Talk Your Book: The Next Generation of Income Strategies

0:00Today's Animal Spirits Talk, your book, is brought to you by Janice Henderson Investors. Go to JaniceHenderson.com to learn more about their whole suite of structured income ETFs. It's JaniceHenderson.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. All opinions expressed by Michael and Ben are solely 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.

0:32Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:40Welcome to Animal Spirits with Michael and Ben. Michael, I feel like on these Talk Your Book episodes, we bring some knowledge to the table, but I also feel like we are learning along with some of these. Sometimes we come in bald. One of the things that we've learned, I think, a lot in the last couple of years is how structured products work. And this isn't like an area of expertise for you and I. We were not coming up in the structured product world. And these auto callable ETFs and the option income ETFs have just exploded. I will admit the auto callable idea was kind of a blind spot for me.

1:14This is not something that I think many investors had ever heard of before or used. and it's a very interesting way to sort of transform your equity exposure.

1:24Michael Batnick:There is a reason why this category has exploded. I'm pretty sure I said on the show today, we'll record this intro, I guess a week after the recording, but we got to do a rebrand. Imagine what this category can do if it was named something that actually had a hook. This means auto callable means nothing to anybody. And yet, I don't know how fast it took to get this to a billion dollars, but what's the ceiling on this? How about automatic income? 50, 100. Yeah, that works. Well, automatic is tricky for compliance. I don't know. We'll go to the lab. Auto income. Okay. So we talked with Mike Laughlin, who's the executive director and ETF client product specialist at Janice Henderson.

2:03We've talked to Mike before. It's always good to talk to someone who's in the weeds on this stuff because you and I just pepper him with questions and to learn more about how these things work. And it's pretty interesting stuff. And this is stuff where I think before you go into something like this, you really do have to understand how these things work.

2:20Michael Batnick:Yeah, there's a lot of moving parts. Yeah, there really are. So here's our talk with Michael Offlin from Janus Henderson. Mike, welcome back to the show. Great to be here, Michael. Ben, love the opportunity. Appreciate it. So I was talking earlier with somebody in my office, a colleague of mine, and we were talking about like the evolution of our industry and our business. And on the asset management side specifically, 2010's area was kind of boring. And it seems like this is the roaring 20s, both inside the wealth management industry on our side, on the REA side, in terms of everything that's happening with technology, but also on the asset management side.

3:02Michael Batnick:I mean, this is absolutely the roaring 20s. One of the areas that we're going to get into today is the structured product market, which is something that I'm sure there is some sort of regulatory change code, whatever, that allowed these products to go into the wrapper. And they've made a massive dent. And I actually saw that Vanguard's share of the overall ETF market has stopped going up for the first time ever. And part of the reason is because of products like these and others. That was a long introduction. But why have structured products in particular gotten so popular? Well, let's hope 2029 ends differently than 1929.

3:41One working mental model I have for our industry is that anything that can be ETF'd will be ETF'd. And I think this is the current leading edge of product development, if you will. The ETF wrapper itself is a technology, and that technology has improved over time. And as it improves, it allows more and more parts of the market to be incorporated into the wrapper. And so structured notes are an example of that. The structured note market itself is 40 years old. However, being able to incorporate it into an ETF is new. I think advisors and clients value structured notes because investing is inherently an emotional and uncertain activity.

4:21And anything that can provide definition around investing, and in some ways, that's what these structured products are structuring, is defined risk and outcomes is something that people inherently are gravitating towards. Traditionally, advisors did these as one-off notes, which was great for those clients, but it is operationally intensive for an advisor. It was something that was typically done in brokerage, typically only done for larger clients. And we think bringing it into the ETF wrapper is going to allow advisors to reduce that operational burden, use it in more places across their book.

4:56The outcome you get from these strategies is, I think, pretty easy to understand for people in grasp, right? You could get some sort of yield from something you could get downside protection, you could get sort of a, you know, you got a collar on this side and a collar on this side. So it's just maybe more defined outcomes. So people understand, I think, what you get. But I think what goes into these strategies and products is a lot harder for people to understand. So like, maybe you could just tell us from a broad general perspective, like what actually goes in, you know, because I know that there's a lot of paperwork for doing these products when you're dealing with options and swaps?

5:29It's a lot of behind the scenes stuff that has to happen for these things to work. It's a lot of behind the scenes and it's a lot of ongoing monitoring from an advisor's perspective as these different structures. And it depends on what type of note we're talking about. On the growth side, you have buffered notes that then became very, very popular buffered ETFs. Now we're seeing more of the income notes, something like an auto callable or a stability note that are making their way into the ETF wrappers today. But the underlying physical notes are operationally intensive for both advisors and actually asset managers.

6:00It's one of the reasons, at least in the products that we have launched or are launching, we've been sort of replicating those exposures actually through swap rather than when actually owning the physical note. But there is a lot of complexity and operational pipes and plumbing that go into this. And I think that's, as those things get better over time, it's what unlocks more and more asset classes for broader wrappers like the ETF.

6:22Michael Batnick:So the auto callable category is relatively new to the ETF market. And it's huge. I don't know how many billions of dollars it is already, but I got to tell you, now that you have anything to do with this, it could use a rebrand. How is anybody supposed to know what an auto callable anything means? And please explain yourself. Yeah. The language for sure is not friendly, maybe even unfriendly. I think though, So if I was to sort of boil it down in the simplest way, there are investors who really want protection from severe market declines and uncertainty. And auto callable investors are basically taking the other side of that.

7:00To use maybe an apropos analogy here, it's like insurance in a way. If you're a homeowner, you have homeowner's insurance. You pay a premium to an insurance company because there's a risk that you don't want to bear, which is the risk of your house, say, burning down. Most years, your house doesn't burn down. And at the end of the year, you're not unhappy that you paid that premium. You're happy that your house didn't burn down. But the insurance company is earning that return, earning that premium for bearing the risk that you do not want, right? Because as an individual, having your house, in many cases, a home is somebody's largest asset.

7:34Having your house burned down is catastrophic, both personally and financially. And so you basically offload that risk to an insurance company who earns a premium. And almost by definition, you overpay for that, right? The insurance company's earning a profit. You're overpaying for sort of like the probability weighted outcome of your house burning down. But you're okay with that because the outcome is so severe. I think thinking of this like insurance is pretty helpful. This is income that is not duration. It's not credit. It's not dividend. It's not illiquidity. it's almost like it's underwriting income if that helps and makes sense.

8:14It does. So let me try to explain it. Let me know if I'm on the right path here. It's essentially the risk of these auto callables is the tail risk, right? So there's some sort of downside barrier, whatever it is, 40%, 50%, whatever your number is. And I'm guessing the lower the drawdown level, the higher the payout is going to be or the higher the, but it's, so let's say you did an auto callable and the downside is 50 % losses. If the stock market were to fall greater than 50%, that's when the risk kicks in for these strategies, correct? That's exactly right. The big risk. Yes. So functionally, you can think of the structured notes as a package of options.

8:49And so in an auto callable, as an investor in the auto callable, the income comes from basically selling two main options here. The first is you're basically selling an at the money call. And that's where the term auto callable comes from. Because if the market goes up over a specific time period, that position, that structure note is basically called away from you. And then the other thing that you have sold is exactly what you described, Ben. It is a barrier or a down and in put. And so if you struck your barrier at minus 50, and let's say the underlying asset goes down 49.99%, well, you're fine.

9:26If it breaches the barrier, though, now you're knocked in basically back to$1 on that. And so that's why it's different than a buffer in that way. It's different than just a short put in that way. It is a true contingent barrier put option. And that's roughly the structure of an auto callable. Because that risk exists, you don't want to own just one of these, right? You want to own a bunch of them at different time series. It's essentially like you're building out a private equity or venture capital portfolio where you want different vintage years or vintage weeks or months, however you explain it.

9:59Exactly. And that's a benefit of the ETF wrapper as well, is you can diversify through underlying. and that can mean type of note, but it can also mean what that note is referencing, whether that's an index or individual stocks, a basket of individual stocks. So you want to be diversified across your underlying. You want to be diversified through time so that all of your notes are not observing at the exact same point. You want to be also diversified through counterparty, so the different banks that you're working with. And so it's all designed to say, are we eliminating risk in these structures?

10:31No, we're not eliminating risk, right? The income is not free yield. It's income for taking on a defined risk. But by doing it in an ETF wrapper, we can hopefully make the portfolio resilient to the drawdown of any one name or any short time period, like a Liberation Day, for example.

10:48Michael Batnick:So how do these different ETFs work? Like, all right, I open a menu and I'm looking at what exactly? So it does depend on the ETF, what the underlying sort of reference asset is, we have launched a couple of products in the space, JELM, which stands for Janus Equity-Linked Moderate, and JELH, which stands for Janus Equity-Linked High Income. For our strategies, we have a pretty broad opportunity set in what we can create autocallable notes on. So we can do it on individual indices. We can do it on individual equities. We can actually do it on a worst of basket of indices as well. Today, in our strategies, all of the notes that we have are actually on individual equities.

11:33And there's a reason for that. If we look in the market right now, cross-correlation among equities is near historic lows. Or said another way, idiosyncratic risk in the market is high. And when you're functionally monetizing risk or monetizing volatility, we think you get paid well today to sell that idiosyncratic component relative to the index. And so if you were to look at our strategies, like if we crack them open from the ETF wrapper, what's under the hood? You're talking about 25 or 30 auto callable notes on 25 or 30 different individual equities, and then staggered through time so that they're not bulleted at the same date.

12:15Michael Batnick:All right, let's take these 25 or 30 names, whatever the case may be. And you're comparing an equal weighted version of these actual stocks versus how the ETF performs on a daily basis. What is actually happening? Are you tracking the stock performance? Is there some sort of the price return is being transferred to an income source? How does this work? Because there's an auto call feature here, you're not paid for the upside of the stock, right? If the stock goes up 10 % or 100%, it's irrelevant. You're collecting your coupon. And the way that you collect your coupon is if the price of the stock stays above those barriers on specific observation dates, you get paid your coupon.

12:55And so that's basically the name of the game here is we're trying to create a portfolio of stocks where the value of that stock is above that barrier. So we continue to get that coupon through time. It's a little different than how a fundamental manager might look at building a discounted cashflow model or an intrinsic value model for a specific name because they're trying to understand over a defined time period, what's the upside of this. For us, it's much more about how do we avoid large drawdowns to the best of our ability, but really create a portfolio that's diversified and continues to pay that coupon income stream.

13:28How would you compare this type of strategy to one people are more familiar with, like selling call options? That's kind of the option income strategy a lot of people have really grasped in the last couple of years. How would you compare the attribution or how these things perform or look? Maybe not perform, but you know what I'm saying, the risk profile. So in a covered call strategy, the defining feature of that is you still actually own the stock. You generally will have still a pretty high correlation. What you've sold away is the upside exposure. So for you, a good environment is flat to kind of slightly up.

14:02And where you lose is kind of in that explosive bull market, where that position is called away from you. But the defining feature is still that you own the underlying stock. Here, the source of your return, again, is kind of that underwriting premium, if that's an easy way to think about it. So a flat to kind of like moderately trending market is still good for us. But here, what we are trying to avoid from a risk perspective would be like a deep, broad and persistent sell-off. That's the kind of a market that really stresses an auto-callable structure like the one I described. So like selling calls, you're giving up some of your upside, right?

14:39But you are sort of protected on the downside. And auto callable, if there's a raging bull market, that doesn't mean you're totally giving up on what's going on in the market around you. Yeah. And I would say in a covered call as well, you're only protected on the downside to the extent of your premium income, right? So you still own the stock, so you still have the downside below what you earned in premium. In an auto callable, and this is what differs from a buffer as well, where sort of a buffer is like linear protection. In auto callable, you're protected up to that barrier. And again, to your point, then these barriers can be 40 or 50 % below the current market price.

15:13So they can be fairly deep. But that's the difference is actually in a covered call strategy, you will recognize, you'll start to take on losses potentially earlier because you're only protected by the premium income.

15:27Michael Batnick:We've been zooming in. Let's zoom back out. An advisor gets a question from a client, hey, I heard about these auto call balls. What are these things? What's the simple elevator pitch from an advisor to a client? Because it sounds like a lot of what we've been talking about is pretty complicated. It is complicated. I think for an advisor who's looking to explain these strategies in the simplest way possible, I would lean on the insurance analogy, but I would help people understand that they're earning a return basically to bear a risk that somebody else doesn't want for some reason. So most income strategies, you're paid for owning something.

16:07You own a bond and you get paid a coupon. You own a stock and you get paid a dividend. Here, you're again paid for underwriting something. And I think that framing is probably the simplest for an individual client. When we think about attributes of these strategies, they can have lower betas than other types of strategies because you actually don't, relative to a covered call, like we were talking about, you don't actually own the underlying stock. You're just monetizing that volatility component. But I don't like that language for a client. I think relating it to, you're basically underwriting risk that somebody else is willing to overpay to offload, I think is, or in our opinion, overpaid offload is the best framing.

16:50I like your analogy of, think about you as the investor, you're the insurance company, right? And to your point, these things, I don't know if you even call it mispriced, but you're right. People are willing to, it's the same thing with call and put options, right? They're not priced the same because certain people want to hedge risks in certain different ways. So that mispricing or, you know, that difference just always exists, correct? For that really strong tail risk. Correct. Yes. Whether you want to bring in something like loss aversion, The pain of losses is felt greater than the joy of gains.

17:21But you will see, especially for severe market events, that is especially painful for investors. And so systematically, they will pay more for that downside protection than the expected value of that protection, again, in our opinion, because of that. It's the same idea in my house. I pay more to my insurance company than the probability weighted value of that insurance, but I'm happy to do so because that event is so catastrophic for me that I want to eliminate that risk. So when these auto callables come due, is it more efficient to just reinvest it back into new ones or is it more efficient to pay out to the investors in income?

17:58How does that work? There are specific observation dates where you're comparing the price of the underlying asset to its inception price. If you get all the way to maturity, as long as you're above the barrier, you get your full principal back. So in our ETFs, when that happens, what we basically do is look across our opportunity set of individual names or indices and say, okay, we have an income target that we're trying to achieve in this strategy. We're trying to do that in the least risky way possible. We just got principal back from a note that matured. How do we deploy that across this entire opportunity set to basically hit that income target in the lowest risk way possible?

18:38And there's an optimization that occurs as part of that, but that's functionally the process for what do you do when you either get a coupon payment in or when a note matures.

18:49Michael Batnick:So before we get off this topic of the structured note marketplace, could you describe good and bad environments? Like when would a client or an advisor be upset? Like what would be the, oh man, this is not like what I was expecting. So a good environment is, I would say, just flat to moderately up, moderately down. Because in those environments, you're collecting your coupons. And all of your return in these structures functionally is the coupon. So those are the good environments. The bad environment I would anchor around would be a deep, broad, and persistent sell-off. And each of those is important.

19:27It needs to be deep because, again, these barriers are minus 40, minus 50 % in cases. So they are significant barriers. It needs to be broad because if you have a basket of 25 or 30 stocks that you have notes on top of, then you're diversified across different sectors, different parts of the market. So you need basically the entire or large portion of the market to get tagged. It needs to be a broad sell-off. And then it needs to be persistent. It needs to exist through time such that multiple of your notes are missing their coupon payment or maturing below their barriers. So that's really the most stressed market that you can imagine is a deep, broad, and persistent sell-off.

20:08Could that happen? Absolutely. But we've tried to design products in such a way that they're as resilient to that outcome as they can be.

20:15Michael Batnick:So just to be clear, if there is a deep air market that doesn't recover right away, these things will be treated like equity or close to it. Yes. There's a path dependency to these. as you get closer to the barrier, the sensitivity to the market increases, which should make some sense. And also as you get closer to an observation date, the sensitivity to the market increases. Imagine you have an auto-callable note on stock XYZ and it's incepted at 100 and the stock goes to 150. Well, your delta is basically zero because at that point, you're so far above your barrier that you're going to get your coupon and it's going to get called away from you.

20:51But as you trend down closer, let's say the barrier was minus 50 and the stock goes to 100 and then it goes to 90 and then it goes to 70 and then it ultimately goes to 51. Well, all of a sudden now you have a lot greater sensitivity right around your barrier, your delta and below the barrier. Delta is one, right? It is like owning a stock at that point. And so this is what makes these, to your point, complex strategies and why we think you want to have professional management folks that understand how to model the different option outcomes. But it is a path-dependent structure where your sensitivity will change through time.