we're able to deliver oftentimes multiples of what you can get with dividend names with option based income and do that without sacrificing diversification.
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C
So you all have three different ETFs available right now. You've got a suite that includes the qs, the equal weight and ifa. Within each of those three buckets. Is the strategy of the way that you deploy the income or generate the income, I should say. Is that consistent?
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D
Yeah, it's exactly the same portfolio construction and design and discipline process across all three. So QQA on the NASDAQ, RSPA for S&P 500, equal weight and EFAA for MSCI. EFA. Obviously very different underlying indices, different option market dynamics. But the process that we follow is the same across the suite.
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A
Are you doing options on the individual securities or are these index based options?
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D
They're all index based. So yeah, we don't do individual security. We want to have kind of the broad market exposure on the option side.
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C
How does option income work in terms of what we're going to need to deliver to the government with that deficit problem at all? Is it ordinary income?
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D
Yeah. So the way we've constructed the option income overlay, it is ordinary income. So we're one of the few that, that deliver the, the option income as 1099 income. And you know, some of the reasons that we've chosen that route, you know, and we've looked across all different instrument types for the best outcomes for, you know, US based investors is that we're not going to be returning principal. So we don't have a return of capital associated with it. But we also don't have tax straddle implications with our particular design, which can complicate the tax picture. So in a broader theme of the way we've designed these strategies, we're trying to build them with no surprises. We want to deliver value at outcomes with no surprises. When you can deliver consistent income, bonafide income, that makes it a much more transparent and predictable outcome for investors. On an after tax basis, what does.
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A
The volatility of the income look like? Because obviously I know that the option income is not interest rate sensitive, but rates can affect the, you know, the payout for the option. So like, how stable is it from month to month?
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D
Yeah, that's another key tenant of our design is consistency of the income. So we've built it such that the yield does not fluctuate very much and very much by design. The thought process there is, you know, for clients to use income in their portfolios, they don't really want the level of yields to be tethered to something like the VIX or market volatility, which is also really volatile itself. So what we've tried to do in our design is rather than have the strike price of the option be kind of a fixed variable that you're always trying to keep consistent, we want the outcomes of the portfolio to be consistent. Mainly that's the beta and the yield. And in order to do that, we allow the strike prices to float. So, you know, we're keeping the weight to the overlay always the same. It's, it's on half of the portfolios. And as market volatility changes, we're pushing those strike prices further out. When markets get volatile, they're going to be closer when markets calm down. But that process of systematically adjusting the strike prices to keep the yields consistent is basically how we drive that. That level of yields that, that you see on a monthly basis being, you know, similar across time.
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C
We're all about driving towards good behavior. And I think one of the things that some of the quantitative minded investors might miss with dividends or anything that might be like suboptimal in a spreadsheet is the behavioral component with dividend specifically, if you are, if you were sitting in Coca Cola during the gfc, for example, all right, not to say that there's not a lot of pain involved, but if you're relying on the dividend, like there's a mental crutch there that, you know, Coca Cola is money good. And I think there's some, there's something similar going on with these strategies where people, ordinary people, don't necessarily care about optimizing their Sharpe ratio or whatever the case may be, it feels good. It keeps them in the game. They want to invest, they want exposure to the market, but they might not want all the smoke, particularly in the case of the cues. Um, but can you also talk about on investor behavior and investor education, some of the other strategies that offer like a hundred percent yields just for people that might just only be looking at the yield? I think that'll be helpful.
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D
Yeah. Michael. I mean, this is like my biggest pet peeve when we look across this space are some of these crazy, egregious yields that you see coming out. And you're right, like, some of them, I think, do have 100% yields. And unfortunately, I think some of these asset managers are likely trying to prey on end clients and end investors who don't really look under the hood and realize that yield is not the same as return. I think there are buyers of some of these products that look at that type of yield and literally think they're going to grow their capital by 100% by investing in them. But at the end of the day, there's a really simple kind of mental model to keep in mind when you're looking at yields. And this doesn't apply just for option income. It's anything that's paying out a yield. If the total return is going to be below that yield, you're going to get your principal return back to you and you're going to get charged fees in the process. So, you know, if a fund is. Is delivering or saying that they have 100% annualized yield, which, well, after one year, that means they're going to return all of your money back to you and the underlying portfolio is going to have to double in order to kind of keep the dream alive and not have run out of money. So you actually see some reverse splits already happening in this space for, you know, with ETFs that have paid out too much income. And.
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A
If you look at the price charts of these things, they do, they just go down, right? Because, yeah, you're right, it's return of capital, essentially.
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C
Well, yeah, I'll give you $100 and you'll give me back 10 bucks a month, right?
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D
And yeah, I think unfortunately, people there is the behavioral aspect of they like the feeling of seeing a distribution hit their account on a monthly basis. But there is no free lunch. There's no way to support those yields if you're not actually earning. We often say, like, just don't spend more than you earn. Well, that applies to ETFs too. If they're spending more than they're earning through time, they're going to run out of money. And so in our approach, yes, there are a lot of option income ETFs that have that issue. There are also a much smaller segment that we think are responsible and they are very thoughtful, managed by option based professionals like ourselves. I've been in the option markets for over 20 years managing equity and option portfolios. And I think it's really important to know, is there a team being thoughtful about solving real problems in portfolios behind it, or is it a product that got launched because the covered call space got hot and they want something that has headline yields that'll entice people into the strategies? In our case, we're aiming for about 10% yield on QQA. We're aiming for about 9% on RSPA and about 8% on FAA. Yes, those are attractive yields, but they're not so egregious that we can't possibly expect to compound at rates that exceed those levels over the long run. So we did a lot of work on, you know, how do you balance income and growth? We want our NAV to be growing at the same time that we're also delivering those attractive yields. And that balance is why I mentioned we only have the overlay on half of the portfolio. Well, the other half is always there as a growth engine to participate in equity market upside. And even the part that we do use the options on those are out of the money options that we're going to have some upside participation there too. So without that balance, you can go way too heavy into income, sacrifice your participation and end up with an NAV that's perpetually declining. So that's the opposite of what we want.
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A
Michael, what was the product or the fund strategy that you used to call the Security Cat High yield? What was that one?
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C
No, we called the Chicken Equity.
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A
Chicken Equity Junk bonds. So you said, yeah, junk bonds were Chicken Equity, not in a derogatory way, but for people who are nervous about, like owning the Qs. Right? Yep, I want to be in this, but boy, I'm nervous because the valuations are high and the returns have been so good. So they decide, okay, we're going to do qqa, which is your Income advantage fund, on the qs. What kind of expectations can you put on people in terms of like, upside and downside? Capture the understanding that I know it's not set in stone, but, like, what kind of ranges could you expect? The downside and upside capture to be on a fund like this.
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D
Yeah, Ben, I mean, I think that's one of the key use cases here, is for people who want to maintain exposure to all the great innovation that's happening, AI, quantum computing, et cetera, with exposure to the NASDAQ 100, but also want to downshift their risk. And that might be that they're trying to dip their toes in to that exposure or they've already been invested and they're trying to take the risk down. And you know, our design, I think I mentioned consistency of both yield and beta. Over the long run. We expect the beta to be around 70.75. So you can expect, you know, roughly 3/4 participation up and down through time. And actually we hope to exceed that a bit and drive some asymmetry, more upside than downside capture around that kind of 0.75 expectation. And there are various environments where that works better than others. Since inception, all three of our ETFs have captured more than 80% of the upside in pretty strong markets as a whole, while also reducing that risk between 20 and 30%.
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C
So let's take that at face value and say that you would deliver 3/4 of the way up, 3/4 of the way down. Well, somebody could say, all right, well then just buy 3/4 of your position. If you wanted to invest 100 bucks in the queue, just buy 75. But, but the reason why there is so much money going into these products I think really does speak to the fact that people don't live in a spreadsheet. They live in the real world, the feelings and emotions. And for reasons that are obvious to me, they're choosing to go into these products.
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D
I would say that's maybe part of it, but there is this element of wanting. We're really after some asymmetry there. So we don't want perfect 75 up, 75 down. We want more than 75 of the upside, less than 75% of the downside over the long run. And some of the reason that that's possible is because we are extracting an extra source of return from the options markets that's really hard to recreate where you can't recreate it with just cash and equity. So that's, you know, part of the value proposition here is that this isn't necessarily just a way to convert total return into yield. We set that bar much higher when we're trying to design our strategies. We don't want this to be just another proxy of 75% equity and 25% cash. There should be an excess return beyond that that we can deliver through time.
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A
I also think the monthly. Sticking with the behavioral piece, Michael and I have talked a lot about people's unwillingness to spend from their portfolio. And there's this whole idea that why do you need income when you can just create it yourself and sell the shares? But certain people just don't have the ability to do that. And we've seen this where people come to us and they say, listen, in retirement I want to live off the income, I don't want to touch my principal. And to us that seems irrational, but that's the way that some people think about this. And they almost need that income to give them permission to spend. And so I think the fact that you get it on a monthly basis, it's effectively like you're paying yourself. I think that's gotta be a big piece of this too, correct?
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D
It certainly is. I mean, it's definitely attractive to have a strategy that's throwing off monthly income. But again, I'll go back and say if this was something that you could simply just sell shares on a monthly basis and recreate the same type of risk return profile, that wouldn't be enough for us. We want to be able to add more value on top of a strategy that's kind of the do it yourself, take capital out as you need it type thing. A couple of things that I'd point out about that comparison would be, you know, it's not only about the yield, it's about stable risk reduction too. You know, so there's the risk that we can take out of the market while, you know, hopefully outperforming kind of the equivalent of cash based risk reduction. And then, you know, the fact that the strategy of selling like only once a month to take your capital out, that's really path dependent too. So, you know, you're picking a random day, just once a month to make a sale. You can have really bad luck in trying to manage that on your own, which I think is a good maybe segue into one of the other things that we do that's really important, not just for us. But I think anybody looking at option income, you should be thinking about diversifying path dependency as much as you can out of that strategy. In our case, we ladder the positions every day, even though they're monthly options.
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A
Sorry, what do you mean by path dependency? Like you don't want to have bad luck on the timing of when you implement the options?
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D
Yeah, essentially, you know, and we've done a lot of work on this to look at, how much does that matter? You know, options are obviously expiring assets so they're going to be dependent on your trade date and then the date they expire or the date that they're rolled. So you're kind of, you have these windows of time where the options in the portfolio and if you only deploy those say on like the third Friday of the month, which is by far the most popular path to take through time. Just because that's traditionally been the exchange lifting schedule, that approach has really underperformed all the other days that you could have done that historically. And we spent a lot of time on this modeling it. Our team is pretty proud of the, the data platform we've built internally to, to assess all this stuff. But what we found is that simply pretty low hanging fruit, right? To diversify the paths by instead of just trading the entire overlay all at one price once a month, we, we get 20 bytes of the apple per month because they're you know, about 20 trading days in a month and we trade 1 20th per day. And that's really helpful in terms of smoothing the risk return profile.
- [21:33]
C
So if somebody's listening and they decide to invest in one of these products, how does this go wrong for them? In what scenario would they reach out to yours and say hey, I didn't know that X, Y or Z could happen. Like what would be the worst type of environment for something like this? Because I think we all understand the upside, right? It's like it's the income, it's a stability, it's, it's not taking all the upside or all the downside. But like how does this, how does this piss people off?
- [21:59]
D
Yeah, we spent a lot of time on the kind of pre education making sure people understand the expectations going in. So I'm glad you asked about that Michael. It's fairly straightforward and as I said, our design is all about trying to minimize any sort of surprises. We want these expectations to be clear on yield and beta. So quite simply, if you zoom out down markets, you know, we're not using any leverage. We're always fully covered, collateralized, very structurally defensive. So in down markets we're built to outperform. We expect that we should do better than the broad markets as they fall. And that's exactly what we've seen in periods like April of this year. Flat markets, we're still going to be collecting that income from option premium qualified dividend income and you know, so we should be outperforming in flat markets as well. Sharp rising Markets, you know, our beta is only about 0.75, so we're not going to capture, you know, all of the upside in, in that type of an environment. But you know, I think it's also important to note, like through a cycle, you usually get a mix of down months, flat and up. And so when you get enough, you know, wins on kind of the down and flat markets, you can participate. That's how you get a little bit of that asymmetry, capturing more than 75% over kind of a rising market environment through time.
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A
So talk a little bit more about the. You mentioned that you do the options on 50% of the strategy. So essentially you're saying if you wanted to ramp it up and do options, you could increase the income, but that's not worth it to you because you want to have a little more balance in the total return. And like you said, growing the nav versus just extracting all the income you can.
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D
Exactly, yep. If we covered the whole. We think of the trade offs here as if you've got too much income, you're going to stunt the growth of the portfolio. You're not going to have enough participation. And the only way to really drive total returns in equity markets is of course to participate in the upside. So that's why we're pretty thoughtful about limiting the exposure.
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C
All right, so, John, there are a lot of different flavors of these strategies. A lot for investors to consider. If you had to just pinpoint one or two that really differentiates you from what some other people are doing, what would you say it is?
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D
Yeah, you're right. It's a becoming a more crowded space. You know, first, I would say all of these are built differently. It's really important to look under the hood. And so at Invesco, we've been spending a lot of time educating clients on kind of what to look for in option income design, because that can, you know, the way some of these design choices are made can really impact the outcomes. A big differentiator for us is back to that laddering process. Smoothing the path dependency while balancing the yield and the growth. And to give you an example maybe about why laddering is important, you think about what happened in April and the violent sell off that we saw for a couple of weeks there, and then a sharp recovery after. Well, imagine if you had traded your entire overlay on the third Friday of March and then you've got your hands tied behind your back before you can trade again until the third Friday of April and all of that activity in between, you really didn't get a chance to adapt the portfolio or take advantage of that volatility in our case, because every day we have the chance to adjust a part of the strategy. We were able to move pretty quickly and adapt to the market conditions. Almost like the Bruce Lee quote, be water, my friend. We were able to move those strike prices as the environment was changing through time. And that really helped us both on the downside, but then also in capturing more of the recovery than we would otherwise if we didn't have the ability to adapt in times of volatility.
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A
I think that's an important point for people who aren't used to dealing with options in the fact that it's really hard to do a set it and forget it approach with options. Right. Because the variables that, that price, those options are constantly changing so much. And the stock market volatility is one of them. You, you almost have to have an adaptive approach for this. Or like you said, you're, you could get, you could just have bad luck and your timing is wrong and then you're kind of stuck. Right.
- [26:23]
D
A hundred percent. And that's, you know, again, back to no surprises. If you're only trading once a month, you're kind of, you're taking quite a bit of risk. That, that path that you're taking is going to be what people expect. So by smoothing it through a laddering process, again as frequently as daily, we see that having a big impact even over strategies that only do weekly. I mean, just think about it. If you only have four bytes at the Apple to adapt to changing market conditions, that's a big difference between having 20 and 4.
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A
Perfect. John, if we want to let people learn more about these funds, where do we send them?
- [26:59]
D
There's a great webpage dedicated to income advantage. If you just Google Invesco Income Advantage or look across the Invesco website site, there's some really good information that are, that's been put together there.
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A
Perfect. Thanks so much, John.
- [27:12]
D
All right, thank you.
- [27:15]
A
Okay, thanks again to John and invesco. Check out invesco.com to learn more and email us animalspiritscompoundnews.com.