Talk Your Book: Option Income Is So Hot Right Now

0:00Today's Animal Spirits Talk Your Book is brought to you by Neos Investments. Go to Neosfunds.com.

0:30solely their own opinion and do not reflect the opinion of Ritholtz Wealth Management. This podcast is for informational purposes only and should not be relied upon for any investment decisions. Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:48On today's show, we are joined by Garrett Peolella. Garrett is the co-founder and managing partner at Neos Investments. I went for a drink with our good friend, Tom Lydon, who made an investment into Neos about a month ago. And I had never heard of Neos. And I'm with Tom and Garrett and we're talking, catching up, whatever. And Garrett tells me, so tell me your story. What are you guys doing? And it comes out in conversation. They were at$7 billion in assets. And I said, holy moly, incredible. And then today after the recording, Garrett said, hey, Michael, remember we were together about a month ago?

1:30Today we crossed$8 billion. So the client demand for these sort of strategies, which are transforming a lot of the total return from price into, they're chopping it up into a big portion of the total return coming from income. And what can I say? People just love, love, love income. And the options-based income too, it's just exploded in popularity. And going to, we said on the show, it's going to continue to grow in popularity because you get this, I've had multiple conversations over the years with retirees who say, I don't want to touch my principal. I want to live on income. And I think these kinds of strategies for those people who have that psychological hurdle, these types of strategies make that happen.

2:22And for people who want to live off of their portfolio now who aren't retired, but just want to have throw some income. I think these products are actually popular with younger investors now too. It's not just retirees. Yeah. So of course there is no free lunch in investing. On today's show, we get into some of the red flags that people should be aware of as this, I don't know if it's a nascent category, but it certainly is new-ish. And the growth seems to be accelerating. So as more of these come to market, please do your homework. Make sure that you understand the trade-offs because like everything else in investing, there is a trade-off.

3:00And so we get into all of that and more on today's show with Garrett Paolella.

3:07Garrett, good morning. Morning, guys. Thanks for having me today. You're welcome. Thank you for coming on. A, congratulations are in order. You guys won the best new active ETF, which is a very competitive category, I would imagine, for the NAO. Is it NEOS or NEOS? NEOS. Okay. I don't know why I said NEOS. That would be weird. For the NEOS NASDAQ 100 high income ETF, The ticker is QQQI. Why did you get that honor? Yeah, listen, I think overall, we look to help investors through generating income in tax-efficient ways. This product is unique in that sense that we're really focused on leveraging the NASDAQ 100, which historically hasn't had a lot of income thrown off of it, in ways to generate that tax-efficient income.

3:53I think performance was certainly part of the category and considerations as well. And obviously the adoption that the fund's around two and a half billion right now, which is about only 15 months into launch. So certainly client adoption as well. Whoa. It's such a hot category these days of clients wanting income and advisors having the tools to deliver it. So I'm looking at the performance of the triple Qs versus your product. and it tracks fairly close. I mean, very close, not fairly close. So it tracks very closely, not exactly one for one, but effectively they do the same thing. And so I'm guessing that as you just mentioned, you are giving a similar return profile, except you are transforming some of the price return into income return.

4:46Yeah, I think that was said well. The longer term will give up some of that upside. You gotta, you know, can't always have your cake and eat it too. You know, so the idea is you give up a little bit of that upside in order to generate that current income through the use of, right, selling, you know, call options on the Nasdaq 100 against your Nasdaq 100 position. Right. So you would imagine, especially in a rip-roaring bull market, you're probably going to lag a little bit just by the nature of the strategy. Exactly. If you're in a rip-roaring bull market, you know, being long only is obviously going to be a place to be.

5:20We should have some general lag to that. And it's more looking at it on a month-over-month basis than it is really longer term than that. So some of these strategies will actually sell options on the individual security. Some use the index. It sounds like you just used the index. Is that right? Yeah, we use index options everywhere we can here at Nios, and specifically on this product, because you get favorable tax treatments on using index options. They can't be called away from you. They're cash settled. So in our opinion, there's a variety of benefits for the end investor to use an index option wherever you can.

5:55With a caveat that we're not tax professionals, what are the tax benefits here? Yeah, so when you look at index options, first and foremost, they get taxed at a 60 % long-term capital gains rate and a 40 % short-term. Come out. What? Yeah. 60 %? All right, say that slowly one more time. Sorry, that's surprising to me. I didn't know that. Yeah. So regardless of the investor's holding period, if the position could be a day, it could be a month, it could be even longer than a year. The index options get taxed at a 60 % of allocation to long-term capital gains and a 40 % to short-term because they're cash settled.

6:32So that, in theory, if you want to think about being in the highest income tax bracket in the nation, it's going to get you a tax rate of around 27%. So really advantageous than ordinary income, short term. Obviously, the only thing better is going to be long-term capital gains rate on the whole piece plus Medicare and all the other stuff you got to pay. So that's 60%, no matter the holding period, that sounds like a cheat code. Is this something that you discovered or is this just like out there and other people are just maybe unaware? Like talk to us about what you're doing versus what a lot of the other people in this giant and grown category are doing.

7:11Yeah. So the index options, certainly no cheat code. It actually falls, if you want to really nerd out section 1256 of the IRS tax code, kind of goes through futures and index options. They're all cash settled, the IRS taxes them in that 60, 40 way. So not unique to us. What is unique to us is given the fact that these are all income bearing products for us, we want to have the highest net after tax return. So we do embed tax loss harvesting in our investment process also. So there's another layer of things that we look at on the tax structuring, but from the index option standpoint, much more favorable, but that's not unique just to NEOS.

7:49Anyone who trades an index option that's got the capacity to, right? I mean, if you think about a NASDAQ 100 index option, it's worth about$2.2,$2.3 million for just one option contract. The regular retail investor can't trade usually that amount of size. If you were trying to do something similar, but at the individual stock level, I would assume that the tax treatment is different? That's correct. Single stocks, ETF options, swaps, equity link notes, all of those get taxed at 100 % short term, which ultimately is ordinary income. So how often are you doing the tax loss harvesting piece? Is that a regular ongoing thing?

8:24Are you more proactive depending on the market environment? How does that work? Yeah, so it's just a regular thing. So it's embedded in our roll process. So as we roll our options, traditionally, especially when we're talking QQQI, that's on a monthly basis. And so we're going to look that, think about this, the easiest way to explain it, market runs 10 % in a month, right? And we had sold short call options against our portfolio that gave us maybe an upside capture of 7 % or 8%. We're going to capture all that 7 % to 8%, but that 2 % to 3 % we didn't capture is going to come in the form of a loss against the options.

8:59And so when we go to roll our options, we can take a loss of 2 % to 3%. And the best part about the ETF structure is those losses get carried forward indefinitely. So we're able to then, for that month, the investor's up 70 % total return. Let's just call it 8%. We distribute 1 % out to them. So NAV appreciated 7%. They got a 1 % distribution, but we were able to take 1 % of that 2 % upside that was capped as a loss for the portfolio. And so you get to just simply in standard gap accounting, you offset a loss versus a gain. And the gain is the distributable part of the portfolio. There's probably no way for you to know this, but what do you think it is about income that clients are finding so attractive?

9:45because I suspect that most people in this product, they like to see the income hit their account. They're not necessarily using this product to fund their living. Like they're probably not taking the distributions and living on them. I'm sure there are some people that are, but there's something about seeing that distribution come in that is very seductive, I suppose. And sorry, it's a monthly distribution. Is that right? Yeah, everything is a monthly distribution. I think I'm going to answer your question too. It's like, it's actually unique. We see, so nobody's done this longer than us overall.

10:24My co-founding partner and I, Troy, brought out the very first option-based income portfolios and ETFs back in 2013. So under a different company at that point. But as we've seen the market and the adoption shift from income investors, they actually, a lot of them like to take that income on a monthly basis. So it's unique in the fact that this used to be focused more on retirement, later stage investors that are looking for income. Now we have people in their 20s easily adopting the products because they want to find alternative passive income sources, right? You know, people who are real estate agents, right?

10:57Or they're out doing something in their core day-to-day business. They're finding this as a way to supplement their income and their lifestyle, you know, on an ongoing basis. We see all walks of life of who are investing in these types of products, and they want to get that in the most tax-efficient manner, especially if they can get income monthly distributed out to their investment account and swept into their bank account at a much lower tax rate than ordinary income. I guess that DoorDash bill ain't going to pay itself. Yeah, that's right. So you have, depending on where you look, the distribution yield of the QQQI is 14 % or 15 % right now.

11:35Some are in that range, depending on where you look. How volatile is that payout yield? Like how often, because obviously that's not the same thing as a yield on a bond. This is not like a bond substitute, but how much does that fluctuate? Yeah, so it doesn't fluctuate actually that much. That's part of our investment process. So a little different for us than the rest of some of our competitors out there. We're not focused on distributing way more than we need to. So when vol spikes and you can generate more income, Our concept is actually keep a consistent distribution rate so that people know and understand what they're going to be receiving on a monthly basis.

12:12And if we can smooth that out over low vol and high vol times, then that just makes the product that much more consistent for an investor. Some of our other folks that compete with us in the space, like when vol is low, they really reduce their distribution. When vol spikes, they throw out crazy numbers that are just astronomical. In our opinion, it's let's kind of smooth this thing out for income investors, knowing that they can rely on a pretty consistent basis. How are you able to do that? It seems like alchemy. Yeah, so we look at things a little different. Like we target these yields. So as Ben was just talking about, right, we're looking for kind of a 12 % to 15 % annualized distribution rate for QQQI.

12:49Some of our other products might be in the 10 % to 12 % range for equity indexes that have a little bit lower volatility. but really to keep it simple for today is when vol is low, that means the equity markets are rallying. We tend to write our options a little closer and on more of the portfolio. As soon as we hit that income threshold, that's because you get reversion of the mean. You tend to get an equity market sell-off. You get that equity market sell-off, vol goes up significantly. You can generate income on an easier basis. So we're writing those options further out and on way less of the portfolio because you get that bounce back.

13:22And the key and more the risk that we like to talk to investors about is how much of your upside are you capping to generate a high amount of current income right off the NASDAQ 100. And so we, on a monthly basis, our models are shifting the options to really take into account meeting that income need first, that the first investment objective of the prospectus states. And then secondarily, we want to capture as much upside as we can by shifting those options. So Michael asked about the yield thing. And we've been saying for years that we think yield is probably the easiest sale to make, right?

13:54There's not a lot of, obviously there's some explaining to do and some education behind it, but people see the number and sometimes that's all it takes. Do you think that your investors are okay with giving up some upside because they have that more stable yield coming in? Is that the right trade-off that people are making here? Yeah, absolutely. We're very forefront in working with investors and advisors and where these products fit in their portfolios. They're compliments. They're not replacing your whole Q's exposure, right? They're not replacing your whole equity exposure. So you blend this in as part of your portfolio to generate a really above average and tax efficient, you know, yield above what you're getting from dividend paying equities, but it's not your whole equity sleeve.

14:33And so I think with that, it's really around like messaging. It's around working with clients within their allocation framework. And so that it's a part of your portfolio, no one investment, regardless of what it is us or anybody else should be your entire portfolio thinking that it's going to be the Holy Grail. This sort of investment might drive some quants nuts because they're like, well, you could just do X, Y, or Z and do it yourself or whatever. And I think that the fundamental misunderstanding or what they might not be understanding is that people are willing to pay for an easy button. We're lazy.

15:09I mentioned DoorDash earlier. People pay 26 bucks for a Caesar salad to get delivered because they don't want to go out and get it themselves. And this is a very similar concept because there are ways to do this. Why don't you just sell some of your cues and just generate income that way? But this is consistent. It's easy. It's reliable. It's automated. It doesn't break. Talk about the behavioral component of this. Yeah. So I think you hit the nail on the head. One, it's easy. And I think people like to have that easy button within their overall portfolio as a compliment to their other investments.

15:45They're not just looking at one product. If you're going to do this in your portfolio, there are some structural difficulties. Yes, you can do it. What's different, the main ones I'd point out is it's not putting the position on once a month for you. If you're trading QQQ ETF options, those can get called away and that can call your whole position away. So let's just say you owned 10 grand worth of the Qs and you sold a call against it. If the Qs run, That person could exercise against you. And now you have a taxable short-term gain, not only on the option, but also on your underlying position, right?

16:19So there's operational, there's a lot of work to it, but then there's also the tax consequences that trading that ETF option is ordinary income. Getting your whole underlying position called away from you could be a significant taxable gain on your broader part of your portfolio. So this is a way that you can just lay that all off. Let us do it in an institutional manner, be able to trade those huge institutional contract sizes that give you tax efficiency plus the tax loss harvesting. Because that ETF structure, as I mentioned before, gives you that capability as well to carry losses forward longer than other types of holding structures.

16:54How proactive do you have to be in trading the options? Because obviously we know one of the things I've always thought is it's hard to do a set it and forget it strategy with options because the prices are changing based on interest rates and based on volatility and where the stock market is. So how proactive does your team have to be when making these trades? Yeah, so it depends on the products. These types of products actually are on more of a monthly cadence. We've spent decades of years managing these types of products and strategies outside of ETS for major institutions. And we've done tons of research and analysis, building out our models of what's the best worst reward.

17:27So on some of the products, they're monthly. On some of them are weekly. We don't go into the dailies because ultimately, you're kind of in a synthetic equity exposure. and, in our opinion, not getting as much of the juice and the volatility reduction that you want. You do want some vol reduction given their income strategies. But to answer your question, monthly and weekly are our traditional cadences across our products. Right, because you do have a strategy that works on the S &P 500, that's SPY-Eye, the Russell 2000. And then are those similar, I guess, in nature in terms of how the strategy, or are those different because of the size of those markets?

18:03Yeah, no, they're all the same. The model runs slightly different just because the volatility levels of those indices are different. But yeah, we're trading an S &P 500 index option, a Russell 2000 index option. But yeah, generally the same concept, just some subtleties of differences really because the underlying indices. Okay, so you also have a Bitcoin high income ETF, which I would imagine is relatively new. What movie is the line from like, you want to get nuts? Let's get nuts. What is that from? Is that with the Bitcoin? option is, I guess. That's what the Bitcoin one is. I imagine this one is a little different, but maybe I'm wrong.

18:39How does this one work? How does the Bitcoin income product work? Yeah, so generally same concept in a sense, but in order to get the Bitcoin exposure in a 40-act structure, not like a 33-act where all the ETPs live, because we can't trade derivatives and spot Bitcoin all in a 33-act. So there's some structure behind it, but not to go down a rabbit hole. We're essentially giving you exposure to spot Bitcoin through long one of the ETPs as a portion of the holding to what we're allowed to. The other side is creating a synthetic where you sell a Bitcoin index option, put option, and you buy a call option.

19:14It gives you delta one exposure, so full up and down exposure being linked to spot Bitcoin. And then just like the QQQI or the other products we talked about, we're laddering out short covered calls using Bitcoin index options to generate. Biggest difference, Bitcoin vol, 60 relative to an S &P at 15 to 18, a Nasdaq historically at 20. So you're generating 25 to 30 % a year in distributable opportunity just because you're leveraging that Bitcoin vol is just incredible. So are you able to keep that relatively constant too? Or is that a little harder in a strategy this volatile? No, same thing. So we're shifting our options.

19:53I mean, just so for like a quick example, those options can be positioned 15 % to 25 % out of the money. We've seen since we've launched this product and had it out in the last like nine months. And so we're just shifting the amount of overlay percentage and where those options are positioned to keep that consistent. So when vol spikes again, we don't want to overgenerate. And when vol and Bitcoin comes down a little bit, we got plenty of opportunity to still generate income and have upside. By the way, it was Michael Keaton and Batman who said that. I forgot about that, but now I'm reminded. All right.

20:24So, wow. 25 % annualized-ish, give or take the market environment. Again, it's the same type of deal where you are transforming the price return, at least a large portion of it, into income. And listen, some people might say, well, why would you want to do that? Well, maybe you don't. But the proof is in the pudding because you just launched this. at least the proof is in terms of like, you know, adoption, user demand. You guys launched this in October and it's already at$347 million in AUM. Like, holy, people love, people love income. There's no denying it. I guess if you want, if you wanted like to, you know, some people want to dip their toe into Bitcoin or crypto, I guess this would be a way to do that if you were really nervous about the other aspects of it, right?

21:17Yeah, no, we've seen that, Especially more from the advisor side of like client demand pushing, like, I want to own some crypto in my portfolio. And like, you missed it at 60, then 80, then 100, you know, random 110. You're like, what's the deal? This is a way to kind of dip your toe, get a little bit of that exposure for clients. But know that at least you got, you know, some income being generated off the amount of volatility if a trade sideways or slightly goes down. You got something there and you're not just, you know, betting on it going to 200 ,000 or, you know, a million depending on whose price target you follow.

21:46Yeah. And this goes without saying, but it's obvious that these yields aren't based on par. So the price of the underlying goes down. Yes, you're getting a high yield still, but you're not getting as much income. Just had to throw that out there, obviously. Yeah, yeah, yeah. Well, wait, you are getting as much income. It's just the total return is going to go down because the price is going to get crushed. Well, that's what I mean. The percentage, if Bitcoin goes from 100 to 50, then you're still getting a 30 % yield. Your income gets cut in half. Yeah, yeah. Yeah, that's what I'm saying. Exactly.

22:14Yeah. The best way I've explained this to some people over the last decade or two has just been like, think about it like a real estate position, right? You're building your house is going to fluctuate, but your rental income is going to be able to come in. And so over long periods of time, your underlying appreciates, but over short periods of time or different timeframes, your underlying can fluctuate. That's the same in any one of the 12 products that we have here is, right, you're using that volatility as a way to generate the income from the underlying. But that underlying exposure core holding S &P, NASDAQ, Bitcoin, right, will fluctuate with the price of those reference assets.

22:49We were talking with Todd Sohn the other day, and he has a great chart showing some of these single stock levered ETFs. And listen, if you want to trade with leverage, Apple, a product like that makes sense, right? Like it's less complex. It's the easy button. It's easier than buying options. But is there not a line where it's like, come on, guys. So the chart that I'm describing is it's market cap versus date launched. and the big boys, the Apples, the NVIDIAs, the levered ETFs were launched a while ago. And now they're going downstream and the market caps are getting smaller and smaller to the point where you see like a levered Regetti and some of these quantum names.

23:40It's like, all right. So with that, I ask you, is there no limit to what sort of price stream you will turn into income? Short answer is no, there is a limit, right? I mean, as an institutional manager, right, you have to be cognizant of underlying liquidity of that underlying reference, you know, asset that you're exposed to. And at some point you're going to max that liquidity. The single stock levered, you know, is not something we'd ever plan. We just don't view those, you know, as something that ultimately is as beneficial as, you know, building more structural long-term wealth. But for us, I mean, yes, we're exposed over 12 products right now from gold to Bitcoin to real estate.