Talk Your Book: Defining the Downside

0:00Today's Animal Spirits Talk Your Book is brought to you by Innovator ETFs. Go to InnovatorETFs.com to learn about their new barrier ETFs. That's innovatoretfs.com. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnick and Ben Carlson as they talk about what they're reading, writing, and watching. Michael Batnick and Ben Carlson work for Ritholtz Wealth Management. All opinions expressed by Michael and Ben or any podcast guests are solely their own opinions and do not reflect the opinion of Ritholtz Wealth Management. This podcast is for informational purposes only and should not you relied upon for investment decisions.

0:36Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast. Welcome to Animal Spirits with Michael and Ben. We had Bruce Bond back on today to discuss a new product that we are bullish will have product market fit with the investing universe. This time, they're basically, they're doing like structure notes inside of an ETF wrapper. And what I mean by that is you're getting some income and there are some downside protection. If you pierce the downside protection, the buffer goes away, you're fully exposed, but you've got the income to offset it. It's defined.

1:11We said that on the show, but that to me is the appeal. It is, hey, I like this risk award. No, I don't like that risk award. And you decide. I think the light bulb went off for us at the same time. I could kind of see it when he was explaining what it does. And you said before me, you said, this is like a structured note. And it really did feel like that. And I like the explanation of trying to think of where these alternative strategies fit in. And he said, think in terms of covered calls and high yield bonds and corporate bonds. And I think that will make a lot of sense for advisors. So I think these products are going to be interesting for advisors and investors looking for income who want to have these defined outcomes.

1:45So without further ado, here is our talk with Bruce Bond from Innovator ETFs. We are joined again for maybe the seventh time, I don't know, I might have lost count by Innovator ETFs CEO and founder, Bruce Bond. Bruce, welcome back to the show. My biggest question for you starting off the bat is who on your marketing team keeps coming up with the names for your new ETF lines? Because you guys got them pretty good because we started with the buffer, we have the stacker, what else? Now we have the barrier. You guys are pretty good on the names. Who's coming up with these? We've got to keep it simple to make sure everybody understands what they are.

2:17I don't want them getting them confused. That's true. So we have this new line of ETFs, the income barrier ETFs. It looks to me from the glance at the website that this is some sort of combination of income in stocks. Why don't you explain to me what these are and maybe how they differ from some of the other products? Sure. I'd be happy to do it. You guys are familiar with the buffers and the barriers are really similar to that in that they have a level of which the market can reach that you're protected. But then after that level, you're exposed to the market. Now, the difference with the barrier versus the buffer is if the market is down 11 % and you bought the 10 % barrier, you would be down 11%, not 1%.

3:01And that's an important distinction for people to understand between the buffers and the barriers. But these are really very simple. What they are seeking to do is to provide a high level of income with a barrier against losses. And I think people are really sensitive to after the fixed income losses, they're sensitive to the risks that they have there. And so we're trying to bring this new way of delivering income in an ETF that hasn't been available before. It's been done for many years. It's a strategy that's been used in the institutional level for years and years. In fact, over the last few years, they raised billions of dollars in this type of strategy, this approach.

3:43And we're really taking that and making it available in an ETF so that advisors and investors can also have access to this type of approach. This sounds like a structure note sort of a product, the buffer ETFs, we spoke about them in the past. They've got this level of tax efficiency in the sense that you don't need to go from one product to the other. There's no maturity. How does it work with these products? Because if you tell me that you're exposed to the downside past a certain level, it sounds like there is some sort of a payoff date or am I misunderstanding? The way to think about this, so let me just explain what they are and how they work, and then we'll kind of get into the details and unpack it a little bit.

4:25So the barriers, we have four different products that are going to be launched actually and listed on Monday. And the four different barriers are there's a 10 % barrier, a 20 % barrier, a 30 % barrier, and a 40 % barrier. So there's these different levels of barriers. All of those barriers are based on the S &P 500. So when I say 10%, if the market is down 10%, you would hit the 10 % barrier. If it's down 20%, you would hit the 20 % barrier and so on with the 30 % and the 40 % barrier. Now, at the same time, you get a certain fixed distribution in each of those barriers. So for example, the 10 % barrier right now on average would pay you 10.28%.

5:10And then the 20 % barrier is going to pay you a little less because you're taking less risk with it. It's going to pay you 8.82%. The 30 % barrier would pay you 7.31%. And then the 40 % barrier pay you 6.14%. So the idea here is you say to yourself, okay, I'm going to invest in this. I want to get 10.28%. But you need to know if the market is down 10%, you don't lose anything at 10%. But if it goes beyond 10%, you're going to be down whatever it's down. the market is down, meaning the S &P 500 past 10%. You've received 10 % in income over the year. So if you're down 10%, you're about net even at that point.

5:54But if it goes down past that, you would start to incur some losses. A good relationship between risk and reward there. Exactly. The less protection you have, the higher your income, the more protection you have, the lower your income. The lower your income. That should make sense. That's exactly right. Is the income coming from the options? Is that where it's coming from? Yes. It's coming from selling puts, basically, a put spread and a put. So that's where the income comes from, as well as they pay out quarterly in April, July, October, and January. So on the calendar quarters, they will pay quarterly.

6:29And the beauty of this, guys, is that you know the amount of income you're going to receive, kind of like a coupon. We know up front how much we've received in premium. We also know how much the treasuries were going to put the money in and are going to generate. So we know pretty much what you're going to receive in distributions each quarter across the year. Because of that, as the ETF trades, it could trade up a little bit, that's going to cause your yield to drop, just like with a bond. If the ETF share value drops down below its initial offer price, let's say 25 bucks, you're going to actually get a higher yield out of that because these payments are fixed.

7:05We know what they're going to be. We kind of tell you upfront this with the payments are going to be. There's a potential for the last payment to be adjusted a tiny bit, but we expect them to be very, very close to each other. So could you explain when are you exposed to the downside? So I buy this as a 10 % barrier, the market falls 14%, but then it rises. And then now I'm only down 9%. When does the loss get incurred? I'm having trouble understanding that part. Only at the very end, just like the buffers. You're only exposed at the end to where you're at because these options are one-year options.

7:40And so you're good throughout the year. So even if it's down and you're like, okay, yeah, it's down 14%, but I'm still collecting my coupon. I could buy more down here if I want to, but I'm just going to hold on and see what happens. Now, the important thing is let's just use a$25 offer price, the initial offer price. At the end of the year, if it's down 9%, it's going to be$25 again, or very, very close to$25. And you're going to do it again for the following year. And we're going to tell you the amount of the income that's going to be delivered the following year, just like you're used to with the buffers.

8:14If you bought the 9 % buffer or the 15 % buffer, it would just tell you each year how much premium is available in the risk market to pay you, plus where are the interest payments in the underlying treasury bills? I'm going to be honest with you. I'm a straight shooter. That risk reward doesn't excite me, the 10%. If I'm trying to get income right now, I'll just take 5 % in my treasuries or whatever. It's a different instrument, but here's where I'm going with this. If you can get 10 % for a year with protection down to 10%, if the market falls, say, let's say that at the end of the cycle, the market's down 30%.

8:53You're down 30%. I know you don't give advice. What would you do if you're in that situation? Would you just roll it again? Because you could say to yourself, hey, man, this sucks. I'm down 30%. But if I'm getting 10 % this year, I know that there's a path to getting back to even. Whereas I guess with the stock market, you would have to hope or base the stock market always does come back, but it could take years. What would be the thinking there if you get dinged in a really bad market? That's exactly the trade-off you're making. if you're like hey i don't want to get the 10.28 for a 10 down in the market but i would take the 8.82 down for 20 down in the market or if you're even more risk adverse you'd say yeah i'm going to do 30 down i mean last year when the market got completely crushed it was only down 18 over the year january 1 to end of december so i'm going to do the 20 i'm going to collect 8.82 percent in income.

9:50And if you compare it to bonds over that period, they got crushed, equities over that period got crushed. But here you, you're going to return back to 25 and you're going to get 8.82%. I have to imagine that in that scenario, if markets are down 30 % at that point, your income is going to be a lot higher too, correct? Because of the option volatility. Yeah. Income would be a lot higher because on these, if the volatility is higher, your income is higher. I just want to remind you guys that literally, Michael, like you said, I mean, if you look at the structured products market, billions and billions of dollars of this approach were done.

10:24Now, it's usually sold on something like Treasury, some really highly volatile Tesla, some super highly volatile stock. We're just saying, look at the S &P 500 and pick what amount of volatility you're comfortable with. And if you're comfortable with 20%, then you can get 8.82%. Now, remember, that's like saying upfront, you're going to get 8.82 % this year, unless the market goes down more than 20%. You know you're going to get that. And the same thing, 30%, well, you're going to get 7.3 % regardless if the market's down 30%. It seems asymmetric in a good way. The difference between down 20 and down 30 is, if my math is right, that's a lot.

11:09Yeah, it's big. But to only sacrifice 1 % in income, I would choose the 30. I'm a 30 guy. That sounds like good risk reward. Get almost 8 % in income and you only eat losses if the market is down more than 30 % over a 12-month period. I like those odds. Those odds I can get comfortable with. Your point, more volatility, juice in the option, more income. How often are you rolling these new products out? If we're in a 2017 market where it's just grinding higher and there's zero volatility, there's zero juice in the market, in the options market, would it make sense to way? How should investors think about implementing this strategy?

11:42The beauty of these for everybody that we think will participate is that you can look at the rate anytime and know, this is what I'm going to get. So they're going to come out quarterly. All four of these are going to come out quarterly until there's enough demand where we say, okay, we've got to bring them more than quarterly. But each quarter, you'll be able to look and say, okay, I'm going to pick this one up. I'm going to buy the 20 % or the 30 % or figure the market it's been down, what it's been down. I mean, who knows what's going to happen after all the earnings numbers come in? Is it going to go down again?

12:12Who knows? But you can pick a number and say, well, it's not going down 30%. And I'm going to pick up 7.31 % over the next year. That was our average over the last 30 days. I'm going to pick that up over the next year. And the beauty is, looking forward, you're saying, I don't think it's going down 30, or I don't think it's going down 40, I'm going to pick up 6.14 % over the next year, unless the market goes down more than 40%. If you really want to have these defined outcomes as you lay this out, you want to buy this when it rolls out and hold for the year, because that's how, to Michael's point, if the market is moving and yo-yoing in between, you want to have that outcome defined so you know what your loss levels are and what your income levels are going to be as you buy it.

12:56That's right. I mean, we recommend people get in toward the beginning. of these. But as you guys know, with the buffers, and we recommend that with the buffers too, but there's a lot of very savvy advisors out there that are saying, hey, if this thing drops down and this yield pops up a little bit, I'm going to jump in and buy it. So there's a lot of that going on too, where advisors are looking for opportunities to participate in these barriers as we go throughout the year. How should investors think about how these things are going to trade on a day-to-day basis? Are they going to move with the market or are they going to not move very much at all.

13:31So here, I'll give you an example. You buy this and the S &P 500, you've got a barrier of down 10%. And the S &P 500 is up, I don't know, 5%, 7%. It never really dips negative and it's just up between 5 % and 8 % for the year, something like that. How would these things trade? They're not going to move around a whole lot, especially on the upside. They're not going to move up on the upside much. They're going to stay really close to their initial offer price. And they're not going to move around much on the downside either until they start to get within some range of the barrier level. But you guys know there's all that time value in the options early in the year.

14:09But then as you get past six months, that time value, some of that starts to wear off and they'll start to move a little bit more. So I would say in the first quarter, very little. In the last three quarters, you might see a little bit more movement. And definitely in the last quarter, you could see even more movement. Sorry if you already mentioned this, but just want to clarify. The upside is capped at the the income. So that income is the, like if markets take off, that income level is what you earn regardless. That's right, Ben. You're basically saying, I'm going to accept whatever that income is.

14:37So on the upside, you shouldn't expect to get that. Now, remember that these do accrue. So they're going to accrue a little bit in the share price, and then it's going to be distributed and it'll drop back down, just like other ETFs do before they make a distribution. We've been talking about the downside risk, and it makes sense everyone pays attention to that these days, but obviously there's more often than not the stock market is up. These are meant to be looked at as fixed income. And as a alternative source to fixed income, if people want to increase their level of income, have a barrier, this barrier against losses, and they're looking to increase their income level, there may be an opportunity for them in here to participate.

15:19And the other thing here is I know that equities and bonds have been fairly correlated in the past or in the recent future here. But hopefully, some of that will start to go back to the norms. And then you will have within your low risk component of your portfolio, you'll have some of your income based on equity, some of it based on bonds. And therefore, that will tend to neutralize that safe portion of your portfolio, which we think will bring better value for portfolios and investors. Here's a way to mentally position a product like this and think about risk versus reward. Let's say that you buy the 10 % barrier and you're locking in 10 % income, give or take, if you hold it for the year.

16:03Let's say the market's down 20 % by the time that this expires or gets to its date. You would lose 10%. You got 10 % in income, you would lose 20 % on the investment. So net-net, you're down 10%. Correct. Well, if you're in a 50-50 portfolio of stocks and bonds, and bonds are flat and the market is down 20%, you'd be down 10%. If you position it that way, you could say, this is 10 % income, and if the market is down 20%, I'm in a 50-50 portfolio. That would be the outcome. That's good insight. I hadn't really thought about that, Michael, but that's a good point. You just hired Michael for your sales and distribution team, didn't you?

16:39Michael, I'm going to have to sign you up next time. Ben's talking about our marketing. I have to get you on that team. Here's how I'm thinking about this just from that first blush. So if you look at a high yield ETF, because I do think that sometimes advisors have some hard and fast rules on asset allocation. This has to go in this bucket. This has to go in this bucket. And there is no really alternative or middle ground bucket or I have to take from equities or fixed income. But if you're an advisor and you have an allocation to high yield junk bonds, I think the average yield of maturity on junk bonds right now is 8 % and change.

17:11So if you compare to junk bond ETF, which has downside that is pretty similar to equities, maybe not quite as bad, but it has equity-like characteristics, I think the comparison there would be if I have a junk bond holding, I'm comparing it to your 20 % barrier, which is a similar level of yield with some more protection that you could see. And so I think that may be even a way to look at it as this is one foot in each camp a little bit. You have some of your stock and some of your bond. That's maybe a way for advisors to look at this because I'd be curious to hear how would advisors that you talk to and work with, how they implement these and where they put them and how they pigeonhole it into their asset allocation?

17:47It's funny you mentioned that, Ben, because that's exactly what we're recommending. We're saying, hey, if you have high yield bonds, then they can be very risky, but you really have no protection against losses if the equity market turns, you tend to go down with them. The 20 % barrier, you're not going to lose anything unless the S &P 500 goes down more than 20%. and you're going to receive that almost 9 % distribution over the year. That is a great trade-off for you. If you don't want to trade the whole position totally, I mean, at least split it 50-50, get some exposure to this 20 barrier. And we're seeing a lot of interest in guys moving some of those risk assets over.

18:26The other thing is some of the products have been super popular here. JEPI, are you guys familiar with JEPI? JEPI Morgan? Oh, yeah. Yeah, Monster. So it's huge, right? It's very popular and a good product. But we think the 10 % barrier is just like that, except you have a barrier. When Jeffy, you have no barrier. I mean, you can go down and you can take it on the chin there. Here, you at least have a barrier against losses, whereas Jeffy, you don't have that. And we haven't experienced that market yet, but we think that the 10 % barrier can be an alternative to that. It's basically at the same level of income.

19:01And then we look at the 30 and 40 guys, and the 30 and 40 are really more like bonds. It's more like just your typical bonds. Is this a triple C, double B, or is this a triple A? And then you just pick in there of how much risk do you really want to take? And what is that risk reward that you're comfortable with? In terms of the income, I assume, I'm not a tax guy, but I assume that this is ordinary income? Yeah, it's 1099 income. So better to have this in a qualified account if you can. If you can, absolutely. Anything that generates taxable income, it's better to have in there. How are advisors using this in conjunction with some of the other products?

19:38Some of the early adopters are going to be people that are using the buffers. And the way that they're looking at this is more of an income replacement. Some bond, maybe exposures that they're not as comfortable with. As I mentioned on the high yield side in the 20, also on the 10 % side, there's a lot of people that are participating in these alternative income sources like Jeppe and others, even these huge cover call writing strategies. I mean, we looked at those a while back, doing them on the queues or high yield and all these different ones. And I think after we looked at some of these cover call writing strategies, we just didn't think they really brought value at the end of the day to the investors.

20:17And so I couldn't get there. We do get a ton of questions because that was a strategy that did really well last year in a crappy market. A lot of those strategies, they go for the more low vol, high quality stock. So you got a double whammy last year of some income and some downside protection and some low vol stocks. So what do you see as some of the downsides to those covered call strategies? Because we do get a ton of questions from people about those that a lot of people think it's like a free lunch and we know that that's not the case. Most of those are really returning people's capital to them primarily.

20:45If you look at QYLD and some of these, and I think we ran these out over time and look at the total return. And the total return was no better than buying the QQQ or buying HYG or buying these strategies. We just couldn't justify it internally. We felt like we needed to bring a strategy that was adding income to the deal, not just recategorizing capital gain as ordinary income really is what's happening there. And you get some return of capital. And the other thing, guys, remember, when you're writing those covered calls, the market goes down, you in a sense, or you're giving away your upside all the time.

21:24And therefore, as the market goes down, you don't really have much way to get back up once it's down. I mean, you keep giving away that upside. The beauty of what we're offering here is we have this barrier on the downside that says, no, you're not going to lose until you pierce that barrier, drop below that barrier. And that's the big difference between something like that and something like the barriers where you have that level of protection that's built then. What about interest rates? How do they play into this? So if the Fed is done hiking, maybe they are, maybe they're not. And the two-year goes from wherever it is today down to two and a half percent.

21:57I imagine that that will have an outcome on the yield that investors can expect from these products. It will. It'll have a big impact on it. As that one-year T-bill drops down, it's going to have an effect on the income generated on future products. Not today, but on future products as they roll out, we're going to tell you, hey, here's a distribution, which you can expect based on the current treasury rates and volatility. So each time we'll be evaluating that. Remember, this has T-bills in it. So it is based on the one year, which does give us some pretty good rates right now. But an important thing to point out before you ask that question, Michael, is remember in these structured products, they raised billions and billions of dollars in those over the last three or four years, rates were zero in the treasuries.

22:44And so the selling of that vol and bringing that to people is where there's a ton of value. And so I think that we believe it's always going to deliver this certain margin over what's in the market, kind of like it is today. And so you're always going to get this enhancement with this selling of the puts that delivers more than what they could get on their own. Is the nightmare scenario that you buy, let's say, a 20 % downside barrier, you get 8 % income, the market's down 30, so you're down 22, and then the Fed is cutting because the market is crashing. And when you roll it or the next time it resets, the income is not at 8%, but it's at 4%.

23:30I mean, it seems like that's a plausible outcome. That's something that could happen. It could definitely happen. If that happens, you blame Jerome Powell. Yeah, exactly. Me and everybody else, right? But here's the thing. Remember, if they do that, Michael, you got nowhere else to go in bonds. You got nowhere else to roll that money. I mean, Racer is zero. What are you going to do? You're going to stay with this because you're going to say, okay, well, I could roll out, but I'm at least going to get the enhancement from selling of the options. Then I'm going to get that income. So I'm going to stick with this because it's better than anything I can get out there.

24:03I would think to avoid the nightmare scenario, if you're an advisor, you probably don't go all in on one product at one time. Do you have a lot of advisors that do dollar cost average and they say, I'm going to put a 5 % sleeve in this, but I'm going to put 1 % in every three months or whatever it is. So I diversify my environment a little. Does it work that way with a lot of advisors? I definitely think guys will do that where they'll participate, take a little piece at a time and kind of dollar cost average and see how it goes. But I think there are also some who are going to say, okay, like we just talked about, I'm going to take a portion of my HYG exposure here and I'm going to divide that up and I'm going to just split it for now.

24:41I mean, I see the income I'm going to get here. I know what this income is going to be over the year. I'll look at that again next year and decide, is that good or not? Do I want to stick with it or door and move it somewhere else. I mean, the beauty is, is this is a defined outcome is you know what your future road is. And you know, I'm going to get this income and I'm not going to lose unless the market drops below the barrier. And this is my barrier. So that's what I like so much about these products is that you know the risk and the reward. So I said earlier, only 10 % downside for 10 % coupon.