Talk Your Book: Yield at What Cost?

0:00Today's Animal Spirits Talk Your Book is brought to you by STFM.com to learn more about their two tactical growth strategies, the TUG, T-U-G, STF technical growth strategy, and the TUG and STF tactical growth and income strategy, both ETFs. Come or check out stfm.com to learn more. 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.

0:43Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:51On today's show, we're joined by Jonathan Molchan. He is a managing partner at STF Management. And we got into trend following and option overlay strategies of the NASDAQ 100, which has been a very popular corner of the market. I think what's interesting about what Jonathan is doing is he's taking a different approach to generating income on top of the trend-following model. That we haven't seen. No. It's also interesting to see people from the hedge fund world get into the ETF space. Yeah. Because this is the kind of strategy you would never have seen in an ETF in the past. No. No. We didn't get into this on the show, but he spent time at SEC Capital and Millennium and to Ben's point.

1:28And a theme that we've been talking about on other shows is the ETF milestone of$10 trillion in assets. It's not just index funds. In fact, a lot of the growth in the market is coming from active strategies like this. And the ability to do it in a wrapper like this, that's liquid and tax efficient, and you're able to put all sorts of different interesting strategies is something that's unique and new and interesting. Yeah. So these strategies are starting with the index as the baseline, but then it's also adding a tactical overlay and trend following. Then it's also in the other strategy, the tug in, it's adding an income options overlay as well.

2:04One thing that we got into on the show at the end of it was what might happen to the income being generated on a lot of the popular strategies in a falling rate environment, which is something that I think is not being appreciated by investors in the market and an interesting consideration for those that do. So with no further ado, here is our conversation with Jonathan Mulchheim.

2:33Jonathan, welcome to the show. Thanks for having me. For the audience, just if you don't mind, give us a quick 30-second background. How'd you get here? Who is STF? What are you trying to accomplish in the market? Sure. So STF Management is an ETF issuer based out of Texas. We are focused on active ETFs that complement traditional asset classes, but with an innovative twist that help investors remain invested through different market cycles, as well as solving for the challenges associated with generating consistent current income. We do that through two ETFs, TUG-TUG and TUG-N-TUG-N. These are what I call the third generation of options income ETFs that have moved from a passive underlying passive income to a passive underlying active income to now fully active and touching all asset classes while solving for that income need.

3:31What does STF stand for? Simple, transparent, and focused. Okay, not bad. Okay, so like you said, the first two option-based income strategies, I guess, are pretty well known. So how does yours differ from those? What are you trying to expand on? Sure. So about 10 years ago, I became involved in the UTF industry after starting my career on the hedge fund side. There was a collective curiosity to see if options-based strategies could gain traction within the retail investment community. And what Tug and TugN do differently? So Tug is basically the underlying benchmark. So if we were to think about passive, say, buy-rider covered call products, they're tracking the S &P, the Nasdaq, or the Russell 2000 to name kind of the three big ones.

4:23So what TUG does is it can toggle between an allocation to the NASDAQ 100 and a full replication. But in times of downtrends or heightened market volatility, it can toggle into U.S. treasuries to provide a risk-off component without incurring the cost of a hedge like many hedged equity products. So the key difference is that unlike a passive index product, it has the ability to de-risk in times when maybe you don't want to be 100 % long stock. In regards to TugN, the underlying is the same. The difference there is that it has an active option overlay. And unlike a typical covered call product, it's selling a monthly call spread.

5:10The benefit of that is it can still support the high current monthly income and the distribution. And right now, it has a 12-month trailing yield of 12%. But it can help in reducing capping that upside participation, unlike a passive product can. So, you know, one, you're solving for income. Two, you have the ability to remove the option prior to expiration if the market's moving higher. So you can increase that participation. And it also allows you in changing market environments to be able to lock in those gains and close that option out. All right. So let's stick with Tog and then we'll get to Tog again because you just said a lot that I want to dive into.

5:52So a lot of the hedged products were really built for bear markets. And the reality is bear markets are fortunately few and far between. They exist for sure, obviously. But the challenge is for some of these products that have come to the market, certainly after 08 and even through pick a year, they weren't able to survivable market. And if you can't survive the upside, then you're no good to anyone during the downside. So how is your product accomplishing both surviving the upside and being able to potentially survive the downside as well? Right. So in regards to Tug, it's looking at moving averages, rates of change, market volatility.

6:38And as a trend turns south, it has the ability to, in general, regardless of market environment, there are three scenarios that you'll see the portfolio composition. So you'll be 100 % stock. And let's say the market starts to slow down and then roll. We can go 50 stock, 50 bond. If the market continues to roll, we can maintain a position of 10 % stock, 90 % treasury. So if we want to look back in time, and this is just looking at the market, this has nothing to do with the ETF. In 01 with the dot-com, it would have taken you almost 15 years to recoup that same level of principal balance. That's a long time.

7:22So our ability to de-risk is the key difference. What I will say is that the biggest risk, let's just say with the passive covered call strategy, it's not necessarily that your downside is essentially unlimited, less the premium received. It's that it could potentially take you forever to recoup the principal loss in the sell-off. So we'll use an example here. So let's say the VIX is at 20 and you sell an at-the-money call. Typically, VIX divided by 10 is the premium you'll receive for a one-month-out expert. So you brought in 2%, the market's down 20. So you're down 18, the market's down 20. Alpha.

8:14So now the VIX is at 40, four weeks later. So you bring in 4 % and the market has a V-shaped recovery and now the market's flat. So you're down 14 and the market's flat. That's the biggest risk to these strategies is how do you recover the losses? Fast forward to 2022, which was probably the most unique year that I've ever seen. In that year, you saw the S &P down 18. You saw the NASDAQ down about 32. On that back end of that, long bonds were down about 32 as well. So risk off was still risk on. If you then look at, say, the passive SIBO indices, so BXM, BXN indexes, BXM was still down 11. And the BXN, which is the passive at the money on the NASDAQ, was down about 19.

9:11So you participated in 50 to two thirds of that downside. But if you look at what happened 23 to now, they've only participated in 50 % of their recovery. And what I find interesting about this is that even if you were to use Tug as a asset allocation benchmark, the way in which, you know, tug in with that options program operates, it's participated in 90 % of that total return over that same timeframe. So that's what I like to highlight is yield at what cost? How much total return are you potentially sacrificing while chasing that double-digit yield? I'm curious, a couple things on the strategy.

9:58First, I guess, how often do you look at your trend signals to determine whether to have risk on or take risk off? So that's monitored daily and throughout the day. That being said, there are guardrails in place to not overtrade and for turnover to not be 4 ,000%. You're looking at probably four to five rebalances annually. In a quiet, sleepy market, you could see maybe one or maybe none. So the option overlay is something that you're obviously very intimately familiar with. What do you think are some of the differences between the spreads that you put on versus some of the traditional strategies that have gotten really popular in the marketplace?

10:41Sure. So the idea behind the spread is married to the underlying structure of the tug model. So being that it has the ability to de-risk and has the ability to also source income from treasuries, if in that scenario, the spread can still support a 1 % distribution. The benefit of the spread versus, say, just a straight at-the-money call is at-the-money call, it's going to be short 50 deltas. So basically, what that means is for every 1 % move higher or lower in the market, you're participating in 50 % of that. We're short 20 to 30 deltas. So we're increasing the upside capture when the market moves higher.

11:30And when the market moves lower, we don't necessarily depend on that short call to buffer the downside to the same extent, because we can then go out of 100 % stock into 50 stock, 50 bond. So I'm curious how much of this is rules-based and how much of this is just you understanding the options market? So I would say the majority is rules-based. there is a bit of an arc within options and understanding when certain moves and changes in market structure don't add up. I mean, there's been no shortage of events in the last two, three years since the funds launched. They hit their two-year track record in May of this year.

12:14So the idea here is to support the distribution, reduce the upside cap, and seek to track your underlying benchmark more closely than a passive strategy can. Set it and forget it. People talk about buy and hold. We kind of talked about the advantages of tug versus buy and hold and its ability to de-risk, not participate all the way down, and then hopefully recover on the way back up. The idea of the option is to be complimentary and to reduce that negative contribution to the total return. For the underlying holdings, Are you using ETFs or individual stocks? So on the stock component, we fully replicate the NASDAQ 100.

13:02Okay. So the trend following, was that at the index level or the stock level? And how does that work? So it's at the index level. So Tug was created as a way to combine two uncorrelated assets. And that over time, you could smooth the return profile of a risk on asset and a risk off asset basket. it. So in these two funds, the risk assets in NASDAQ 100, the risk off asset is the least correlated US treasury, regardless of duration. The twist - Oh, sorry, sorry to interrupt, but so that the bond piece can change then depending on the environment. You don't use the same bond piece for every sell-off or every downturn.

13:46That's correct. It's the least correlated to the equity complex. And the reason for that was visible in 2022, where a long-duration Treasury ETF participated in the same downside as NASDAQ 100. Caused the downside. Yes. And especially with inflation being front and center over the past couple of years, historical research shows that anything 10 years and farther out, that correlation actually comes in materially to the point where it's a detriment to the portfolio. I think this is the advantage of Tug in its purest form being an innovative solution to the traditional 60-40 portfolio. Because not only is it helping investors remain invested and not capitulate with market volatility, but it's also solving for the risk-off piece.

14:48So maybe right now you want to be a 90-day paper. If that changes, maybe you're in seven-year duration. Maybe at some point in two years, you're in 20 to 30 year duration. But so it's solving for those two pieces. And then Tug End takes it a step farther and gives you income without, you know, while seeking to not sacrifice that to a return. I'm curious on the Tug End piece. Do the tactical rules supersede the income strategy? So like if you're totally risk off and you're 10 % in stocks and 90 % in bonds, obviously that income piece is a lot smaller, I would imagine. No. So with TugN, it actually is able to collateralize all of the underlying securities, both equity and fixed income.

15:30So if we are in a sideways to down market, we are risk off, we can still support that distribution to the selling of the monthly call spread. So then in theory, the investor is benefiting because they're still supporting the income need on a monthly basis, and they're getting paid to wait for the market to rebound. And that's the big advantage of TUG is that it's removing the emotional bias from investing in the market. It's saying the model is taking care of when do I sell, when do I get back in? because those are two very difficult decisions for any investor to try and make. So just getting back to the trend following, I'm not exactly clear how it works.

16:20So the trend is measuring is being measured at the index level, but then you've got the replication of the individual securities. So is there an in out or is it gradual with only certain holdings? How does How does that happen? So from the holdings perspective, the idea was to give investors the same core exposure that most of them already possess. So exposure to NASDAQ 100 and exposure to US Treasuries. At a single stock level, there is no consideration. Now, the shift between how the portfolio is allocated is gradual in many cases. So you could be 100 % stock, you see a move and the market moves lower, you'd probably get a 50 stock, 50 bond.

17:11If it continues lower, that's when you would go to 10 stock, 90 bond. And it would take a catastrophic event to see something where you would shift from 100 to 10, 90 or inverse. So the moving averages, you said you're measuring them as zoomed in as even daily? So they're monitored daily, but they go from anywhere from three days to 200 days. What about an environment like 2022 where there's just a lot of sloppy sideways, where the longer-term trend is sideways, but the intermediate trend, there's just a lot of bear market rallies and you're in, you're out, you're up, you're down. What about an environment like that?

17:51So when stocks and bonds become more positively correlated, that's obviously a serious challenge for a trend following model that's toggling between risk on, risk off. And operating within the constraints of an ETF, unlike a personal account, you can't go 90 % cash. So there still is that risk aspect within the fixed income complex. What I would highlight though, is that since inception, Tug has outperformed despite 2022, the traditional 60-40 of S &P and Bloomberg Ag. So I was going to ask that. Is that your benchmark that you think investors should look at? Is this is more like a 60-40 portfolio in terms of, I guess, return expectations and risk expectations?

18:40That's correct. So this is looking to give you a smoother return profile so that we can avoid the most volatile days and in that desire to continue to remain fully invested throughout different changing markets. If you were to look at the lifetime of the backtest or even since inception, do you think that 60-40 is the right benchmark? Are you close to, on average, 60 % fully invested? Where did that benchmark come from? So based on if we were to go back over time, a 60-40 is probably the most widely understood or followed benchmark. We also use that because of the recent rule change for a more broader benchmark as a comp for all ETFs.

19:30Since inception, you're looking at probably a 70 % to 75 % on average allocation to stocks. stocks. That makes sense. I'm curious why you chose the NASDAQ here. Is there a certain, um, is it, does it trend more? Is it better for trend following rules? Why the NASDAQ 100 as opposed to like the S &P 500 or Russell 3000 or something like that? Sure. So the two ETFs were actually born out of a SMA conversion. Oh, interesting. Tell us about that. So tug and And it's, you know, at the tug level has been widely followed and used for a little more, about a decade at this point in other, you know, SMA type models, signal research, et cetera.

20:14And, you know, it grew to a point where the idea was to open it up to the broader retail community through two ETFs. TugN is brand new. It took tug and then added the income component. What's great about the tug approach is that it's basically a widget maker. That risk on component can be switched out in other strategies or products. So the legacy SMA was the NASDAQ 100 and then long duration bonds. Obviously, as we came into launch and correlations and bonds and stocks went to near one, that's when the legacy bond allocation was kind of brought into a more adaptive allocation and being able to toggle across the curve.

21:05You know, I'm not surprised to hear you say that it was an SMA conversion because I was surprised to see that you've got almost$200 million in the strategy in – what has it been? Two years? Yeah, you said it's your anniversary. That's pretty impressive for a tactical ETF. So are part of the flows due from legacy holdings converting? That is true. But we have also seen for a new product that is active, which many ways, you know, extends the period of time that investors want to see the ETFs perform. Net creations in both bonds has been impressive, even in this market environment of tremendous uncertainty.

21:48What do you think is a fair period for people to judge the performance of the product? Because trends don't change on a dime, especially the type of upward trend that we have. There's a very much a buy the dip mentality. And so you can go through a sideways to corrective action and still be in a longer term uptrend. So what do you think is a fair, like, do you need a year? What do you think is a reasonable time period for you to judge? I guess that'd be market dependent. So maybe it's not a fair question. But when people ask you, how do I judge your performance? What do you say to them? So, you know, back to 22 being incredibly unique, if we were to just look over the last year and a half, I think that's a pretty decent timeframe to look at.

22:33And why I say that, you know, COVID is a tough timeframe to show, but the last year and a half is interesting because is we see rates go from effectively zero to five, trend sideways, and now we're in this rate-cutting environment where there's no shortage of declining interest rates. If we were to look at any timeframe before COVID, I mean, it was four decades of lower rates. That's not a fair way of looking at how a trend-following model would look. You've got lower rates, rising market, and you're just long the market. So you got increasing rates, flat rates, lowering rates the last year and a half.

23:21You had a ball event that hadn't been seen since COVID. So there's a healthy mix, and that's all alongside inflation. Now, inflation's come down, but it's still relatively high. And if you look at the performance there relative to the S &P, over this timeframe, the S &P is up about 53%, Tug's up about 55%. It's outperformed the 60-40, which is up around 36%. And what I think is even more interesting is that Tug N is up about 50 % over the last year and a half. That's a lot. Jonathan, credit to you for not saying full market cycle, because that's a phrase that I think people use, and I still don't know what it means.

24:07I'm curious how you would, if an advisor or an individual investor came to you and said, hey, listen, we're interested in these strategies. We like the tactical approach. We like the rules-based nature. We like to have an equity-based approach that's a little more cognizant of volatility. How do you help people decide between the two strategies in terms of the pros and the cons, and which one is better for which type of investors? So there are still some investors that options are not the right solution for them. And eventually, we're going to come to a point where with the plethora of products that have come to market in the last few years, that spotlight is most likely going to come out and how options-based products are actually achieving what they are selling.

24:55for someone that is a, you know, let's go back to 60-40. This is a product that can sit kind of on that 50-yard line. So it's taking care of that incremental rebalance for you. The income with TugN can, you know, for every 10 % allocation in a portfolio that's allocated to it, you're increasing your portfolio's yield by, you know, greater than 100 basis points. So there are different ways of looking at it. Sorry. So you're talking a double digit yield on that then based on the option income. Right. You said that there was to be a spotlight to come on some of the strategies. What do you mean exactly?

25:33So as rates come in, the pricing of call options is going to change materially. And let's use any of, it could be products that provide upside with protection, it could be, let's just start there. So as rates come in and the pricing of call options begins to normalize to traditional levels, the call at the current level is going to bring in less premium than it has been during this higher rate environment. So does that mean less upside protection or less downside protection or both? To maintain the similar downside protection, that means that the call that is sold needs to come closer to at the money or closer to where the market currently sits when it's put on.

26:24So, you know, 22, 23 were very interesting because in many instances, you could sell somewhere between 4 % to 6 % out of the money and fully finance an at-the-money put. And it didn't matter if you were looking at home builders, utilities, real estate, or an index. The historical norm is that in order to satisfy 2 % downside fully protected would be an at-the-money call. So as this interest rate dynamic starts to change and REITs come in, it's going to be more difficult to provide that same upside over the last few years with that same downside protection being so tight. Because options are based on interest rates and volatility, so in a lower rate environment and maybe a lower volatility environment, those options are either going to be more expensive or there's not going to be as much range.

27:23Like you said, it's going to be harder to cap the downside while also giving you more room to run on the upside. That's correct. So two things to point out. From 2003 to 2006, in a Fed hiking world, buy rights, even passive buy right indices, outperformed the historical annual return of the S &P every year. They were double-digit returns. So they could satisfy that yield. Now, in declining rates like what we just saw coming out of COVID, they could not. So a rising rate environment actually benefits the overwrite. Declining rate environment is more difficult, one, because equity markets tend to appreciate considerably when rates are low or declining.

28:17And the price of a call option declines, relatively speaking. So that means for that same protection in a hedged product, your upside is reduced. So in other words, if you were able to get 100 % downside protection with 80 % of the upside in the previous regime, now you're saying you get – if you're still trying to get that downside protection, maybe you can get – we're making up numbers, 65%, 70 % of the upside, whatever it is. Not as much as you can get when interest rates were higher. That's true. Okay. All right. The actual levels remain to be seen, but as the price of calls comes down and skewed normalizes, the price of a call relative to a put at the same level is going to be vastly different than if interest rates are at two, two and a half versus five.

29:04So how does that impact the income on your tug-end strategy then? What does that do to your options? So the benefit of this spread is that it can change based on rates of change and market volatility. So as let's just say the market moves higher and yield or volatility comes in, that spread will widen. So that outer wing that you're buying to kind of cap your liability in a running market higher will be cheaper and will still allow you to seek that full 1 % or greater premium received of the NAV of the fund. And if we see the inverse happen and volatility goes up, then it's naturally being supported because of the spike in volatility that directly impacts the price of the options.

30:06Okay. Very good. Jonathan, really appreciate you coming on today. If people want to learn more about your strategy, how do they find you? They can find us at stfm.com. They can also So Google T-U-G or T-U-G-N. We are always around and love talking to investors and, you know, really focused on the education component of, you know, the benefits of tactical and this active approach, as well as what we think is the next generation of sourcing income from options. Awesome. Thanks, Jonathan. Thank you. Okay. Thanks again to Jonathan. Remember, check out stfm.com to learn more about both of these strategies.